Tuesday, December 28, 2010

Commodity Prices and Money

We have seen a recent spike in prices of various commodities like Oil, Sugar, Cotton, etc. Paul Krugman in recent blogpost highlights this as indication of finite world. We are scrambling to explain these changes through the lens of demand supply. However, just this time, I think there is another explanation.

Three components of commodity prices
In current scenario we should think of commodity price as comprising three parameters with demand-supply being one of them. The second parameter is inflation adjustment. Third parameter is wealth retention value.

Inflation adjustment refers to change in prices reflecting change to money supply that feeds only few areas within the economic value chain. Usually, the inflation adjustment is negligible as money moves through designated channels. However, in recent times, the excess money has spilled on to commodities and other asset classes creating a price expansion divergent from fundamentals.

Wealth retention value refers to ability of the commodity to retain purchasing power for the future. When money supply is stable and in line with fundamentals, there is not much need for commodity to carry the wealth, money can do it better. However, in cases of rapid monetary expansion rare commodities are required to carry wealth. Higher the monetary expansion, more commodities comes into this fold. In post-war Germany wheat bread too joined this group.

In Sum
So I think we should look at commodity prices through this three-component lens. I believe the fundamental driver, i.e. demand supply, is more or less along the long term trend. However, in recent times we have seen higher inflation component markups for many asset classes. Commodities are simply exhibiting similar behavior. Further, we might see, depending on how much trust our currencies exhibit, some change to the wealth retention component in coming years.

Tuesday, December 21, 2010

Cannot group India with other Emerging market

Over the past years, I spend part of time explaining this fact. India's economic structure is not like other emerging markets and hence we should not club those together. This goes when you are looking at bond yields, currency forecast or simply equity market valuations.

First, India is a consumption economy. Unlike other emerging markets that depend on US consumption, India is driven mostly by domestic consumption. Sectors like IT/ITES do have significant employment here and thus they do contribute indirectly to the consumption. However, the overall impact of IT/ITES is not as substantive as exports are to other emerging markets. Thus we need to look at India through a developed world lens.

Second, India functions despite of its government, again unlike other emerging markets. In other EMs government is a driver or enabler of growth. Not in India. In fact, wherever government interferes you have problems. So in that aspect too India is unlike other EMs.

Third, India has more efficient capital utilization pattern. Overall, the incremental Capital output ratio, ICOR, is higher in India. While a group of economists believe this is reflection of the stage of the economic development rather than character trait of India, I disagree. While the high level of ICOR is misleading, India will have better ICOR than comparable country at similar economic development level. However, this also means India will pay lesser for everything. In other words, if you expect certain demand at a price point in other countries, expect half that demand in India. MNCs found this very challenging at first. But at the right price point, there is ample demand than you can cater to.

Fourth, Indian banks, thanks to RBI's watchfulness, are very conservative. Even in Real estate lending, thanks to the black economy percentage charged by developers, the individual has higher skin in the game than in other markets. 

So during the next year when you look at investing in India, bear in mind that India is a consumption economy like the west. 

But what does this mean?
To me it implies some direct conclusions.

First, India can sustain a higher Debt-GDP ratio than other EMs. Since the payback comes from internal demand generation, the debt is likely to be more robust than other EMs. 

Second, it also means that India's economic model is directionally right, i.e. correct in intent, but low on scale, i.e. India is slow - very slow. This may mean higher stress on currency. Popular opinion on this topic is against me. People expect INR to continue to become cheaper vs. USD because of national debt. However, over time, people will realize the difference and try to flock into the INR. I do not expect it to happen in 2011 or 2012 but I have been wrong before. In any case, if it were to happen expect capital controls and regulation to manage the currency.

Third, infrastructure payback is likely to be longer. With India infrastructure story being marketed to death, I expect lot of infra-investment to come in without acknowledging this fact. Please expect payback to take longer than your models indicate.

Fourth, India may become a consumption driver of the world sooner than other EMs. It might take two decades more, but India may be first to contribute to global consumption rather than other EMs.

In sum
India is unique, it is a culturally in the middle. It is slow, but it is going the right way.

Thursday, December 16, 2010

Difference in wealth and money

Krugman raises an interesting question in his blog titled What is money? I believe this is a very crucial question we need to ask to understand the context of the current financial crisis. I have dealt with this question in detail in my book "Subverting Capitalism and Democracy".

There is a difference between wealth and our bank balance. Wealth is our ability to purchase future convenience (in terms of products and services). But there is no way to understand wealth in isolation, just as there is no way to understand temperature in isolation. To measure wealth we need a metric - money provides us with this metric. 

