Exchange Rate Conundrum

There is a great deal of talk about pressurizing China to appreciate its currency. The talk is bunk. The idea behind Chinese currency appreciation is not simply about China but it is about an exchange rate regime change. Asking China to let its currency appreciate in isolation will achieve nothing.

The old regime, dominated by US Dollar and other western currencies, was installed through higher savings and purchasing power (ability and intent). The intent to consume remains strong in the western economies. But the ability is seriously impaired due to lack of savings. So the old regime is falling unless we do something about it.

On the other side, a new regime is yet to emerge. China and eastern countries have higher savings rate (ability to spend), but seem to be lacking the intent. It is believed that the savings rate is excessive and may translate into consumption. Michael Pettis, professor from Peking University, believes this savings rate cannot rapidly translate into consumption. The savings are earmarked for social security, pension and education. Thus the demand that we expect from China or other eastern countries will not be that high. In other words, to be a strong consumer for the world, China will need much higher savings and purchasing power.

A rising currency can reinforce purchasing power for any economy. Importing capital goods becomes cheaper. Importing key raw materials becomes easier. There are lot of cost efficiencies that are generated. However, it exposes the economy to competition from overseas. It means employment is threatened. If economy has large population at lower incomes then it reduces consumption at national level. This is a good move for an economy where income pyramid is fatter in middle. It is natural that China would feel threatened by such a move.

There is other way to sustain the economy in appreciating currency environment. This stems from Porter’s competitive advantage of nations. Economies should start building sustaining competitive advantages. Low labour cost is not a sustainable advantage; rather it is a self-cancelling strategy over long term. The answers lie in Germany, in all likelihood.

In sum, it is time to establish a new regime based on fundamentals rather than managed currencies.  In such a regime, those with purchasing power will have stronger currencies than those without. There has to be global agreement on this regime to make it effective. Without it, we are going to wander aimlessly as far as exchange rate scenario is concerned.

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My book "Subverting Capitalism & Democracy - Systemic faults that caused the financial crisis" is available on Amazon.

The RBI policy

The reserve bank of India (RBI) announced its annual monetary policy yesterday. The RBI increased repo, reverse repo and CRR by 25 basis points. The reasons were as follows:

1. Inflationary concerns are dominant. The RBI is keenly watching the change in the structure of inflation. Rising food prices triggered inflation last year (weak monsoon effect).  However, it quickly moved to non-food price increase. This, coupled with abundant liquidity has given inflation a substantial resilience. It is imperative to highlight that food prices have eased since January.
2. The Indian economic recovery is yet to get proper traction. The direction is right but credit off-take (bank and non bank) and other indicators are still wobbly.
3. The policy rates in India are about 100-150bps below the normal rates.  So this is a process of normalization.
4. Global factors continue to remain weak due to impending sovereign crises and playing out of asset deflation. The potential impact of sovereign crises is not fully clear and it is better to be circumspect than sorry.

The step change moves and cautious certain trajectory reminds one of Greenspan era policy changes. We know how that ended in bubbles. However, there are two reasons, intended or unintended, that makes the move a good choice.

There is still a lot of uncertainty in Indian economy. The way to counter uncertainty is by introducing certainty in controllable variables. The RBI has indicated a clear direction towards normalization and given us exactly this.

The RBI is also facing challenge of managing exchange rate regime. Any changes to relative exchange rates, interest rates will trigger a capital inflow into India affecting Indian domestic and export competitiveness. While it is not correct to promote export competitiveness through weak currency, the global exchange rate regime does not allow RBI that flexibility. With many countries following weak-currency approach, RBI will risk exposing domestic industry to unfair competition.

Thus, moving steadily while constantly watching the global scenario will serve the RBI and Indian economy better. The RBI has shown prudence, intelligence and resolve in combating the crises. Overall, this policy reinforces the RBI’s credibility.

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My book "Subverting Capitalism & Democracy - Systemic faults that caused the financial crisis" is available on Amazon.

My book "Subverting Capitalism & Democracy" Launched!

