Drinks are on the house!

3 MARCH 2012

Party revellers know that a rollicking party comes to an end either when regulators, or the police, stop it, or when drinks get over. The world has been partying on an explosion of printed currency, euphemistically called quantitative easing, for a long time. Added to that is a mountain of 'funny money' in various sorts of uncontrolled derivative products which have grown in an unregulated manner. Outstanding obligations under CDSs (credit default swaps) totalled some $ 26 trillion, more than 40% of global GDP, and enough of a financial tsunami to wipe out several banks. The regulators, instead of calling the party to a halt, are supplying more drinks!

The ECB gave its second tranche of long term refinancing option (LTRO) of 520 billion euro which, alongwith the first, exceeds 1 trillion euro. LTRO is a 3 year loan given to banks (800 banks took the second tranche) offered at 1%, against collateral, which is normally sovereign bonds. So European banks e.g., bought sovereign bonds, which yield just under 6%, offer them to ECB at 1%, and pocket the 5% spread.

Now if these bonds are declared in default, the ECB asks for their replacement. So everyone gangs together to see that bonds are not declared 'in default'. The body that so decides is controlled by banks, and last week, stated that the Greek sovereign bonds were not in default. Because if they are declared to be in default, not only would the ECB ask the 800 European banks (500 earlier) to replace them, but those who insured payment under the CDS would be liable to pay. When that happens (and its not an if, but a when) we will have a major crisis.

But until then, its party time. Drinks, in the form of LTRO, are on the house! After the first tranche of LTRO two months ago stockmarkets took off and there is no reason to believe that they will not, again.

For investors it becomes extremely tricky, because global markets are being fuelled by the surge in liquidity created by ECB in order to stave off the European economic crisis. But money, like water, finds its own levels and, when enough of it is thrown around, moves into different asset classes. So markets will go up after this surge in liquidity, but equally, whenever there is a crisis, (and there will be), it will exit as swiftly, leading to enhanced volatility.

What about fundamentals?

A Dec 2011 study by McKinsey Quarterly titled "The emerging equity gap: Growth and Stability in the New Investor Landscape" makes interesting reading.

The global pool of financial assets, including shares and bonds and bank deposits, is $ 198 trillion, of which $ 41.5 tr. or 22% is in emerging markets. This is in 2010.

By 2020 the global pool of financial assets would grow 87% to $ 371 trillion, but the pool of financial assets in emerging markets would grow 167% to $ 111 trillion, representing 30% of total assets.

In other words, because of the higher growth rates of emerging economies, combined with higher savings rate in them, the stock of financial assets in emerging markets would grow much faster, nearly twice the rate, than in developed markets.

So it is natural that the developed markets would allocate an increasing share of their assets to the emerging markets. In the first two months of 2012 India got net foreign institutional inflows of over $ 5b.

Yet, the study says, that there would be a $ 12 trillion gap between what companies want to raise from equity markets in 2020, and what investors are wanting to invest in them. This would raise the cost of equity.

This is because, whilst investors in the developed allocate a larger amount of their savings into equity, those in the emerging markets are more interested in fixed income investment, especially bank deposits. So, if India is to narrow the gap mentioned above, it would need to do far more to attract investors into equity.

We are, however, taking some steps in the opposite direction. For example, we have made it extremely difficult, perhaps impossible, for new stock exchanges to come up. This is evidenced in the legal tussle between MCX-SX, an exchange set up to trade in equities but thus far permitted only in foreign currencies, and SEBI, the regulator.

SEBI is insisting that MCX-SX comply with MIMPS regulation (method of increasing and maintaining public shareholding). Not to be confused with mumps, although those affected by MIMPS may start to resemble those with mumps. Under the regulations, Securities And Exchange Board Of India (SEBI) wants any new exchange to restrict ownership of any entity/group of entities acting in concert, to 5%.

This makes it impossible for anyone to start a new exchange. Why would he, if he gets only 5% of the value, equal to 19 other owners, whilst he does all the work? And is it conceivable that an organisation can be run and decisions taken, with 20 owners having an equal voice?

India, which has 2-3% of its household financial saving invested in equity, and a very small part of its population as equity investors, needs many things to spread the equity cult and thus avoid the gap mentioned above. One of these things is to have several competing exchanges. Now the BSE complied with MIMPS some 130 years after it was born, and the NSE perhaps a decade or so. Commodity exchanges allow entities to hold much more than 5%, as do banks.

Also needed is the growth of the mutual fund industry. This was growing, though not fast enough, until SEBI stopped payment of upfront commission to brokers, after which growth tapered off. In the case of unit linked insurance plans, where there is no such restriction of upfront commission, since it is regulated by a different authority, growth continues. So long as investors are told that the upfront commission is paid out of their capital contribution, and so long as they do not object, there ought not to be an issue giving them. After all, in the case of all IPOs, investors are asked to study the risk factors, which are separately enumerated.

Another interesting study on the McKinsey Quarterly site is called 'The Great Rebalancing' which talks of the need for companies in developed countries to look at innovation to win in low cost but high growth countries. It talks of two main trends. One is the declining dependency ratio in emerging markets, which is also called the demographic dividend. India is best suited to reap this, as a growing, young, population finds jobs, there are more people earning and a lower dependency to feed those who aren't. This leads to greater consumer spend, which drives the economy.