Metrics, like those for length, time, temperature etc, are very specific and scientifically determined. For example, the length of 1 meter was previously defined as the distance between two marks on the specific rod, placed in International bureau of weights and measures in Paris, made of platinum and iridium alloy measured at 0 degree Celcius. Later, a more specific measure was developed defining 1 meter as distance travelled by light in specified time in vacuum. 

However, metric for wealth, i.e. Money, is not specific and absolute. Money itself changes value all the time. Money itself is a commodity created to measure other commodities against it. But since it is a human creation, there is no supply constraint other than what we have self-imposed. Thus, money obeys all the laws of supply and demand like other commodities. It also means that money appreciates or depreciates depending on demand supply changes in other commodities.

The value of money refers to its ability to purchase goods and services. Therefore, wealth refers to value of money at specific time as the value of money changes with information on demand and supply. Thus if you are on an island where news reaches once a month then most likely the value of money will change monthly. This is one reason why fund managers want to know information earlier than others.

Let us say the monthly information comes through that instead of usual 100 apples (the only item that can be purchased on the island), this time 1000 apples were produced. Now the purchasing power of your money has gone up 10 times simply because there are more goods than money. On the flip side we can argue that prices have fallen because of bumper harvest. In either case the value of money, or your wealth, has changed.

Similarly, if suddenly the supply of money changes drastically we will have to work out the new price levels. Say if money supply increased by factor of 10, but supply of apples was same, then prices should increase by ten-fold and to retain your wealth you must have 10 times as much money as you had before increase in money supply. The same process is immensely complicated in a multi-product complex economy. Thus an individual may have no clue how her wealth may have changed during the process.

Today, economies are creating and pumping money in large quantities. Naturally, currencies are facing uncertain environment. The purchasing power of ALL the currencies is in flux. To protect our wealth, we need to step back a little understand how the currencies stack up then, once the volatility subsides, return into a currency denominated wealth. This is why people prefer to hide or park in a commodity that has very limited supply, like Gold or rare metals.

Wednesday, December 15, 2010

Jobs, Skills and development

Noni Mausa, in her blog Tunnel Under Snow: The trace elements of a nation, highlighted a comment she made on a spectacular discussion at Angry Bear about Sir James Goldsmith's views about jobs, skills and development. The original post makes a great reading and the comments, more so by Noni, simply elevate it to a must read discussion.

The arguments are often made against trade related job realignment. Make no mistake, trade does lead to realignment of jobs. Low value add jobs move from higher income countries to lower income countries. Except, of course, those jobs that cannot be moved like Janitors, hair dressers, restaurant operations etc. However, the idea of development means that the rest of the economy must be able to pay higher for these services even though the skills may not be dramatically high value adding. To pay higher and higher for same services we have two options.

First, we can improve productivity of jobs that cannot be moved. That is why floor cleaners at airport use a electric cart with mops rather than do it the old fashioned way like the floor cleaners in poor countries do. Essentially, as income increases, economies tend to throw capital at essential-labour problems to make them cheaper. Capital, naturally, is cheaper in high income countries. This worked fine in times when capital mobility was a constraint. However, the advent of GATT, WTO and later developments have made capital mobility almost frictionless. Thus this difference has been effectively negated and the only differentiation is now in wages.

Second, we can add more value that high-income people will appreciate and hence pay for. Thus, fashion consciousness in high income hair salons is higher than that in low income ones. Low income countries have tailors, while high income ones have clothes designers who have a reputed brand to talk about. The communication revolution has effectively negated this trend as well again reducing the differentiation to wages.

What this means is countries will have the jobs profile similar to the skill profile of the population. In other words, we are looking at a wage-skill rebalancing across the world. Thus we need to look at the skill profile of the economy and match the job profile with it. The skill profile can be managed through immigration i.e. by allowing those with relevant skills to come into the country. So US will do well to export financiers and import engineers. In that sense, the direction of the discussion is correct.

In other words, for arguments sake, a country of doctors will need to import engineers or entice customers to come over for treatment. Enticing customers seems ridiculous but hospitals in India are already offering low cost health care services to wealthy foreigners who fly in get their dental, cardiac treatments done and fly back after recovery. It is called medical tourism.

I have discussed the importance of matching job profile and skill profile within economies in my book "Subverting Capitalism and Democracy".