My book "Subverting Capitalism & Democracy" is now available on amazon (kindle version and paperback version). I am not yet sure why kindle and paperback version are shown as two different books but I think it will be sorted out soon. Here is a brief introduction:

Subverting Capitalism and Democracy

What caused the current financial crisis? A lot of answers have been proposed.  But do we know the root causes? This book looks at the causes behind the causes we know. The micro-faults that subverted capitalism and democracy are still overlooked.

Today, finance dominates our socio-economic hierarchy. Sadly, we know less about finance and economics than we like to believe.  We must relook at the basic concepts of finance and economics. We need to know how large pools of money create systemic weakness. We need to ask why the media and the regulators were sleeping at the switch.  

We have to go beyond lobbying, beyond “intellectual capture”, beyond exotic financial instruments and ask the next level of questions. Only then we will reach the root causes. Now is the time to set the system right. I hope this book will extend the discussion towards a solution.

Now that it has shipped I can see a million mistakes in it, a billion ways I could have made it better. But what the hell! I look forward to your feedback to make second version a better one.

The challenges facing Indian IT

Indian IT companies are not fully cognizant of the challenges facing them. There are many forces at work here:

1. The terms of exchange rate contribution will be adverse. Going forward, I expect the INR to appreciate closer to 35 (INRUSD). The only variable is exactly when. At the moment, financial analysts have lulled the managements into thinking that these levels are not possible in near future. I am not so sure.
2. Exchange rate will trigger further competitive pressures from global IT majors.
3. The need for cost cutting and efficiency is driving demand for IT companies. This may not remain as strong as expected. There should be some pressure on margins in this area.

Overall I would be keen to have in-depth session with top managements of Indian IT majors.

Debt Repudiation

After a long time we have come back to essential question. Is it ok for households to walk away? Naked Capitalism has a post by Edward Harrison titled Guest Post: Is Debt Repudiation a Good Thing or a Bad Thing? « naked capitalism.

I do not see why not. I think households should be allowed to walk away from non-recourse mortgages and no one has any business trying to create social pressure into paying more. Banks and financial institutions have played this as an economic game, no emotions. So why blame individuals when they make economic decisions.

Second, writing debt off is also used as a trick. You write off the debt but hold on the portfolio. Whatever the household pays back is then directly added to the profits. It might seem idiotic, but I have seen banks do it with ill intention.

Third, The written off portfolio is, in some cases, sold to "recovery agents". These agents follow up and try and recover as much from this as possible. In principle this is not wrong. But with inflated loans and deflated incomes this can be harsh. 

These steps will impede recovery of consumption in developed countries.

China Bust?

Market View and trading strategy from Vitaliy Katsenelson

Vitaliy Katsenelson provides a clear and concise view on the market movement and strategies to make money.

Market Performance Outlook

He predicts another year of range-bound behaviour with higher highs and lower lows. I am not sure about the duration but I agree with higher highs and lower lows theory. Further I believe the cycles (high to low) will be much compressed this time around.

 

Investment Strategy

Katesenelson's investment strategy suggestions are must read for all investors. I would just add that one needs to pick winners/survivors in this crises. This is type of crisis that separates really dynamic companies from sitting ducks. So extra due-diligence is the order of the day.

Vitaliy Katsenelson's recommendation for investment strategy:

In range-bound markets, as P/Es compress they turn against investors; thus investment strategy in this very different and difficult environment needs to be adjusted for the new investment reality:

• Become an active value investor.  Traditional buy-and-forget-to-sell (hold) strategy is not dead but is in a coma waiting for the next secular bull market to return; and it’s still far, far away.  Sell is not just another four-letter word; sell discipline needs to be kicked into higher gear.
• Margin of safety needs to be increased.  Typically, value investors seek for margin of safety to protect them from overestimating the “E”.  In this environment it needs to be beefed up to accommodate the impact of constantly declining P/Es.
• Don’t fall into the relative valuation trap.  Many stocks will appear cheap based on past valuations, but past secular bull market valuations will not be in vogue for a long time, thus absolute valuation tools such as discounted cash-flow analysis should carry more weight.
• Though timing the market is alluring, don’t – it is very difficult to do it consistently.  Value individual stocks instead. Buy them when they are undervalued and sell them when they become fairly valued.
• Increased margin of safety and stricter sell discipline will lead one to have a higher cash position at times.  Don’t invest for the sake of being invested, because this will force you to own stocks of marginal quality or ones that don’t meet your heightened required margin of safety.  Secular bull markets taught investors not to hold cash, as the opportunity cost of doing so was very high.  However, the opportunity cost of cash is a lot lower during a range-bound market.