Of course, this would mean that Government creates the wherewithal for job creation. Else there can be social unrest. This Government, however, has been frozen in cryogenic policymaking. Unless it gets its act together very fast, its prospects in the next general elections would be marred.

The second trend is the largest urban migration in history. It is estimated that by 2030 there will be 590m. people living in cities, which is twice the population of the US. These cities will provide 70% of the new jobs. There would be 36 new cities, each with a 1 million population (Europe has 35 cities today).

Again, this would mean a lot of urban planning and sensible laws. Right now we are stuck in a policy paralysis, one that has resulted in GDP growth in the Dec 2011 quarter slowing down to 6.1%, the slowest in 3 years.

The lower GDP growth has resulted in less than forecast tax revenues. Combined with a bigger than expected spend on subsidies and social welfare schemes that leak more than newly born babies, India is, once again, in the throes of a fiscal crisis.

In order to dress down the fiscal gap, the Government tried to desperately push through a sale, through market auction, for the first time, of 5% of its stock in Oil and Natural Gas Corporation Ltd. (ONGC). Now ONGC, which explores oil and gas, is one of the most valuable Indian companies, with one of the highest profits. Rising crude oil prices would mean that its profits would keep rising. Yet the offer tanked, and had to be bailed out by Life Insurance Corporation of India (LIC), who saved the day by putting in a last minute bid. The Government got its Rs 12,000 crores, though still falling short of its targeted Rs 40,000 crores through disinvestment.

The reason ONGC, a profitable company, did not attract investors was largely due to non transparency of Government policy on the subsidy burden ONGC has to share. This is decided arbitrarily by Government. So an investor is never sure how much of its profits would be so appropriated. The other reason is that the Government sought a price which was a bit higher than the closing price of the previous day.

Investors flock to issues which are well priced and have potential to reward them. A week earlier, MCX, the commodity exchange and half parent of MCX SX, got bids for Rs 35,000 crores ($7 b.) and got valued at over $ 1 b. This value was created in under 7 years and is more than the value created by 130 year old BSE.

Last week the BSE-Sensex fell 286 to close at 17636 and the NSE-Nifty dropped 69 to end at 5359.

In the coming week, the election results of 5 states including UP, the largest, will be declared. In UP, the Samajwadi Party is expected to garner the largest number of seats but not enough to form a Government. If it gets Congress support to form one, investors would take it as a bullish sign. If, however, no one can form one, and President's rule is imposed, it would lead to political uncertainty, and investors would take it as a bearish sign.

Thereafter we will have the Union Budget, mid March. The Finance Minister would not have any elbow room to present a benign budget. He would have to raise taxes. A thought - if political parties were made to bear a part, say 5% or 10%, of the cost of any subsidy or welfare schemes they propose, (such schemes are largely in order to get vote banks for themselves, at the nation's cost), then maybe their enthusiasm to usher them would wane.

In international news, North Korea has agreed to accept nutritional food aid (hopefully not hamburgers) from the US in exchange for halting its nuclear programme. This is welcome news, provided the Koreans stick to it and don't renege after getting the food. However, Iran's nuclear ambitions poses a threat, one which the US and Israeli Presidents will discuss on Monday. In a NY Times article, Obama has said that use of force by the US is not ruled out. If the Monday meeting results in a military attempt, markets would slide.

Thus there are, for investors, conflicting trends which will play out at different points in time. Enhanced liquidity will keep the party going longer. At a future date the hangover will be worse, but for now, who cares? Election results in UP could make the Indian market swing either way. Oil prices are high and not wanting to come down. This will hamper India's GDP growth as it is highly dependent on crude oil imports, demand for which is inelastic. The Iran-Israel imbroglio is an imponderable. Net net, buy on dips.

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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6 Responses to "Drinks are on the house!"


Mar 12, 2012




Mar 12, 2012




Mar 8, 2012

US QE3 expected any time soon will result in dollar drop as it is sterile QE3 with bonds programme.
This is expected to bring down Dollar that is what Fed is anticipating to "bringing down the inflation" that being the story.
However, the real story is this will bring down the dollar with it the oil prices. As the emerging currencies would strengthen against dollar.
And the oil price drop can be significant as the emerging markets may hoard on the fwd contracts to buy. And some currencies in the Arab and some other nations which are tagged dollar would fall. Win win for USA and emerging countries and bad News for Arab and African countries.
This is going to planned event to bring the democrats back into power and specially OBAMA on his second term.

on this QE3 news with this new bond programme news Saudis and other Arab nations can significantly stop producing extra supplies to vane down the above effect.

Who wins with all the game. All the way President Obama and his government again?



Mar 5, 2012



Rajesh Bapaye

Mar 3, 2012

Investment in equity markets does not help the industry in any way except that it raises or lowers the share prices of the promoters. Only way the industry is benefited from the markets is by IPO. Hence your comment that only 2 to 3 percent of Indian households invest in equity and should be inspired to do more will do no good. Add to this more exchanges.
Its the nature of savings of Indian public thats giving funds to industry relatively cheap. Add more exchanges & add more investors, fly by night companies will prop up again.


surajit som

Mar 3, 2012

it is not a party,it is an orgy. ghosts of american depression would be terribly zealous. join it as long as it lasts.afterwards? Greece all the way !!!what goes up ,eventually will come down !! jump the bandwagon man , what are you waiting for ?

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