Friday, December 10, 2010

Identifying Asset bubbles

Recently, Scott Sumner and Arnold Kling blogged about asset bubbles. Scott Sumner post is about bubble deniers and how cognitive bias affects our assessment of about predicting bubbles. Arnold Kling takes one central point out of the Sumner argument - how to define a bubble. I think he views Prof. Sumner's post narrowly but his own definition is fabulous. That got me thinking about predicting asset bubbles. Let me explain it. The underlying principle Mr. Kling uses is this:

Asset profitability = rental rate + appreciation - interest cost
The logic is, so long as the asset profitability is positive at given price, the price is justified and hence not in a bubble territory. Let me distill the equation a bit more. I am simplifying here but, rental rate represents income from asset, appreciation represents rate of price appreciation and interest cost represents cost of capital. We also need to remember that that the equation deal in expectations. So asset profitability is expected asset profitability, rental rate is expected rental rate and so on. Further, to be consistent with units, we have to use rates (first derivatives) everywhere. Thus we have,
Asset Profitability = rental rate + Rate of appreciation - weighted average cost of capital (or WACC)
Hence, the limiting condition for asset profitability is,
Rental rate + Rate of Appreciation > WACC
Mr. Kling suggests that prices are in bubble territory when
Rate of Appreciation > WACC (given Rental rate > = 0)

Interpreting the asset bubble condition
Please examine the equation for bubble condition. There is no variable called price. Is it a surprise that the equation, as distilled does not involve absolute prices  or price income ratio or other related variable at all? Well the equation leads us to very important conclusions.

First, we understand the influence of interest rate on asset bubbles. We understand why raising interest rate pricks bubbles. It increases the RHS of the bubble condition. Now raising interest rate or cost of debt by 1% will increase cost of equity by more than 1%. Thus WACC will increase in relative proportion. We must note that WACC is very difficult to determine at a macro level - for the entire market. WACC also increases when risk perception of the environment increases thus popping bubbles. That may be the reason why extraneous events that affect the risk perception for capital pops bubbles and cools asset prices.

Second, asset prices move within a spectrum. Do note the way equation is derived. It shows us how asset price rise, initiated by fundamentals, moves into bubble territory. At one end of the spectrum are assets that depreciate - like machinery. The decision to buy them depends on how much rental rate (or income from that assets) exceeds the WACC. If the rental rate covers the depreciation(1) then assets become profitable. At the other end of the spectrum are assets where Rate of Appreciation is greater than WACC. I expect price of every asset moves within such a spectrum, from the rental rate covering for WACC and depreciation on lower side to the bubble zone where rate of appreciation exceeds WACC.

Third, asset bubbles can be identified by relative prices. The equation helps us understand if the prices we pay are bubble prices or genuine prices for our point of view. We cannot determine if the market as a whole is in a bubble territory or not. To know if markets as whole are in bubble we again go back to two principles. First is the notion that it is difficult for a market participant to estimate market WACC. Second represents the ability to stack assets in order of hierarchy based on rental rate. For any given WACC we can determine relative price hierarchy and thus estimate if rate of appreciation is higher than WACC.

(1) Here we must understand the difference between financial definition of depreciation and effective depreciation that includes maintenance and upkeep costs. Firms use factory maintenance programs to reduce the effective rate of depreciation.

Wednesday, December 08, 2010

How lower Interest Rate create Malinvestments?

Hayek argues about lose monetary policy resulting in malinvestments. But it is important to know how.In essence, there are three components to the argument.

First, interest rate represent the hurdle or minimum threshold return a business must produce. The return on capital is measure of the strength of business model and execution skill of the firm. The higher the return more capable the firm, stronger its business model, better its execution. (Note: does not indicate causality but simply co-existence).

Second, credit flows to those with history. Bankers or creditors in general, prefer to lend to large firms because of reputation, size and volume of credit that can quickly be deployed. In a low interest rate environment, bankers will prefer to loan a project of a large firm with ROCE of 5% rather than lend to 30 small firms with ROCE of 15%. This behaviour stifles the flow of credit to vibrant smaller enterprises, thus restricting new innovations. Because of this low-cost finance availability, it is possible that large corporates create unjustified barriers to entry (for example, dealer credit) to prevent new entrants. Further, it also creates anemic large projects that not only falter at the first sign of trouble, but also impose amplified collateral damage to the banking and credit system as a whole.

Based on my experience, the investment relevance - interest rate curve is a bell-shaped curve. If interest rates are too low then they result in malinvestments. If they are too high they strangle the economy. In between is a sweet spot policy makers should aim for.

Third, interest rate regime sets the benchmark for risk. Every investor, particularly those like mutual funds or pension funds, has a minimum expected return. This return is adjusted in keeping with planned expenses, payout of costs already incurred, adjustment for inflation etc. This minimum expected return is not a fancy number we expect to see, but rather a minimum threshold to ensure you cover your costs.

