Flight to safety, sure, but where is it?

26 MARCH 2011

The stock of global financial assets is a multiple of global GDP, perhaps 4 times. This stock earns a return from the growth of global GDP. When global investors perceive problems, as after the tsunami in Japan, they fly to safety, usually repatriating the money back to their own countries. US Treasury bonds are the favourite safe haven and, during flights to the safety of these bonds, their prices rise so high that the yields are abysmal. Yet this money awaits a time when the worries ease, to get invested back into other asset classes which give them a higher yield than the pathetically low ones obtained on US Government bonds.

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Nor are US Government bonds completely risk free! Japan, the largest but one holder of them, after China, may need to liquidate some, to pay for rebuilding of its tsunami damaged economy, which would drive down prices sharply. China could then follow suit.

This is why global markets rallied last week. The concern that the Fukushima reactor would blow and spread nuclear contamination has reduced after power supply was restored by fearless and selfless Japanese workers, kudos to them! The other main global concern, of oil prices because of a recalcitrant Colonel Gaddafi who has lined his seat with fevicol, was also reduced after Western forces air attacked Libyan forces to stop them massacaring their citizens. The global pool of money needs better returns and can find them in economies that are growing. India, with its 9% GDP growth, reiterated by Finance Minister (though the investing community would be happy with 8.5%) is one such destination.

Goldman Sachs opines that by 2050, consumption by the middle class in emerging markets would make their GDPs grow by $ 10 trillion annually, which is more than twice Japan's current GDP. So, as long as emerging markets such as India have sensible economic policies, continue on the reform path, manage to fix poor infrastructure and to provide energy required for growth, and have good governance, money will flow from developed to emerging markets.

For India we are continuing on the economic reform path. Last week the BJP raised itself above partisan politics (well done!) and provided support to the UPA for the Pension Reform Bill. The UPA Government also gave some concessions to pave the way for the introduction of the GST (Goods and Services Tax) which, when introduced, has the capacity to boost GDP by 1% in itself. If the unique identification project goes as per schedule and is not scuttled by the many vested interests who would seek to do so, it would be another major boost to India. It would reduce the pilferage of funds from Governments welfare schemes.

India's infrastructure will also get fixed, though slowly, because our leaders are still too slow in devoting attention to fix structural problems and are too busy making petty debating points in Parliament, more's the pity! The infrastructure bond issues of IDFC, PFC and others did not get a good response as domestic investors thought the interest rate too low (lower than bank deposit) and the tax benefit, restricted to Rs 20,000 investment, not attractive enough. Yet all 50 States in the US have State supported pension funds which are crying for such returns. They are running at a loss, because the assets in which the funds have invested, are not earning enough, compelling the State Governments (bankrupt) to provide more funding. So our infrastructure growth will be funded, but after the politicians figure out the obvious, which takes some time for them.

It is in the quality of governance that one starts to have doubts about how fast we can grow. The recent eruption of corruption scandals and the unwillingness to seriously tackle the cancerous virus, is something that can derail our economic bandwagon. And the doublespeak of the Government.

For example, the RBI wanted, in the new branch licensing policy, the FDI limit in banks, currently 74%, to be reduced to 49%. The Finance Ministry has sent back the suggestion for reconsideration, saying that this would not send a good signal to investors. One agrees with the Finance Ministry, but one also wonders at the doublespeak. For, in the case of its 19 public sector banks (excluding the RBI), the Government is reluctant to let its own ownership fall below 51%. In other words, for its own banks, it wants to restrict outside ownership to 49% - why does this equally not hurt investor interest?

It is this cap on ownership that is curtailing growth of banks, as it restricts market capitalisation. The market cap of banks like ICICI and HDFC Bank are, for example, larger than most of the PSU banks, even though the larger PSU banks have more deposits and branches. The valuations of the PSU banks suffers because of the ownership cap. Now the safety of India's financial system would not be compromised if the Government retained majority control over say 2 or 3 large banks, including SBI and a 26% holding in others. RBI, the monetary authority, is a strong institution and has strong rules to prevent the sort of shenanigans the US banks got into, contributing to the financial meltdown. Indian banks need to grow (there is no Indian bank within the top 100 global banks in size) in line with India's GDP growth, not least because of the need to fund India Inc.

One sees that in the large takeovers (Corus, JLR, Zain) the funding comes from foreign banks not from Indian ones.

Also inexplicable are some of the views taken by the tax authorities, struggling to raise tax revenue, by means fair and foul, to pay for a hungry Government. Ramalinga Raju had faked accounts at Satyam in order to boost its market cap. When he confessed to the fake accounts, there was a crisis and the Government stepped in to rescue the company and to find a buyer, zeroing in on Tech Mahindra, and renaming the company Mahindra Satyam. The IT Department now claims that the accounts were true, the income was generated (and embezzled by Raju) and wants its share of tax, amounting to Rs 616 crores. Now THIS, Mr Finance Minister, is what hurts investor interest! The company has appealed, something that will take years to wind its way through the system, enriching lawyers and resulting in a huge waste of time and resources.

The other corporate news of interest was that the Finance Ministry wishes that permission for sale of majority holding in Cairn India to Vedanta not be held back because of the royalty claim of ONGC, which is a separate issue that can be legally challenged. ONGC pays 100% of the royalty though it owns 30% of the block. It has a legitimate claim and the Government ought to back it, as do Governments of all other countries. Allowing the royalty payments made by ONGC to be set off against sale, (as it should) would reduce Cairn India profits, and hence the valuation of the deal with Vedanta. So at best the solution would be to compute the amount of such reduction, ask Vedanta to put it in escrow with SBI, clear the deal, and then pay the amount in escrow to either Cairn plc or ONGC, depending on the outcome of the legal verdict.

Last week the sensex rallied a whopping 936 points, to close at 18815 and the Nifty gained 280 to end at 5654, as investor fears on Japan and Libya abated. In the absence of any new fears, the rally has the potential to take the sensex up to 19,500 before once again, declining. It may do so. The global pool of money is seeking investment into other assets and, like water, will find its own path.

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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3 Responses to "Flight to safety, sure, but where is it?"


Mar 26, 2011

I hope you would not quote Goldman Sachs the crooks of Wall St

If you haven't watched it you can watch the following movie

The Inside Job by Charles Ferguson that received an Oscar for the best documentary of 2010


J Thomas

Mar 26, 2011

Re Cairn/Vedanta/ONGC and royalty. I read somewhere that ONGC got the 30 % equity free in consideration of bearing the full cost of royalty. If they got the equity free, then it changes the whole picture.


Piyush Gupta

Mar 26, 2011

Very well said - Keep it up !

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