S&P putting India rating outlook to negative - comments

Everyone knew that India's situation is precarious. Lack of reforms, rising fiscal deficit and lack of focus from a dream-team that brought in first wave of reforms. So it is hardly a surprise that India's rating outlook is changed to negative. It is made big news, was shrugged off by the markets. But it deserves a few comments.

It ratifies that India's policy direction has reversed signifying the third phase of reform process - reversal. Between 2001-2004 the direction of policy reform was positive. Between 2004-08 there was a policy logjam, primarily attributed to stifling policy of the Left parties. However, post-2008 the policy environment has turned adverse despite no participation by Left in present government.

The current policy environment is typically familiar territory of Congress party - it is a poisoned policy environment. There are arbitrary decisions (Spectrum allocation), abnormal legislations (retrospective tax liabilities), populist measures (NREGA, reversal of first fare hike in 8 years in Railways), arbitrary intervention in infrastructure sectors (under the heading of environmental clearances - POSCO deal), gross corruption aimed at filling the party coffers (commonwealth games scandal), disregard for law and order particularly by government, etc.

To top it all, no change of policy-scene is likely in future despite the promises of finance minister and Prime minister. These people were not waiting for S&P to turn negative before bringing in the main reforms. They do not want reform.

For everyone, investors, general public, firms, foreign investors etc, consistent long-term strategic direction about policy is more important that precise current policy regime. It is immaterial if you have high fiscal deficit, but it matters if you have no plan to come out of such deficit. It is immaterial if there are high taxes so long as there is a progressive clarity in tax laws and consistency in application.

In all, the only change possible is that this government is defeated and subsequent government will bring in a clear long-term strategic view to policy making.

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My book "Subverting Capitalism & Democracy" is available on Amazon and Kindle.

Deploying Public Assets (spectrum, coal blocks, etc.)

One of the important functions of the government is to deploy public assets for public gain. However, selling these assets or renting them has landed many a government in a soup. Be it the mill-land fiasco in Mumbai, spectrum auctions for 2G or coal block allotment, governments seem to fumble at every step. And this is not the only problem with deployment of public assets. Let us look at problems and solutions to selling or deploying public assets in the interest of public.

The problem with deploying public assets
The process of deploying public assets is difficult. Inappropriate deployment usually turns into allegations of scams and threatens the political order.

1. An infant nation is compelled to deploy the assets it owns in a legal environment that is not yet sophisticated and evolved. Thus, such a nation is faced with immediate prospects of inappropriate deployment and therefore political disorder.
2. Asset deployment theories themselves are still evolving. Thus, the jury is still out on whether renting is better than sale of assets in conditions of uncertainty, how long should lease durations be,etc.
3. The asset pricing mechanism is ill-developed for untested or new technology. Here, it is difficult to estimate the present value of the asset. These new technologies are sensitive to choices and, in scientific parlance, to initial conditions. thus, what may be a good technology elsewhere,and therefore priced at premium, may become a failed idea at high costs. In such cases it is nearly impossible to estimate in advance and accordingly price such assets.
4. The question of opportunity cost is of prime importance. If I sell an asset to a firm and the firm does not develop it but simply sits on it. That may be advantageous for that firm but it defeats the purpose of sale of assets by the state.
5. The risk being taken in new development must be paid for. In other words, when the entrepreneurs bid for a technology that has not established itself, they are taking risk. If the government starts demanding higher initial payments, the entrepreneurs' risk is amplified resulting in under-developed sector. A better way is to let the initial payment be lower while gain from profit sharing or revenue sharing mechanism.

Two types of asset sale problems or mistakes
Even when there is no corruption, there are two types of problems or mistakes government can face or make with asset deployment. 

1. The government sells the asset at lower than market value thus resulting in loss for the exchequer. This is usually because the government cannot value the asset correctly. Alternatively, government is advised to "leave some value on the table". In all these circumstances, the exchequer is the loser. 
2. The second type involves selling the asset at market price but to someone less qualified or simply, preferring one buyer over the other. Here the problem is not for exchequer directly. Here the shareholders of the company denied the asset end up losers while those of winning company gain windfall profits. It is possible that the preferred buyer may not have technical capabilities to effectively deploy the investment thus resulting in second order loss for exchequer. 

Out of the two types of problems with asset deployment, first is detrimental to the exchequer but the second is indifferent (at least directly). It follows that the level of tolerance for first type of mistake should be lower than the second one.

Types of Asset pricing
Asset pricing depends on various mechanism for cash flows and availability of asset itself. 

1. One-time sale - this transfers public asset to private ownership: This involves higher risk to government as the real value of the asset may not be correctly assessed at the time of sale. However, once sale has concluded there is not much that can be legally claimed from this type of transaction. 
2. One-time payment for right of usage for few years and renegotiated every few years: This is capitalized rent and the value of this changes as perception of risk changes. The risk involves depends on what the asset is and how long is the first lease period. E.g. Mumbai Mill lands have been leased to companies on 99 year leases. Recently 99 year period has expired but the ownership of those lands has not reverted back to government.
3. One-time license-fee payment followed by share of revenues/profits: Here the one-time component is lesser to account for untested risk that entrepreneur must take. Thus, this option is less risky for entrepreneur as well as government. There are sub-categories within this option depending on where the government takes its cut - at revenue stage or at operating profit stage or net profit stage.
4. Only share of revenues or profits: Technically Taxation achieves this effect either through general tax or specific industry based levy, either in the form of excise, cess etc.

