Why recovery from the global financial mess will take a long time - Straight from the Hip by J Mulraj
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Investing in India - Straight from the Hip by J Mulraj
Why recovery from the global financial mess will take a long time A  A  A

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21 FEBRUARY 2009

The global financial crisis is really the consequence of an excessively short term outlook, propelled by greed and unstopped by regulation. The short termism is due to several factors, not least of which is the enormous growth, in the past 3 decades, of the mutual fund industry. When mutual funds were first launched, they were sold as open ended funds, primarily to enable this product to compete with bank deposits which could be withdrawn. The majority of assets of mutual funds, (the industry has surpassed the banking industry in asset size) are open ended. This places enormous pressure on fund managers for short term performance, relative to competition and relative to the index. This pressure, in turn, gets translated to corporate management, which is asked to deliver short term (read quarterly) improved numbers, never mind the long term future.

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President Obama may have got a second rescue package cleared by the US Congress, but it is going to be a long while before toxic assets in the banking and financial system get cleansed. A couple of years, at least. The latest estimates of toxicity is over $ 2 trillion. This would suggest that even economies such as China and India which are relatively better off, would see their stock markets languish. There is, however, a huge pool of money (some $8 trillion in the US alone) of liquid funds waiting for confidence to revive; this could cause large temporary upswings, even though the trend would be downwards. It is Obama's intention to try and revive investor confidence as early as possible.

One of the things being debated are 'mark to market' accounting rules. In an article in Barrons, Jacqueline Doherty talks about there being a legislative change to do this. In their greed to generate income, banks and financial institutions had conceived a plethora of fancy derivative products, winking at the inherent risks. Accountancy rules required the assets to be marked to market. The problem is that now there is virtually no 'market' for most of these fancy products; the market price is not indicative of a true market with many buyers and many sellers determining a fair price. Instead, the price is the result of distressed sellers desperately trying to sell.

Many of the assets continue to meet their obligations but yet need to be marked to market to meet accounting rules, thereby creating holes in the balance sheets leading to demand for more capital. Thus there is a school of thought wanting this to be changed. This school says the rule is perverse. In bullish times, mark to market results in book profit (since asset prices get inflated) thus encouraging banks to lend more at a time when prudency demands they rein in lending. When times are bad, the rules create book losses, thus needing financial institutions to seek fresh capital at a time when the economy needs them to lend more.

The IMF estimates that banks will sustain $ 2.2 t. In losses, of which $1.5 t. will be mark to market losses rather than loans gone bad!

Rating agencies have hugely contributed to the mess by giving unjustifiably high ratings to many of these fancy products, thus encouraging investors to invest in them on assumed safety. In a 5 day review exercise Moody's downgraded 91% of Alt A mortgages from AAA to junk! How can they be so wrong? And now, the same rating agencies wish to downgrade India's rating for its fiscal profligacy.

True, India's fiscal management is abysmal. Indeed, so is India's overall management. Witness the scenes in State legislatures, with elected MPs jumping on tables, hurling objects and shouting, thus providing further evidence of Darwin's theory of man being descended from the apes. India has one magnificent opportunity to correct all its problems and turbo charge its way towards being a super power. It is going to miss that opportunity.

The opportunity is in finding out about the huge pool of money stashed away in Switzerland, Liechtenstein and other tax havens. The German police have got information on Liechtenstein accounts and is willing to share it with any Government that seeks the information. UBS has agreed to provide USA with details of its American account holders. All that the Indian Government needs to do is ask! But doing so would open a can of worms; so it won't happen. Never mind that that the estimate of Indian money stashed abroad exceeds our GDP and can thus solve all of our fiscal woes and funding problems for our infrastructure.

This is borne out also in the way the Satyam scam is being handled by the State Government, which did not allow other agencies access for a long time after its promoter self confessed to fudging of accounts. After over two months, it is being revealed that over Rs 1700 crores lying in an overseas branch of a state owned bank is missing. Probably diverted to the two companies run by the two sons of Ramalinga Raju. These companies, it seems, violated Company Law Board norms and have lent/invested far in excess of permissible limits.

The question is, what was the Company Law Board doing then? Was it not overseeing? Why do scandals have to break before action is taken?

The Company Law Board has now 'allowed' Satyam to raise its authorised capital to enable it to allot shares preferentially to a buyer. The Board has been 'allowed' to find a buyer. Whether anyone would wish to buy a company whose accounts are admittedly false, and not yet restated, is anybody's guess. Probably not. Its marquee clients like Coca Cola and GSK have forsaken it.

Thus not only will the global recovery take a long time but, given the poor way our country is run, only for vested interests and damn the public, it would take also take time for our markets to recover. The current rate of borrowing by the Government would, whenever the economy starts to recover, crowd out borrowing by the private sector for investment. The obvious solution is to reduce expenditure; a visit to any Government building indicates the enormous potential for saving. What applies to citizens does not apply to politicians and bureaucrats who see no need to cut expenditure but find innovative ways to squeeze out newer forms of taxes.

Last week the BSE-Sensex fell 791 points to end at 8843 and the NSE-Nifty fell 211 to end at 2736. About 40% of the fall was due to two scrips, ICICI Bank, contributing 153 points and RIL, contributing 151. Movements in these two often determine the short term trend. With gas output from its KG basin commencing from March, would it help RIL rally, and with it, the sensex?

If it does, it would be better to get lighter.

J Mulraj is a stock market columnist and observer of long standing. His weekly column on stock markets has run for over 27 years. An MBA from IIM Calcutta, he has been a member of the BSE. He is Conference Head - India, for Euromoney. A keen observer of events and trends, he writes in a lucid yet readable style and takes up issues on behalf of the individual investor. Nothing pleases him more than a reader who confesses having no interest in stock markets yet being a reader of his columns. His other interests include reading, both fiction and non-fiction, bridge, snooker and chess.

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