All aboard QE II

16 OCTOBER 2010

The very mention of QE II conjures up an image of a luxury cruise. Financial markets have been taking a cruise, however, on expectations that the US Federal Reserve will soon go in for quantitative easing, phase II, or QE II. Noted economist Joseph Stiglitz, writing in an article in Economic Times of Oct 13 says that QE II wont work, as, indeed QE I hasn't. The US Government has already bought $1.7 trillion of US Government bonds, in a bid to get banks to lend to businesses so that entrepreneurs can start new businesses and provide jobs. US unemployment is stubbornly high. But it hasn't worked. The large companies are flush funds, and the smaller companies, that need them, have only mortgages to offer as collateral, and that's a depleting asset.

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The money being created is going elsewhere, leading to (justified) fears of asset bubbles being built up. Other emerging markets, such as Brazil, have placed curbs on short term foreign inflows, and RBI will probably follow when it feels the time is right.

In the meantime the liquidity generated by QE is finding its way into different assets and geographies, and not helping the US economy grow. Indian stockmarkets are one beneficiary, with the sensex hovering just below its January 2008 peak. One of the signs of excessive liquidity is a plethora of IPOs as companies rush in to take advantage of it. The Jan 2008 peak coincided with the then biggest IPO of Reliance Power. We now have Coal India, an attractively priced issue, entering the market with the largest ever IPO from India (the real kicker will commence in 2013 when it starts selling washed coal, which will improve sales realisation by 50%; investment in washeries would have a payback period of just 8 months). Just last month Petrobras of Brazil managed to raise a whopping $ 70b. in Sao Paulo, the world's largest ever issue.

In Jan 2008 it was Anil Ambani who raised the over $ 2b. IPO. Brother Mukesh Ambani's Reliance Industry has now raised $ 1.5b. in bonds to part finance its shale gas acquisitions; of this $ 1 b. is in 10 year bonds, at an attractive price of just 2.13% above comparable tenure US Treasury bonds and $ 0.5b. in 30 year bonds. US Treasury Secretary Tim Geithner would make more money buying 30 year RIL bonds than buying 30 year US Treasury bonds!

The flush of liquidity, if used to build infrastructure assets such as roads and power plants in India, would help. If used largely to drive up stockmarkets, they pose a future danger. Both RBI and SEBI would be alert to the dangers.

Other than themselves, it is mainly Japan which is buying US Treasuries. It has bought $ 55 b. in 2010, overtaking China as the largest creditor to the US as China has reduced its holding. Prices of gold/silver are also at a record high, moving in tandem with emerging market equities as well as bonds, which suggests that there is too much liquidity going into these assets than into productive ones.

It would take a very long time for the US to repay the debt burden this QE is building up. Its property market is sluggish and it is estimated that even now, 20% of mortgage borrowers would be forced to foreclose. Forclosures are also not helping because banks cannot afford for long to spend money on security, taxes and maintenance of the foreclosed properties, and selling them further depresses the market. Several home owners have negative equity (the market value of their property is less than the loan outstanding) so, even if they get jobs elsewhere, they cannot move as they will end up minus even by selling the property.

The US is trying to pressure other countries to revalue their currencies. The Indian rupee has become stronger against the US $. However China, the second largest economy after the US, is resisting. Last week the IMF failed in its attempt to pressure China to more aggressively revalue the renminbi; and has passed on the onus of pressuring China to G 20, which meets in Seoul in November.

In corporate news of interest, the Government is trying to get Cairn India to share the burden of royalty, which it initially agreed to impose entirely on minority partner ONGC (which makes hardly any money out of its share of the oil blocks as a result), as a quid pro quo to clear the sale by Cairn UK of its stake in Cairn India to the Vedanta group.

In corporate quarterly results for Sep quarter, Infosys showed a double digit growth in net profits which went up 16.7%. Axis Bank's net profit was up 36% and LIC Housing's was up 37%. The IT companies are hiring strongly and the three biggies, TCS, Infosys and Wipro, plan to hire 40K, 36K and 14K respectively in calendar 2010. There is increasing concern, however, that protectionism will rear its ugly head; the US is already railing against outsourcing of IT jobs.

The sensex, after starting the week strong, ended it at 20125, with a weekly loss of 125 points. The Nifty ended at 6062, down 40. It would be healthy for the market if there is a sharper correction and asset bubbles do not grow to a point where, when pricked, they cause greater damage. But with QE II likely to set sail shortly, can there really be a sharp fall? It would be a great opportunity to buy the Indian market, if it did.

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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