Bernanke misunderstood? Chidambaram silenced? - The Honest Truth By Ajit Dayal
Investing in India - Honest Truth by Ajit Dayal
Bernanke misunderstood? Chidambaram silenced? A  A  A
21 JUNE 2013

In mid-2005 at a "we love India" conference in New York Palaniappan Chidambaram, then the Finance Minister of UPA-1, got up to address the audience. It has been a year, pointed out the Finance Minister, since the UPA has come into power. And look at the great progress we have achieved, he said proudly. The Finance Minister of India went on to rattle how the BSE-30 Index had surged by some 50% in one year and the INR had gained 4% against the US Dollar. Investors who were disappointed to see the election loss of the NDA in May 2004 (the BSE-30 Index had lost 20% in one week) were proved wrong, gloated Chidambaram. The UPA was the government that would deliver - and it supposedly had.

Graph 1: UPA spins an Indian rope trick on the BSE-30 Index in 2004/2005
Source: Bloomberg

I recall my comment then: it is dangerous for Finance Ministers to gauge their success (or failure) based on market movements. But those were happy times when India was part of this adored BRIC myth. How many politicians would wish to be modest when immodesty is thrown at you? Probably equal to the same number of businessmen who wish to be honest when some national resource is being bestowed on them by deals with dishonest bureaucrats and politicians!

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Now, the times have changed. The performance of the stock markets and the INR in his most recent innings as Finance Minister that began on August 1, 2012 is slipping (Graph 2). Is this because the UPA is now seen as the government that cannot deliver? Or is this a personal blow to the Finance Minister and his reputation of fixing things? Or is this decline in Indian stocks due to external factors beyond the control of the Minister and his government? Or could it be a combination of many factors? Well, whatever be the case, the Finance Minister is in good company. He has recently stated that gold is just a shiny metal - and it is no better than brass. People should consider gold to be a dull metal, implores the Finance Minister. Or maybe as dull as the promises made by the tired UPA government to kick start the economy.

Graph 2: Chidambaram's magic words losing their shine - but still better than gold?
Source: Bloomberg

The truth is that while there is a lot of India noise and local failures which the geriatric leaders have not been able to resolve, the real cause of the difficulties for the Indian stock market and the Indian Rupee is what is happening outside India.

Our dependence on foreign stock market buyers is more worrisome than our imports of oil and gold. With all the excellent support from think tanks, policy makers, various committees, and practitioners in the fattened financial services industry, the local Indian investor has lost so much money from investing in the stock market in past boom/bust cycles that they are totally absent from the Indian stock markets. The movement of the Indian stock market is solely a function of what the foreign investor does. Over the past 10 years, foreign investors have been net buyers of USD 115 billion in the Indian stock markets, while local Indians (via mutual funds) have been net sellers of USD 1 billion. During this 10 year period, the Indian stock market has gained about +470% in USD terms. So the foreigners made the right call on "buying India" and the local investors lost the opportunity to make money. (By the way, much of this wonderful achievement of a decimated retail investor base has been accomplished during the reign of the UPA. Maybe the Finance Minister should point that out at the next conference in New York or London.)

What does a foreigner want?

Most of the source of global foreign capital is from pension funds, university endowments, and sovereign funds. They control a pool of over USD 20 trillion and they need to earn a rate of return from investing in India (or gold or emerging markets or real estate or any other asset class) that is benchmarked against their equivalent of "keep my money in the mattress". This global benchmark is the interest rate for the US government 10 year bond (see Graph 3).

Graph 3: Is that a turn in US interest rates after a 30 year decline?
Source: Bloomberg

Over the past 50 years, the interest one could earn from investing in a 10 year US government bond and holding it till maturity was, on average 6.6%. In early 1980, in a bid to cleanse the economy of bad businesses and bad banks, interest rates were raised and averaged 15.8% for the September 1981 quarter (as an aside, please note how this differs from today when Wall Street banks and Indian businessmen want their respective central banks to reduce interest rates to help spur growth!). After all the recent cuts in interest rates since the Lehman bankruptcy in September 2008 and the subsequent global financial crisis, the interest rates on a US 10 year government bond fell to a low of 1.6%.

With interest rates so low - and declining for the past 30 years - the general flow of money was from the western world to the stock markets of the emerging economies, like India. In every decade there was a love for one region of emerging markets. In the early 1980's the investors fell in love with the Latin American economies till they went bust. Then they loved the Asian Tigers till they went bust in 1997. Then they created this 4-legged act called BRIC to show their love for Brazil, Russia, India, and China. That, too, has now been busted. Whatever the packaging and whatever the name on the box, the real reason why emerging markets have done well has been this flow of money. Lower interest rates in USA for the past 30 years translated into a desire to move money to other parts of the world, to help fund the economic development of other economies, which meant better stock market returns in the emerging economies.