The first three methods are used where the asset is scarce (usually resources like spectrum, mines, land etc.). The fourth method is used for everything else.


Structure of Corruption around these problems
Corruption is structured around these potential problems to aggravate the loss to exchequer. Following problems occur generally:

1. Asset is impaired and sold thereafter: Impairment can be positive act or negative acts. Positive act means the asset is deliberately impaired wherein losses increase and asset appears hopeless. A negative act means allowing the asset to degenerate without actively doing so.
2. Mechanism of Asset pricing is changed midway: Here the original intention of pricing the asset is ignored. First, the asset is priced lower to encourage investment by lowering the risk in the asset deployment. Thereafter, an argument is evoked at the deployment is only profitable at such low prices and hence the asset value is actually low. Thus, Mill lands went from following method 2 above to method 1 without commensurate payment.
3. Concessional rate for PSU buyers: In this form the government allots a public asset to a public sector undertaking (PSU) company. This seemingly benevolent act can be hideously corrupt. Unless the PSU is 100% owned by the government, it is reducing public gain and has same effect as selling the asset at throw-away prices. A PSU in receipt of such asset must not complain if the government caps the prices of the end-products it produces.
4. Concessional allocation to PSU and subsequent divestment: This is modified part of third problem in which asset is alloted to a 100% government owned PSU and thereafter the ownership is divested. This buries the asset under the PSU performance and makes it less valuable to lay-person. 
5. Asset Valuation is not proper: In this case, the sum-of-parts value of the asset is higher than the asset itself. Thus the parts must be valued appropriately. Thus the land owned by a specific PSU that is divested may be of more value for other use than for use of PSU itself.
6. Profitability Estimation is impaired: This form works with assets like airports and roads where the right to collect toll or charge for services is leased to private entities. Recent experience suggests the estimation can go wrong in both ways as has happened in toll-roads and airports privatized recently.
7. Arbitrarily choosing pricing mechanism for two similar assets (Inconsistency): For reasons unknown, without effecting a policy change, government allots one asset in one manner and other using different pricing mechanism.
8. Granting asset to unqualified buyer: When asset is granted to an unqualified buyer who sells the license to other party at substantial profit, there is ground for doubt to believe that asset is underpriced and opportunity exists for arbitrage trade.

Note: The list is not exhaustive as people are infinitely more creative than anyone can anticipate.

The solution
The real solution is not a model for asset pricing but one of transparency. 

1. Conservative approach: I believe, from the exchequer's point of view the risks associated one-time outright sale are quite high. Instead, a non-trivial license fee in addition to share of revenues forms a better alternative. It allows for future adjustments of asset value and exchequers share in the same.
2. Transparency: If the process is transparent and mechanisms are fair, there is not much corruption that can happen. 
3. Changes to reflect true assessment of changing value of asset: If it so appears that initial payments were underpriced, then subsequent revenue sharing could be raised and net effect can still be adjusted.
4. Consistent changes: Any policy driven choice must be applied consistently. Thus if government chooses auction method then auction should be followed everywhere. If First-come-first approach is used it should be used consistently and fairly.
5. Principles of natural justice and equity: Any solution accepted by government must abide with principles of justice and equity enshrined in the constitution. Thus, if all qualified parties are given equal opportunity to bid for asset, there is not much scope of corruption.

In Sum

The focus of asset deployment is to get best value for the asset being deployed for public interest. The duty of the government is to deploy public assets for public gain. So long as basic principles are adhered we can have a flexible system that can account for past mistakes in an on-going manner.

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My book "Subverting Capitalism & Democracy" is available on Amazon and Kindle.

Why QE or Asset Purchase is bad idea?

In my humble bid to respond to Martin Wolf's post in FT, I must de-clutter the arguments. But first let us look at the questions:

1. Why suddenly does QE have to be of this large magnitude?
2. When does QE work? What are different types of liquidity problems that QE can solve?

To answer these questions we must understand how the asset bubble phase worked. Let us take two important policies that aided the previous boom. 

Two policies that aided the boom

First, we were in era of low interest rate and low inflation. Second, inflation, everywhere is measured by estimating changes in the price of basket of goods and services, no matter how exhaustive or qualitatively superior the basket is.

The question really is - what happens to a person who has a lot of money but he cannot put in a basket which is watched closely? Logically, he puts it into another basket. What if there is no other basket? Well, he creates another basket. This is exactly what happened over past three decades. 

People wanted to invest in assets that were included in inflation basket because the goods and services in the basket comprised important daily items. However, they realised that too much investment makes the central bank tighten the money supply by increasing interest rates or calling for higher reserve requirements.

So these people started investing in other baskets - let us call them basket 2. In many countries real estate was in this basket. This created substantial bubble in these asset classes. The level of bubble was so high that these investors baulked at the prices and were reluctant to invest. Some internal value compass was indicating a diversion from reality and presence of unprecedented risks.

So these people had money and no where to invest. So they created a new basket - basket 3. This comprised derivative of assets in basket 2. This reduced the risk associated with assets in basket 2 and calmed the frayed nerves of investors reluctant to invest directly. Now these people can invest, because the risk was, supposedly, reduced. 

The basic rule was to created tradable assets where this excess money can go to without stoking inflationary fires. This is what I call Asset-creator boom.

