Hardening interest rates...? The US will go belly up.

I am a bit flummoxed by C.Rengarajan’s theory that interest rates may harden.

I think we have to distinguish between short-term interest rates and long-term interest rates. In the US, the Federal Reserve does not really control long term interest rates. They can tweak it occasionally through quantitative easing and through the purchases of 7 / 10 / 30 year bonds but what they control is the short-term interest rates (the Fed fund rates). Hear out Ben Bernanke, and you feel the short-term interest rates will stay low for a very long time. In America the fiscal deficit this year will be around USD 2 trillion and I do not think they can cut the fiscal deficit next year because if they cut it, it will have a negative impact on the economy. So I rather think that the fiscal deficit will stay at this level or in my opinion actually even increase. That will lead the Fed to keep interest rates artificially low because should they increase short-term rates meaningfully then the cost of servicing the government debt in the US will escalate substantially. So I think as far as the eye can see, monetary policies in the US will stay expansionary.

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That means US dollar shall remain weak for a very long time and that means most $ funds will find its way to other currencies / asset classes. Liquidity is therefore assured and no bank will have the guts to jack up lending rates because money flow is not going to be tight for quite some time. Then where is the question of rates hardening...?

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The bond dealers are in for some rough times. But then they can't do much else except to squeal and crow for hard rates !!!!

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Never blame securitization

Securitization offers many advantages to all participants in the marketplace. Derivatives decrease barriers of entry to a host of markets, increase potential diversification and customization, and enhance liquidity and hedging activities.

Securitization has represented a series of innovations that have brought about greater efficiency but the problem with innovation, almost by definition, is that they outpace the ability of the infrastructure, on both the private and public side, to sustain the innovation.

Now, the system is trying to catch up but we risk an overreaction that may limit the potential of securitization. Hopefully, an understanding that a return to securitization is crucial to economic recovery (by allowing banks to lend more through risk transference) will lead policymakers to resist any misguided populist sentiment.

The new products present challenges for risk managers and regulators alike. It also burdens operations, technology, and settlement systems in the process. In reality, every level of the financial system will need to continually adapt to changing risk and complexity.

Unfortunately, policymakers, almost by default, will always be behind the curve. Because an attractive fee is extracted at every stage of securitization, the agents, or intermediaries, will will always be prone to excesses. Innovation will always outpace the ability of the infrastructure to sustain it and securitization crises will be a recurring phenomenon in the new age global finance, you bet. But try doing away with it, you're only deepening the liquidity crisis.

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Heading into anti-bubble?

I think we are getting into some kind of an anti-bubble.

In a bubble, prices become disconnected from values because purchasers believe that, whatever the fundamentals, they will soon be able to sell what they have bought at a higher price. The bubble must burst eventually because the supply of new people willing to buy at ever higher prices will be exhausted, and generally bursts sooner than that because people come to realize this.

In the opposite of a bubble, prices become disconnected from values because sellers believe that, whatever the fundamentals, they will soon be able to buy what they have sold at a lower price. The anti-bubble must also eventually collapse because the supply of new people willing to sell at ever lower prices will be exhausted.

And then there are some that chooses to live in denial. And there are others that believe otherwise. Where do you think we’re headed?

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Economy? Go to hell !

“The battle against inflation will likely come at the expense of economic growth, which looks set to decelerate in the second half of 2008 amid cooling domestic demand and persistent external weakness,” says Sherman Chan, an economist with Moody's. The recent decline in global oil prices will not lower India's rate of inflation, which will remain "stubbornly strong" in the coming days despite monetary tightening by the central bank. Until next June, energy prices will also remain notably higher on a year-ago basis because of the cut in subsidies two months ago. The rise in global commodity and food prices is still a major driver of inflation in India. The retreat of oil will only help ease the pressure on the government to further raise domestic energy prices, according to Ms.Chan.

Makes sense. Now read what the Deputy Chairman of Planning commission Montek Singh Ahluwalia has to say. The fiscal deficit target set at 2.5% of GDP for 2008-09 is set to be higher by a significant margin. It is estimated the deficit will be breached by almost twice the budgeted target due to high oil prices and a whopping fertiliser subsidy bill. There had been a substantial increase in off-budget numbers and there were good reasons for this. He said the fiscal deficit is not a long-term problem as, next year, some of the increases would not be repeated and a significant revenue buoyancy would help ease the situation.

All hopes. On the ground inflation remains the growth killer. RBI can raise interest rates, mop up dollars to arrest a falling Rupee (that inflates oil bill) and introduce monetary measures like hiking CRR and Repo rates. Now the key element is augmenting commodity supplies. Who controls that? Commerce and Industry Ministry? It’s just a toothless caricature of its once powerful self (when quotas prevailed and licence raj was full on). Now I conjure up its icon Kamal Nath only as our emissary at WTO to make sure the talks fail!

Enough drama. Getting back to reality. Raw material costs are up 26% while interest charges are substantially higher at 34%. But instead of passing on these higher costs through price hikes, companies have retained them on their accounts so that growth is not compromised. Is this compromise sustainable at such low net margin growth? But then, there are more important issues to resolve!

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The charity incentive

“The Inflation can drop below 8 % if confluence of factors like fall in global crude oil followed by a good monsoon work”, says Prime Minister's Economic Advisory Council (EAC) Chairman C Rangarajan.

It touched 11.98 per cent for the week ended July 19.

And then? The improved fiscal conditions would be used as an excuse to pursue populist schemes in an election year. The government already have to fund the generous farm loan write offs ($18 billion at the last count) and the liberal pay hikes to the government staff ($5 billion in arrears and $2.5 billion annual outgo). The latter is now deferred (a bungling government waking up to the folly?) emphasizing the thoughtlessness of the award. Now I think of the majority tax paying tribe that gets no benefit from any of it - the non-government employee citizen or a farmer with no loan outstanding. You think I am biased? Here is Moody’s rating, for the record !

I might rather donate all my taxable income to the Red Cross. That will make me feel a lot better.

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Art of going naked

Now some reverse sweep.

A few months of living with an appreciating rupee it seems had robbed our exporters of their art of making profits from currency fluctuation. Now the Rupee has been depreciating since June, our IT vendors have been steadily making – yeah, you guessed it – losses.

Here is the score card. HCL Tech – $65-75 million; TCS - $12 million; Mindtree - $3 million; Biocon - $ 7 million.

These are violent times in the currency markets and no one can accurately predict the direction of a currency. In the best of times, sometimes it pays to go naked. I had figured it out more than a month back, well almost!

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Would you buy the GDP?

GDP is commonly used as an indicator of the economic health of a country, as well as to gauge a country's standard of living. Critics of using GDP as an economic measure say the statistic does not take into account the underground economy - transactions that are not reported to the government. Others say that GDP is not intended to gauge material well-being, but serves as a measure of a nation's productivity, which is unrelated.

Those arguments always make me feel this is one indicator that can’t be trusted at all. My work life has taken me to some of our Government market intelligence gathering departments and I would put their data collection methods, at best, as archaic. There’s no way that one can vouch the veracity of the data they had collected through dubious means (sending a query card to a few upcountry wholesalers and accepting whatever they fill in) and generating reports on the basis of such data. When these reports form the basis of computing GDP numbers, you know how reliable that could be.

We all know bulk of India’s property transactions go under-reported if not unreported forcing even the Government to acknowledge it. Is the world so short of talented mathematicians, statisticians and economists that they can’t suggest an alternative? I fret because central banks set/reset interest rates on the back of these numbers and put out inflation rates that form the basis for reining in or letting loose money supply, DCF analysis in major M&A deals etc.

Anyone has a better idea…?

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