To hit this minimum return, investors now need to take more risks. In other words, we have modified the risk calibration. Each modification creates a portfolio churn, sometimes increasing the risk within the portfolio, sometimes reducing the risks as signaled by the interest rate regime changes. This is a form of mal-investment.

However, lower interest rates do help longer gestation vibrant projects. Infrastructure (or rather appropriate infrastructure) comes under this classification. Thus, a low interest rate environment can be used to create a longer term strategic advantage. Clearly, such process must involve stricter policy oversight and control.

Tuesday, December 07, 2010

When to support Asset Prices and at what level?

Back in 2007-09, during the peak of the crisis, world central bankers and regulators initiated strong actions to support asset prices. Some of the ideas continue to seep into the current bailout and stimulus strategy. However, to my mind, supporting asset prices is not a right strategy as it depends on the level at which supports are extended. Let us look at dynamics of asset prices to understand if their actions were warranted or not.

The asset price support strategy is in effect a response to bursting of asset bubble. There are two central considerations about supporting asset prices. First, should we support asset prices at all. Second, if we had to support, at what prices level should we support?

Why support asset prices at all?
The logic for sustaining asset price level rests on the fact that negative asset prices hurt a lot more than declining incomes. This is particularly true if the assets have claims on income (because of debt funding of assets). The collapse in claims result in cascading effects on the economy resulting in asset price deflation spiral.

For example, if a person or household earning $1000 per month with a conservative mortgage payment of $500 loses employment, then it immediately goes under prompting a loss to the bank. As the bank tries to recover its money by asset sales, the value of asset declines if many people lose their jobs and houses simultaneously. The situation is converse of a bank run. In a bank run, the liabilities of the bank get called in while assets are locked up. In this case, assets start getting marked down thus increasing the risk of liabilities being called in. Hence it renders banks undercapitalized. An undercapitalized bank freezes the entire money flow channels as it desperately tries to hold on to all the money it can.

At what prices should we support asset prices?
Given that there are situations wherein asset prices may need support, the question comes at what price can support be justified? To answer this question we must understand asset prices in more detail.

Asset prices have an income equivalence. In other words, every price point of an asset corresponds to an income level of the population. For example, if a person can spend only $100 on a car, then that will form the ultimate ceiling on the cost of making a car. Similarly, if an income producing asset can produce $100 worth of income (present value discounted appropriately), then that forms the ceiling of the asset price. For houses the income of future buyer will form the ceiling price of the house. This principle is captured as affordability ratio. About 100 years of data indicate that typically the house price is 5-7 times the current annual household income of the buyer. Conversely, when we support asset prices at a certain level, we should be sure of incomes rising to near affordable limits in short span of time (no longer than 6 months). This makes sure that prices can be sustained by the buyers through their own work and contribution.

Support for asset prices, particularly housing, should come at affordable prices and not at artificially high prices created during bubble times. I would also venture that the support for asset prices should be established at a point just below the affordable price so that tax payers' (those bailing out or helping support the prices) interests are protected.

Thursday, December 02, 2010

Income bubble or asset bubble?

What is the objective of QE2? Is it holding asset prices higher or is it pulling incomes higher? In other words, is the purpose of QE2 to create asset bubble or income bubble? In any situation, I prefer income bubble to asset bubble. I always thought it was ridiculously straight-forward. But may be the US FED and authorities do not understand it. Or may be I don't get it. So let me put the arguments out.

Rising asset prices do not give as much benefit as rising income. 
To gain advantage out of rising asset prices you need to monetize the assets. The monetization is advantageous if you replace the higher value asset with other asset. Replacing asset value with consumption is wrong. Any financial analyst worth his salt will explain that it impairs the balance sheet. Further, using asset values to create more debt is absolutely mindless. 

If asset prices have to be artificially inflated, it means there was mal-investment in the first place. If asset prices are held up, it gives the signal to the market to create more assets. This is exactly opposite of the signal we intend to give to markets.

When policy makers want to support asset prices they create a price floor. This only allows the prices to increase. They expect higher asset prices to translate into higher consumption expenditure (through wealth effects) and thereafter into higher incomes (through consumption led growth). It seems to be a round-about way of achieving growth. 

Contrast to that, working with incomes is better. 
Rising incomes create surplus disposable cash. Thus,  income creates direct support for asset prices. Let me highlight the support is direct. Now, working with income relates more to working on unemployment (or ensuring full employment) than issuing income diktats. Keynes understood this mechanism and hence advocated full employment. Full employment is able to efficiently translate income growth towards best skills. 

Thus, the objective of bailout or economic revival policy should be full employment and not a certain level of asset prices.