Two type of Assets

The asset creators initially scouted for most promising of productive assets. However, once all the investable assets were exhausted, they started creating paper assets. These paper assets are not productive and have same utility as coins or chips from a gambling house.

To complicate matters, the developments in this asset class were creating winners everywhere. Traditionally, the gambling house always wins, but here was a gamble where the clients were winning big. Naturally, the paper assets had same problem as that of gambling house chips. They are good enough till the gambling house is good enough to pay money for them. Once the doubts about gambling house start creeping in, there is bound to be trouble.

Since the economic policy remained in this zone for long time,  the quantum of these paper assets grew to large order of magnitude. In comparison, genuine productive assets grew at a modest pace - as they usually do.

The essence of QE

Usually, QE or infusion of liquidity, or asset purchase, is done when there is no buyer for assets and that stalls the economy. When this mechanism was invented or discovered, assets usually referred to productive assets. So even when the central banks buy these assets, the assets do produce something of value. Over time, people tend to appreciate the value of these assets and buy them back from the central bank. Thus QE works when the system has more good productive assets than bad assets.

This time, the central bankers are buying paper assets leading to two major issues. First, the quantum of purchases is going to be substantially large sometimes as much as the real economy itself. Second, no one is going to purchase these assets back from central bank later as they will realise that these are worthless. So, for all practical purposes these assets are destroyed or taken out of the system. Thus, the central bank asset purchase schemes put out a lot of money in the market while reducing the quantum of assets in the system. This is what leads to talk of inflation.

Problem of inflation

Now, we have too much money, pumped in by the central bank, chasing too few productive assets. Note that no one wants to hold the dummy assets any more. 

In our basket-3 type assets, there was a micro-thread connecting these assets to the productive assets. The thread was too weak and too thin that it escaped perception of investors. Hence there was no effect of basket-3 asset bubble on basket-1 goods and services. 

Today, investor want assets strongly linked to productive assets. Naturally, there is a good deal of impact on underlying goods and services. Thus price of these goods and services are becoming increasingly volatile. Inflation is all about changes in prices of these goods and services.

To have sane pricing of goods and services, we will need some equitable relation between total money in the system and total number of productive goods, services and assets. It means this excess money will have to be destroyed. To counter this excess money chasing core, productive assets, central banks have decided to pay interest on money it created, so that this excess money simply sits in a bank account doing nothing. This incentive prevents money from chasing any assets. Further, the central bank knows where the money is sitting so that it can quickly destroy it when it becomes troublesome. Alternatively, the currency will lose its value and adjust to new price equation.

The problem of sovereign debt

The ideal solution to our crisis was thus. The central bank creates excess money and gives it to investors. These investors, worried of the risk in the system, invest in government securities. This gives government enough money to deploy in programs that can promote real, productive growth of the economy. Meanwhile, as the growth returns, investors are more confident of what are good assets. They buy these assets from central bank thus returning the excess money.

This time, the excess money available with investors was truly large. The government could not come up with a credible list of projects that will build long term advantage of the country. Hence, investors have started demanding that the government either tighten their belts to meet their obligations or show how their spending will create future returns. Government has been able to do neither. Therefore, we see substantial demand that government undertake austerity measures. Government, on the other hand, believes that since the central bank purchased assets no questions asked, the investors should also purchase government bonds no questions asked. A sort of quid-pro-quo. But investors have not kept their end of the bargain.

One wonders, if this conditionality should have been embedded at the time of central bank asset purchase and if it was wise to believe that investors will uphold their end of the bargain. The question therefore remain, why did the central bank have to purchase bad assets at all? Why QE?

In sum

Nevertheless, that is the story of QE. Those are the reasons QE will not work. It is said that false money created from casinos should have been destroyed at the hands of the gamblers. By purchasing these gambling chips for real money, the central bankers have, in effect, sold the tax-payers and citizens short. Hence, QE is, for all practical purposes a bad idea.

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My book "Subverting Capitalism & Democracy" is available on Amazon and Kindle.

Taleb on Antifragility | EconTalk | Library of Economics and Liberty

I like what Nassim Taleb usually writes. Here he is talking on Anti Fragility talking with Russ Roberts who produces an incredible podcast at EconTalk. I am a regular listener. Taleb on Antifragility | EconTalk | Library of Economics and Liberty.

The critical question he thinks about is how to design antifragile systems. Particularly relevant is the discussion on definition of Antifragility: (worth reproducing)

What is the opposite of fragile? And of course we think we know what that is. The opposite of fragile is robust, you say; it may be unbreakable. But you argue that's not right way to think about it. It doesn't capture the essence of fragility. So, why do we need another term? Because if you send a package by mail to your cousin in Australia and it has champagne glasses, you write "Fragile" on it. If it is something that is robust, you don't write something on the package. You don't say you don't care, you can do whatever you want. So the fragile, the upper bound comes back unharmed or [?] and of course the worst is completely destroyed. So, that's the fragile. The robust has an upper bound of unharmed and a lower bound of unharmed. The empty fragile would be a package on which you'd write: Please mishandle. Because a lower bound would be unharmed. And the upper bound would be improved--you'd get, instead of sending 6 champagne glasses, 8 would arrive. Exactly. Like in mythology. Or they'd be better glasses, stronger somehow. Like the Hydra--you cut one head, two heads grow back.

Must listen.

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My book "Subverting Capitalism & Democracy" is available on Amazon and Kindle.

Crisis Basics: Solvency Crisis Vs. Liquidity Crisis

Let us understand what a solvency crisis and liquidity crisis are.