On May 22, Helicopter Ben - better known as Ben Bernanke, the Chairman of the Federal Reserve - gave the first hints suggesting that one-way direction of interest rates may be over. On June 19 he said a few things which frightened the markets.

Everyone knew that interest rates cannot tend down to zero.

Everyone knew that interest rates would stop declining and head upwards.

Now Ben Bernanke has given them a time frame when interest rates will start increasing.

Now, everyone is sure that the era of lower interest rates is over, though no one knows where the interest rates will head to: maybe 3%, maybe 5%?

But, common sense says that when interest rates start to increase - when your own government is willing to pay you more for your savings - why put money in other areas of the world, including emerging markets? Why not put more money in bank deposits? That's what we do in India: we place our money in "safe bank deposits" and stay away from risky share markets. Well, the foreigners may now do that. They are not likely to withdraw all their money from emerging markets like India, but some of it. And, since no local Indian is buying the shares which the foreigner wishes to sell, the share prices take a big fall.

A Bharat Ratna to the Indian financial services industry?

So, that is what is happening: India is hostage to what the foreigner does. The Indian financial services industry - particularly the mutual fund industry and the ULIP manufacturers - should be given a Bharat Ratna for their masterpiece act of extracting the all those upfront fees from millions of investors. This erosion of wealth has convinced Indian investors to buy gold and place their money in bank deposits - and step out of the stock markets. This has left India vulnerable to the risks of foreign capital mood swings.

This current scenario is different from the period after the Lehman crisis: then there was fear of a collapse of the global financial system. Therefore, everyone went home and took their money with them.

This downward fall of the global stock markets on June 20 is not due to the fear of an extensive global collapse - but there is less of a need to be in Indian stocks if the US interest rates (in US Dollars with no Indian currency risk), is increasing. This is a simpler risk-return trade off in the eyes of the foreign investors.

Of course there are other factors that aid the decline of the Indian stock markets: a sleeping government, high oil prices that hurt India's trade balance, high gold imports that hurt India's trade balance, slowing profit growth from a slower GDP, the wonderful rise of corruption in India particularly under the UPA (another statistic for the Finance Minister in his next speech)...yes, these are these "other reasons". But the tide of money flows - if, indeed, it is changing - is the driving reason for this change.

How much can the Indian stock market decline by? How much further can the Indian rupee fall? At the time of the Lehman bankruptcy in September 2008, Indian stock markets fell by 55% in 5 weeks and the Indian Rupee lost 20% in 3 months. Panics can be ugly.

Can Indian stock markets buck a global sell off?

Before you hit any panic button and try to reduce your equity exposure, here are extracts of the June 19 press conference given by Ben Bernanke, under which he outlined when interest rates would be increased:

"...if the incoming data supports the view that the economy is able to achieve a reasonable cruising speed, we will ease the pressure on the accelerator by gradually reducing the pace of purchases..." (note: the purchases referred to here has the effect of reducing interest rates, so if purchases are reduced, then interest rates will rise)

"...if the incoming data is broadly consistent with these forecasts... (of a good growth and lower unemployment)"

"...if you draw the conclusion that I said our policies (of lower interest rates) will end in the middle of next year, then you have drawn the wrong conclusion..."

Is Ben Bernanke really saying that he will raise interest rates? And is he not saying that when jobs are being created, when the economy is doing better, then the interest rates can be increased? Should the markets have the sell-off that we have seen? Well, markets can turn on a dime and wake up from their slumber in one day! Frankly, they do need to wake up because, someday, (and it may not be 2014) interest rates will increase in the US and global capital flows will shift. This will dislocate the Indian stock markets.

Can India survive such a shift in interest rates? We could, if we get all the local problems fixed.

The Finance Minister and his team spend a lot of their time telling us not to buy gold - can they spend a few minutes to tell us how safe it is to trust any of the financial firms with our savings? Can we trust company managements with our investment in their shares? Can we trust the financial service industry to give us products that are good for us, as opposed to good for their fee income? And when this trust is broken will the Ministry of Finance stop meeting these financial honchos? And will SEBI shut them down? Will the RBI fine the CEOs of the guilty institutions and confiscate their salaries and bonuses?

Theoretically, the mathematics is in favour of some positive outcomes for India in a bad global environment. Indians save approximately USD 400 billion every year. If 10% of this was to find its way to the stock markets, that is USD 40 billion every year. Today that number is negative - Indians are selling out of the share markets via their mutual fund holdings. The highest inflow from foreigners was USD 29 billion in the calendar year 2010. The highest outflow was USD 12 billion in the calendar year 2008. Theoretically, the local money power can offset and overpower any outflows.