Links

The Big Picture » Blog Archive » Welcome to Another Lost Decade

Rahul Deodhar: Cyclicality of global slowdown

Rahul Deodhar: Picking Survivors

Stimulus - Monetary, Fiscal or both

Ed Harrison initiated a discussion on stimulus. The question was whether the US government stimulus was necessary. Here is my response.

US Dollar views

I am starting a new initiative. I will hereafter add videos rather than posts. Here is the first one on US dollar.

Defining end of recession

Just a quick note:
If it takes three consecutive quarters of GDP decline to call a recession then how can we call it over by just one good quarter?

Dollar will go down - just not yet!

There is a lot of talk about return of the USD, specially after Jim Rogers declared that he is long USD. Jim Roger put out a counter trade argument. Simply put, there were too many people betting against the dollar. So no way it will go down right away. There is one more argument!

Exporter push developing country central banks to the wall!

While USD weakness is well known, the developing country central banks are under increasing pressure to  manage the exchange rates at current or pre-crisis levels. Entire exporter lobby staff is on just this one task. The thing they don't understand is that US demand is not coming back to pre-Sub-Prime Crisis levels.

I expected this lobbying. But I also expected large exporters to start geographical diversification. This would suggest that exporters are buying time while preparing for new world realities. But there is still no sign of it. I believe, exporters are still in denial!

Currency tango - It still takes two for it!

Central bankers, on the other hand, do not want to be the first developing country to let their currency appreciate. So it will be a game of who blinks first. The usual strategy is such a poker game is to suggest that one will defend the peg no matter what! That is what China has done.

But I would venture they will be the first to act, and they will act decisively. But till that time we are in for holding breath under-water! It is unlikely that anything substantial will happen in 2010 on this front, may be during fall of 2010. One can only guess the impact once currency revaluation sets in. Lord have mercy!

Hidden Risk in Indian Tech

One of my hobbies is to poke holes in stock ideas of analysts. Recently, these talking heads have put out strong buy ratings on Indian tech companies, the likes of Infosys, Wipro, TCS and even Satyam (post scandal). Here is what I need to know before I can be certain of such a trade.

Winning contracts in currency uncertain environment

Indian IT companies have been winning technology contracts from top companies, most recently Walmart. Now imagine a US company that knows USD will depreciate. So how would this impact my sourcing strategy? I, personally, would accelerate all the supplier contracts in today's dollars. Iron-clad them in legal fine-print to mitigate risks from demand collapse and currency fluctuations. The longer such a contract the better it is! Now the question for me is, sitting on other side of this agreement, how have IT companies managed this risks?

The currency risk

This is the most potent business killer, if ever one exists, in Indian IT companies. A lot of analysts have sensitivity analysis ranging from INRUSD of Rs 30/ USD to Rs 50/USD. A few smart investors have already stressed the financials till INR 20/USD and seen the impact. Even smarter investors know that the impact is non-linear in nature. Such currency volatility needs business model innovation (as above) rather than simple currency hedges. The volatility implied in such scenarios may actually test counter-parties in hedged transactions.

Survival Necessities for coming years

Given our current situations, IT companies will have to prepare differently to survive.

• Multi-location operations will be an advantage: This implies having robust processes to create and manage scaling issues well. Companies like ones mentioned above are operating in various countries thus helping them react better. 
• Flexi-sizing will be key: If the currency valuations reach new normalcy, it will be important to relocate manpower to cheaper locations. Companies will have to be quick to rapidly expand, move or lay-off employees. While, all the companies above have what it takes to do it, we should realise it is not an easy process.
• A bit more fat! The crisis is upon us and the IT companies are cash rich. The key is to keep higher than normal cash reserves and not fall into the acquisition trap at this early stage. 

The best time for investment is not now!

Once the currency crisis hits, there will be more clarity on winners and losers. At that point valuations will be saner and those that survive will definitely give better results. Till such time, I would keep a safe distance between myself and IT stocks.