A Liquidity Crisis

Here is a popular example that was given in past few years. “A tourist stops at a motel and gives the manager a $100 cash deposit while he looks at the rooms. The manger runs and pays off his $100 debt to the butcher. The butcher runs and pays off his $100 debt to the farmer. The farmer pays off his debt to the feed store, and then the feed store owner pays off his debt to the motel owner. The motel owner then gives the $100 deposit back to the tourist.” This is a liquidity crisis.

Point to note:

1. All people were in debt. The size of debt is immaterial. The hotel manager could have had debt of $1million to various vendors.
2. The debt was used to create value. That, is the most important aspect of this debt.
3. The value dominoes were stalled because of lack of liquidity which the tourist provided.

A solvency crisis

Here let me use the example from Bob Steinke. 

Imagine instead that a restaurant owner takes out a small business loan to stock his wine cellar. The next day Bernie Madoff comes in and drinks $1000 of wine, paying with cash. The restaurant owner turns around and invests that cash in Madoff’s hedge fund. The next day Madoff comes back and drinks another $1000 of wine, paying with cash (the same $1000 bill he used yesterday), and the restaurant owner turns around and invests that money with Madoff too. This continues ten times. Madoff has drunk $10,000 of wine, and has a $10,000 debt (the investment he is supposed to eventually return to the restaurant owner), but he only has $1000 of cash to repay that debt. Madoff has a solvency problem. His net worth is less than zero. Temporary use of some cash, to be paid back later, would not solve this problem. This situation is different because value was actually destroyed. The $1000 of cash still exists, but $10,000 of wine disappeared into Madoff’s stomach, and Madoff didn’t produce anything of equal value he could use to pay for the wine.

Points to note:

1. Debt was created just as in previous case.
2. Debt was deployed to non-productive ventures. In this example Madoff drank-off all the wine. It means value was destroyed.
3. The debt domino does not stall easily in this case unless doubt creeps into the mind of the restauranteur.

Therefore

1. Now clearly solvency crisis seems bad one. If only we had someone who could tell the restauranteur that Madoff was a crook. That someone, in many cases, should have been the ratings agency.
2. Whenever there are debts, there are also bad debts. Good debts are deployed towards creating value higher than the value of the debt. 
3. This begs further explanation. Let us assume an entrepreneur takes $100 of debt @ interest rate of 10% per annum. This debt is employed to do work that ideally produces output greater than $110 in one year. Thus, debt of $100 creates, let us say, $130 of value. Then we say that debt of $100 create $10 of value for the creditor and $20 value for the entrepreneur. 
4. From the creditor's perspective, let us say the creditor makes 100 such loans. So the total debt is $10,000. Potential value it should create for the creditor = $1000. 
5. Now imagine one entrepreneur fails and loses everything. 
6. From the creditor's point of view there is not yet a problem as other 99 loans are good. The creditor will lose $100 of capital and $10 of interest. Thus, the creditor will earn $890 in that year. In technical parlance we would say, the creditor had write-off of $110.
7. Solvency crisis happens with size of bad debts is higher than the value created by good debt.

The problem of misdiagnosing a solvency crisis as a liquidity crisis

The authorities tend to pump in more money to solve what they term, rightly or wrongly, as a liquidity crisis. The money often goes to Madoffs of the world who disappear with the money. The problem gets compounded when a solvency problem is thought to be a liquidity problem.  This actually increases the level of bad-debts in the system.

The way out of the solvency crisis 

There are various ways out of solvency crisis, each dependent on the size and structure of the problem. 

1. One way out is to write off the debt and start afresh. Everyone takes a hit and blames their naivety and goes back to work. 
• This is relatively easy when the size of the problem is relatively small, as in our example above. 
• There is a problem with relative size of bad debt is colossal. In such cases, creditors need to be wound down in a systematic manner. At the same time, the resulting recession has to be managed by promoting employment and counter-recession measures.
2. Textbook way is a little different. Technically, it is possible to increase the level of the good debt to such an extent that the bad debt can be written off without any problem. There are two ways to create good debt. 
• First, by reducing interest rate marginally bad debt can become good debt. It is interesting to note that the first approach works only if the amount of bad loans is uncomfortable but not catastrophic like we had in 2007. In other words, the difference between good and bad debt has a bearing on effectiveness of this approach. Monetarist do not agree with this pre-condition. They believe this approach can work for any difference between good and bad debt.
• Second, by pumping in additional money into the system. The additional money, ideally, will create value that will dwarf the losses from bad debts. This is like making a line smaller by drawing a longer line beside it. The second approach only works when you have body of projects that can absorb the new capital and still be classified as good debt. The gains from these projects must be quick and substantial. For example, if by some stroke of policy we can quadruple the exports then debt required to fund that policy can become this text-book solution.
3. The third way of escaping a solvency crisis is what I call the Chinese-bank way. In this mechanism, you combine all bad debts, distressed assets into a special purpose vehicle. This cleans up the balance-sheet of corporates holding those assets in first place giving them room to borrow and invest in their businesses. The special purpose vehicle is then backed by government whose solvency, ideally, is not a problem. Over a period of time as industry grows back into a healthy state, government offloads its stake in SPV to the markets which digest these debts. 
1. Naturally, these bad debts are a little different from other bad debts. These bad debts must be productive under some conditions, which are denied because of the impending crisis and may return when the crises abates.
2. If government is holding really bad bad-debts then it can write-off the SPV investment and claim the debts as taxes either from public or corporates at later date.