Doing all the grand stuff of building more roads, power plants, and ports will help with "the India story" - but seeing some serious action against the financial firms (and companies with rigged IPOs, fake accounting, insider trading, suppressed information) which have destroyed the savings of a generation of Indians would help bring local investors back to the stock market. Oops, slight problem: it is these very financial honchos and corporate chieftains who sponsor the global conferences which the dignitaries attend to remind the foreign audience what a great job they have done! With earnings of Indian companies not likely to be stellar and the confidence gap of the local investors still pretty large, the Indian stock markets will be at the mercy of foreign flows and foreign events.

Views on other asset classes:
  1. Debt funds are not as safe as they sound if you need your capital quickly; a weak Indian Rupee could force the RBI to raise interest rates, this will hurt the NAV and your older investments in debt funds; Liquid funds and bank deposits are better;

  2. Gold has been whacked globally, but has received some shelter in Indian Rupees due to our weak currency; at Rs 27,000 per ten grammes, hold on to it;

  3. Silver acts like a precious metal (gold) and like an industrial metal (copper); both are getting crushed; At Rs 40,000 to 45,000 per kilo, I still like it - but have more in gold;

  4. Equities are still not crushed, but they have declined; assuming that you are earning money, good time to keep adding - if it collapses, then you may get the opportunity to add more; but don't expect and gains till after the next general election;

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Disclaimer: The Honest Truth is authored by Ajit Dayal. Ajit is a Director at Quantum Advisors Pvt. Ltd and Quantum Asset Management Company Pvt. Ltd. The views mentioned above are of the author only. Data and charts, if used, in the article have been sourced from available information and has not been authenticated by any statutory authority. The author, Equitymaster, Quantum AMC and Quantum Advisors do not claim it to be accurate nor accept any responsibility for the same. Please read the detailed Terms of Use of the web site. To write to Ajit, please click here.

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7 Responses to "Bernanke misunderstood? Chidambaram silenced?"

Nandkishore Purohit

Jun 22, 2013

Kudos to Mr Dayal for his excellent commentary and honest opinion!
I wonder however, if the Indian stock markets are almost certain to decline further, is it not wiser to liquidate holdings in MF's and stocks, rather than keep invested?



Jun 22, 2013

Our FM says Gold is nothing better than brass and is dishing out "advice" asking the aam aadmi not to buy gold.In that case,can he explain why his wife has gold jewellery worth crores?
Another case of "Don't do what I do but do what I say".What hypocrisy!



Jun 21, 2013

You have summed up facts brilliantly.there is enough local money to take care of any FII outflows.and noone will invest in Gold,if the other avenues were safe and NSE was not riiged.Regulators SEBI(rigged IPOs and stock prices) and RBI(comical penalties on banks for recent cobrapost expose) have failed to deliver.


madhav ranade

Jun 21, 2013

a very well written article.

if u don't mind, pl send me a link which can be posted on my website


Sarath Chandra Nimmagadda

Jun 21, 2013

I have been an avid reader of "Honest Truth" series of articles since day one.

In my personal opinion, this has been the most outstanding, the best.

Not many people have the guts to say the following:
"Equities are still not crushed, but they have declined; assuming that you are earning money, good time to keep adding - if it collapses, then you may get the opportunity to add more; but don't expect and gains till after the next general election.";

and such advice (the candid expression in its freest flow) can come only from Honest Truth.

Kudos, thanks from the bottom of the heart to you, Mr Ajit. Please do keep us enlightened & empowered, as always.



Jun 21, 2013

To the best of my humble understanding the scenario is unfolding as below:-
1)In the aftermath of Lehman and US housing collapse their TBTF entities faced massive losses and the mortgages were stuck.
2)The US FED worked out a scheme whereby the TBTF's were supplied with cheap credit that it knew would not fuel domestic business.The public sentiments were assuaged and a panic run on the TBTF's avoided.
3)As planned the infused cheap money infused by the US FED was deployed in commodities,precious metals, crude oil, and BRIC equities.It is being churned since 2010.
4)In a little over 5 years the TBTF's have recovered their impending losses on the books due to the puncture of the housing bubble.The public percepton has also improved and the balance sheets of the TBTF's can provide for the losses on account of the housing fiasco.
The economy has also shown some signs of growth.
5)Thus helicopter Ben can now afford to ease up on the cheap money regime.The dollar will appreciate.Imports will be cheaper for the US economy when it rebounds.The BRIC countries will be left holding the BRICK with depreciating currencies.
6)Most importantly, the TBTF's shall be in the pink of health......a massive transfer of wealth having been completed.
7)Am i imagining this??


Venugopal Juturu

Jun 21, 2013

I agree with all your points. But you need to ask one big question why people are not investing in the stock market. Do you believe majority of these companies? do you believe majority these analysts?

If you do not believe or trust them you do not invest. How many companies are doing legitimate business, where is the guarantee that tomorrow CBI raids on these companies and stock value falls to half?

As long Indian industry does not bring the trust by doing legitimate business, persons like me do not want to invest for long-term. Please tell to Master Chidambaram.

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