In sum

We can notice that quite a few ways for countering this crisis have been tried. We haven't had much success. As stated, half-hearted attempts to solve the problem compound this problem, thus, we are in a bigger soup. Let us hope, further solutions are better managed.

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My book "Subverting Capitalism & Democracy" is available on Amazon and Kindle.

Jeremy Grantham knows we were warned!

Years back in 2008, I wrote a post about how Shakespeare's Polonius (from Hamlet) had good advice for us investors. Today, Jeremy Grantham, in his quarterly newsletter, discovers that very advice.

Here is my post from 2008: "How to avoid the credit crunch?"

I was really surprised when I realised that entire credit crunch and related problems were highlighted and we were warned back in 16th century itself.

For Rating Agencies
See thou character. Give thy thoughts no tongue,
Nor any unproportioned thought his act.

For investors - particularly those who misguide people on CNBC
Give every man thy ear, but few thy voice;
Take each man's censure, but reserve thy judgment.

For US / UK and European Consumers
Costly thy habit as thy purse can buy,

For Mortgage dealers (they heeded but CDS borrowers didnt)
Neither a borrower nor a lender be;
For loan oft loses both itself and friend,

For all market operators
This above all: to thine ownself be true,
And it must follow, as the night the day,
Thou canst not then be false to any man

Here is the full advice:
Yet here, Laertes! aboard, aboard, for shame!
The wind sits in the shoulder of your sail,
And you are stay'd for. There; my blessing with thee!
And these few precepts in thy memory

See thou character. Give thy thoughts no tongue,
Nor any unproportioned thought his act.

Be thou familiar, but by no means vulgar.
Those friends thou hast, and their adoption tried,
Grapple them to thy soul with hoops of steel;
But do not dull thy palm with entertainment
Of each new-hatch'd, unfledged comrade. Beware
Of entrance to a quarrel, but being in,
Bear't that the opposed may beware of thee.

Give every man thy ear, but few thy voice;
Take each man's censure, but reserve thy judgment.

Costly thy habit as thy purse can buy,
But not express'd in fancy; rich, not gaudy;
For the apparel oft proclaims the man,
And they in France of the best rank and station
Are of a most select and generous chief in that.

Neither a borrower nor a lender be;
For loan oft loses both itself and friend,
And borrowing dulls the edge of husbandry.

This above all: to thine ownself be true,
And it must follow, as the night the day,
Thou canst not then be false to any man.
Farewell: my blessing season this in thee!

- Shakespeare in Hamlet (Lord Polonius advice to son Lartes)

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My book "Subverting Capitalism & Democracy" is available on Amazon and Kindle.

Commodity valuation

A lot of people believe in strength of commodity prices but the boom is fragile for the following reasons.

Substantial part of valuation depends on strong and sustained commodity consumption driving growth in India and China. The growth is unlikely to be either strong or sustained (in near term). This may take the wind out of the boom.

But I believe we have underestimated two other reasons.

Commodities as store of value
A part of boom in commodities can actually be explained as a result of money trying to protect value of developed countries investors. To protect value, you translate your money into equivalent basket of benefits (goods and services) that can be bought with your money. So we can imagine the equation as (money I have in year "t") = (sum of products and services that can be bought in year "t").

Every year this equation must be evaluated from the RHS not LHS. Thus, the true comparison can be achieved when we compare (sum of products and services that can be bought in year "t") vs. (sum of products and services that can be bought in year "t+1"). Ideally, we must be able to buy more products and services in "t+1".

However, in common parlance we do compare LHS. The question we ask ourselves is "do I have more money than last year?" It is a misleading question. People get fooled when the answer is yes. In fact, American middle class thought they had more money in every subsequent year. But in real terms the wages are stagnant for more than 2 decades.

To protect the RHS value, investors try to hoard certain commodities that are irreplaceable. The degree of irreplaceability, knowledge of alternatives, certainty of whether commodities will indeed be part of value-store equation are all unknowns.

The Real Chinese demand
The resource intensity of growth of China will reducing drastically. This is simply because of three main reasons.

Firstly, China has built out infrastructure for next N years, advancing their consumption of commodities. This will revert to mean in the next N-4 years. (The value of N is matter of debate).

Secondly, China has already bought or locked in its commodity requirement for next few years and this has no price implication for commodities hereafter.

Lastly, it has to reduce drastically just to make scientific sense. This will have new winners and losers within different commodities. 

Evaluating commodity boom is difficult
Thus, the factors affecting commodity prices and demand are different than normally discussed. I am yet to see a reasonable assessment of the two main changes above. Hence, I advise to be really, really careful with commodities. At least do not build any position you cannot liquidate quickly. 

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My book "Subverting Capitalism & Democracy" is available on Amazon and Kindle.

The Value of Indian Rupee

The Economist recently published the Big Mac Index that shows Indian Rupee as most undervalued currency contrary to the popular perception of its value. The Big Mac is priced at $1.62 in India vs. $4.2 in the US thereby giving undervaluation of 2.6x.

It raises some hard questions:

1. Has Indian Government absorbed substantial part of costs? Indian government subsidizes diesel and that could show up as mark down. This bloats the government balance sheet but keeps inflation from showing up in consumer goods prices. This has double effects, when high oil prices are absorbed by the government, Indian prices languish. Further, when the global prices start correcting, Indian prices tend to remain firm.
2. INR is undervalued because Indian government finances are not in good shape. India's government finances look more like developed countries than developing countries. To compound the problems, Indian export basket is quite price sensitive while import basket is not. So then does it mean Indian inflation has substantial way to go? 
3. Does it mean that Big Mac Index works better when government budget is nearly balanced?
4. Another important thing is that the price of entry-level burger at McDonalds has been coming down since McDonalds came to India. Part of the reason is product development, but significant part is because of raw material efficiency. This latent competitiveness has not yet been harnessed, but if done so, will make India more resilient to global factors. It may even make Indian exports more competitive.

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My book "Subverting Capitalism & Democracy" is available on Amazon and Kindle.

Sticky Wages, Prices and effects of pouring money

Scott Sumner has a post about pouring of money - i.e. effects of expanding money supply. He disagrees with the metaphor that money pours into certain asset classes. While I agree with the principles behind Scott Sumner's post, I find most of times the metaphors send better signals for interpretation. But my main point is about prices and wages.

Prices and wages are embodiment of information - historical, present and future. If they change too quickly then the historical aspect is lost. For better or worse, our scale of value are anchored to the past. It does get influenced by present and to a less degree by expectations of future. But if we lose our anchor point or the reference scale then our mental models collapse and we lose our sense of reality. Thus, if we get paid $30,000 in year 1, $3,000 in year 2 and $3million in the next year, we will develop a sense of confusion.

Then comes the question of pouring. What pouring refers to is change in the relative value of asset classes. Imagine a spread of assets along a value spectrum, sort of a hierarchy (with sometimes assets jointly occupying a hierarchal position). 

If money increase does not modify the hierarchy then it does not impact much. If it does then it creates gainers and losers just because money is created. For example, if a really thirsty person would rather be just under the tap than away where water will eventually get to him. 

The argument therefore is whether the government or central bankers be allowed to create such distortion that has no grounding of productivity or real value creation.

One can argue that over long term the asset hierarchy goes back to a certain mean. But during the time a distortion is set in motion and the time we get back to time-tested mean we can extract advantage. Finance is prepping to do just that.

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My book "Subverting Capitalism & Democracy" is available on Amazon and Kindle.

United States of Europe

In principle, there is not much difference between United States of America (as it was intended) and United States of Europe (as it is perceived as of date). 

1. USA was a federal structure in a true sense. Barring money, national security and foreign policy, not much role was envisaged for the central government. However, just like in the case of USA, USE must be wary of tendency of the central government to start hijacking things to itself. Sometimes there are legitimate reasons for doing so, for example:
1. Inter-state issues of national security and policy. For example, establishing of FBI, DEA etc.
2. Creating economic efficiency. For example, inconsistent laws between states creates problems and there is good argument for center to create a unifying law.
2. Other times, central agency takes up power at times of crisis when collaborated and concurrent action is required by all the states together. Naomi Klein in Shock Doctrine, highlights some of the instances where disaster was used to by-pass checks and balances of the system.

Implication

So I don't see any problem when there exists a possibility of politically uniting Europe. If handled properly, it could be successful. However, odds are always stacked against it. Pursuing it at this moment will be a mistake. I am reminded of the quote, friendship always exists among equals. In today's Europe, there is no equality and hence no friendship.

Aside

If you have enough decentralization, then any aggregation at the top level has little or no effect. It is the centralization that starts creating the problem. It belittles the citizen and magnifies the government. 

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My book "Subverting Capitalism & Democracy" is available on Amazon and Kindle.

Types of Investment and India's low-hanging fruit

I think India is much better placed at the moment primarily because there is lot of low hanging fruit. I attempt to list a few. When it comes to investment we have two kinds of investment. 

1. The first represents fairly well understood investments where there is ample evidence of cost and benefit and technology is available from the experience of the first world countries. The road-map for development of such infrastructure, its costs, pay-off timelines etc. is well known.
• Agricultural productivity
• Basic Infrastructure - roads, power
• Second-level infrastructure like cold chains, transportation hubs etc.
2. The second is complicated and more like venture capital where risks are higher. Here the objective is to invest in areas that will value-drivers of the future. Here we are breaking new ground and the pay-offs are not clear. US and first world countries are required to invest in such type of infrastructure.
• Alternate energy
• New types of infrastructure including 4G telecom and other related such as NFC payments
• High-end infrastructure e.g. intelligent Highways etc.

  

For India, substantial opportunities exists in the first part. This is what makes India an attractive destination. Starting around 1995, a lot of attempts have been made in estimating this demand. Most have been unsuccessful, but a substantial body of knowledge has emerged in this process. Today is the best time of all for companies to undertake massive infrastructure building projects. The question really is, will government facilitate the process balancing protection of citizen's rights and goals of developments.

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My book "Subverting Capitalism & Democracy" is available on Amazon and Kindle.

2012: Images from the Crystal ball

At the doorstep of 2012, I am here again looking at the crystal ball. There are signs

Reworking the Macro 

1. The Eurozone faces tremendous challenges at the moment. 2012 will see the aftermath of the crisis. I imagine the Euro leaders will be able to patch things back, but substantial political sovereignty will have to be ceded. One hopes the sovereignty will be returned post the resolution of the crisis. In any case, Eurozone will spend the next year in hibernation.
2. As I mentioned in previous post, there are currently two systems - Eurozone system and US-China system. 2012 will see stresses in the US-China system rise dramatically. I think as if rhyming with 2011, we will see stress in US-China system next year same time.
3. We may see Chinese economy under stress. I am not sure how much will happen next year but China is unusually fast. I think we will see slowing of China - about 5-6% growth level.
4. The Arab world will experience post-purchase dissonance with respect to new-found political setup. In worst case it means some new dictators will come up and uprising may start all over again or there may be bigger political discussions.

Financial markets

1. I see increased synchronization - both globally amongst markets and within markets among stocks. Thus, old places to hide may not actually work. 
2. From the investor standpoint, we will be forced to be more in cash or cash equivalents.  Correspondingly, even when invested, we must look to highly liquid names. I was hoping to see derivative markets in their full splendor at such times, but MF Global and lack of counter-party settlement systems keeps check on the system. 
3. The other fall-out of this is steeper moves - on upside and downside. It means we can make or lose money super-quick. Markets may rise 20% in a month, fall 20% in the next. We should see more talk about Vix.
4. Funds with specific low-cash rules should find it difficult. I think in general, the strict rule-based fund management should take a beating. Fund managers with broader mandate are likely to deploy the capital better. 

All in all an interesting year ahead. My best wishes to you all and I will see you next year. Merry Christmas, Happy new Year and happy holidays. Cheers

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My book "Subverting Capitalism & Democracy" is available on Amazon and Kindle.

Comparing Euro with US-China - MMT

Edward Harrison points to a Randall Wray post about MMT, sovereign debt crisis in Eurozone.

Randall refers to difference in location of monetary policy, within the sovereign in case of UK and outside the sovereign in case of France (with ECB), leading to reduced risk of default. Randall refers to this as one main source of problems of the Eurozone.

However, Euro area is not the only problem. When it comes to difference between where monetary policy is located and where fiscal policy is located, we have two examples of this model operating currently- Euro model and US-China model. Both are at risk, different risk, but definitely at risk.

In principle, US-China model has a similar monetary-fiscal policy situation to Euro area. US sets the monetary policy and that policy trickles down to set of countries that peg their currencies to US Dollar. I have only used China as representative, in reality many more countries peg their currencies to USD and this group is bigger than the Euro-group.[1]

The issues is if you have given up monetary sovereignty, you are eventually forced to give up broad level fiscal sovereignty as well. So a system where monetary policy is regional, you must have a regional fiscal policy at least at a broad level. It all boils down to congruence between fiscal and monetary policy.

The persistence with this monetary-fiscal distortion polarizes the participants creating a production pole and consumption pole. In case of Euro area, we have Germany and Greece as representative poles. In case of US-China model the respective poles are China and US.

Now the difference is Germany, the production pole, has larger influence over monetary policy[2] in Eurozone while its corresponding pole China, has no say in policy of US. 

In the US-China case, US does not seem to have a problem. But actually it does. The model requires the China-group to keep buying US treasuries. This allows US more monetary policy room but forces these countries to absorb, either through government or overseas investment, this impact. It masks the problems of US till one fine day US suffers a heart attack. Further imagine the policy environment if Greece ran the policy in Eurozone. I won't go into more detail here but suffice to say this model is equally broken.

Notes:

1. Euro as a group, single entity, also has a similar arrangement. Here Euro-group occupies the position of US and few countries peg their currencies to Euro. In addition, Euro is also influenced by its value with respect to USD. It is sort of a complex fractal. We will leave aside these complications for the moment.
2. Apologies to those who believe monetary policy is truly independent. And, of course - there is no Santa Claus - it was your parents all along.

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My book "Subverting Capitalism & Democracy" is available on Amazon and Kindle.

Uncomplicate the Taxes

High sovereign debt implies increase in taxes in the near future. However, Barack Obama, who wanted to raise taxes, is facing stiff resistance from the Republicans. So also

There are specific problems with our tax system 

First, it is very difficult to calculate the best tax rate or the lowest tax one can pay through the system. Second, taxes have unintended consequences. They sometimes promote or prevent marriages, home purchases, bigger cars, etc. Government has no business interfering with the lives of taxpayers in such a way. Third, taxes are unfair. The rich often pay lower taxes than the poor. Fourth, there is no way to measure return on taxes just as we measure return on capital. Finally taxes are high because they are paying for over-regulation by government or they are paying for large governments.

Better simplify the tax system

It might be better if tax was simplified into just one tax, either on income or consumption. Incomes should not be classified according to their sources. All incoming cash flow should be treated as income. There should be no part exemption what so ever. Government can define a level of income below which tax rate is nil. Above that income, taxes should be at one single rate. The only flexibility in policy will be to determine what rate should be.

The common argument is about the beneficial taxes on cigarettes. Those are not taxes. Those are penalties imposed on cigarette manufacturers for damaging lives of people. Those should be recovered as penalties and directed towards treatment of heart and lung diseases.

Tax filing has been made easy. What is difficult is to figure how much tax we have to pay. That has to be easier. We need to protect individuals from complexity in taxes. Just like the Consumer Financial Protection Agency (CFPA) is trying to simplify credit card agreements, it should also simplify tax calculations.

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My book "Subverting Capitalism & Democracy" is available on Amazon and Kindle.

The Rakoff manifesto

Judge Rakoff's principle based on Contract rights and duties vs. legal rights and duties

Two types of rights (and/or duties)

First are rights created out of mutual agreement, called contractual rights. These exists separately outside the law. Only when there is dispute, the law intervenes. Even then, law only intervenes to clarify what is the real agreement between the parties and has it been honored. Contractual rights exist within the boundaries of law - sort of like a playground where you are free to do what you want so long as you don't hurt anyone. Second are rights created by law. These are typically like the classrooms of strict schools - ordered and disciplined, everything is straitjacketed here. Punishment is imposed by the law to those who transgress the rights of others or duties imposed on them. 

Important consideration is that contractual rights cannot infringe legal rights. Thus contracts to commit illegal acts are void.

Settlement agreement with SEC

Settlement agreements, though contractual in nature, affect rights created by law when settlement is about illegal activity. Hence I agree with Judge Rakoff, one cannot have a settlement and also be considered not guilty. 

Yves Smith has a post on JP Morgan being impacted by Rakoff decisions (read down to comments too) speaks of this debate. (The post itself speaks about not allowing insurance for fraud etc).

I think Judge Rakoff is on the right track. 

1. You cannot settle away an illegal act. And more so when the parties to settlement are not the only ones who are affected. The problem occurs when the other parties are kept in the dark and have no clue they have suffered from illegal acts. The SEC is duty-bound to expose such acts not merely settle them out. Hence the para "But the S.E.C., of all agencies, has a duty, inherent in its statutory mission, to see that the truth emerges; and if it fails to do so, this Court must not, in the name of deference or convenience, grant judicial enforcement to the agency’s contrivances."
2. Courts are not house of power that can be called at the whim of parties. In the particular case, SEC wanted the courts to apply injunctive relief to which the counter-party, Citi Group had agreed. The role of the Court was that of an umpire. 

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My book "Subverting Capitalism & Democracy" is available on Amazon and Kindle.

Basics: General Investment strategy

A very basic view of investment strategy is given below. I will need to explain a few terms below, but do spend time with this chart. In a nut-shell, that is all there is to investment.

Here are some basics you need to keep in mind before using that chart:

1. We first need to do research to understand what is a good company and a bad company. I prefer to meet the management before conclusively tipping myself into either category. Companies with hints of fraud (refer to John Hempton's treatise on Chinese companies and some other fraudsters).
2. Unclear company refers to company which cannot be classified as either. 
• It does mean that you have conclusively eliminated the possibility of apparent fraud. Yet, something about such companies do not feel right. (yes, feel!). 
• Alternatively, you are not convinced about the business models of such companies, though the companies may be upright and well governed.
3. I presume we will know about bear and bull markets. Unclear markets are typically directionless markets or range bound markets.
4. Uncertain investment strategy means, you cannot invest without substantial research. I must repeat SUBSTANTIAL research. It means unless you have a full scale financial model with sensitivities to various scenarios, macro and industry forecasts, appreciation of changing minor trends, met customers, suppliers, industry experts etc, you cannot take a call. It is like a minefield, you are taking a risk and analytical advantage can alleviate some of the risk.
5. Going Long for uncertain companies in bull market has one disclaimer that such companies must not have fraud-flags, even feeling types. Ideal strategy for that box is "uncertain".
6. Companies move in an out of categories. But if a company goes bad, it rarely turns good. I know people will dispute this, but that is my experience. Better stay away or go short.
7. Ideal chart is 3-D where another axis, industry, needs to be included. This parameters takes into account business cycles. One can logically interpolate my strategy from this chart and apply it to business cycle. If someone can make me a 3D chart please email me or leave a comment.

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My book "Subverting Capitalism & Democracy" is available on Amazon and Kindle.

Fraud and illegality in the Crisis

Till recently, that is about a year ago, I believed that substantial part of causes of the crisis were a result of mistakes, incompetence and lack of understanding. However, stark evidence is emerging as to substantial fraud and illegal dealings.  

• First was the Robo-signing scandal (which still thrives) where banks first signed thousands of mortgage applications without any background checks. When a lender behaves in such a manner, he has clearly acquiesced to default.
• Then there was a random credit card fees scandal that Elizabeth Warren talked about. To be sure this was known before but the scale, I realised later, was huge!
• There were some hints, particularly how Eliot Spitzer was sidelined when pursing the money trail. Eliot Spitzer was also to blame, in my opinion, he should have kept his pants zipped.
• Next came Madoff which was more accounting scandal in the family of Enron. One might have thought we had learnt our lessons but that was clearly naive thinking.
• Then came Bloomberg expose about secret Fed facilities to big banks. The problem here is the way Fed is structured as against normal central banks. In many ways Fed looks like a club of bankers rather than a government sponsored, independent controller of monetary policy. Fed reform is critical and I find both Senate and the House, i.e. the Congress lacking in will and expertise. 
• Further, we get the news that Treasury secretary Hank Paulson had a closed door meeting about possible liquidation of Freddie and Fannie while claiming they were healthy to the public.
• The ultimate was expose about Congress being allowed to trade on inside information. This is becoming tragic. This is US we are talking about not some banana republic. 
• Then, the way MF Global was handled, the way client money was dealt with.

One important common ingredient has been how effectively democracy has been subverted by these forces. MF Global showcases how financial institutions are able to subvert the right to property, a fundamental right at the core of democracy, by allowing financial institution to use personal money to further their cause. Janet Tavakoli's recent article is right - this is class 1 fraud. 

Finally, I am surprised at my naivete. I also wonder why no one has yet gone to jail.

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My book "Subverting Capitalism & Democracy" is available on Amazon and Kindle.