Kryptonite

Superman came to earth from planet Krypton when he was just born. He grew up realizing his extraordinary powers. Only when he interacted with a holographic image of his father he realized that there was one thing which was lethal to him – Kryptonite, remnants of his long dead home.

Central banking is relatively a young profession. As they have grown up they have realized their extraordinary power. The first taste of the fatal flaw was inability to work magic on the Japanese economy post the massive collapse in the 1990s. Now they have again brought their fatal flaw upon themselves in US, Europe and Japan – zero to very low interest rates and expanded central bank balance sheets to unprecedented levels.

“The tenth amendment said the federal government is supposed to only have powers that were explicitly given in the Constitution. I think the federal government's gone way beyond that. The Constitution never said that you could have a Federal Reserve that would have $2.8 trillion in assets. We've gotten out of control.”

As they reduced interest rates they reflated bond portfolios from junk to g-secs, housing prices and equity markets globally as risk free rates collapsed. The Japanese stimulus which they expected will grow their exports will take a long period of time as local corporates have over the period spread their manufacturing globally (i.e. Honda in US). So question is will corporates restructure in response to the stimulus or global economy booms to rapidly expand export demand or the time runs out when Japanese pension funds with the adverse demographics are unable to keep up with the expanding budgetary requirements forcing up interest rates. Unfortunately, they do not have much of a choice.

The US Federal Reserve is reversing the stimulus as jobless claims decline. But the risk of miscalculation with the market expectations is high. At the same time the European Central Bank is turning on the stimulus tap worried about potential tightness the US Federal Reserve may cause in the markets and the strong Euro which is resulting marked declines in manufacturing surveys since January this year (France below 50 and Germany at 52, print below 50 represents a contraction).

Massive amounts of capital have been invested by pension funds and life insurance companies into government securities. This capital has no choice but to suffer the increase in interest rates. So let’s assume a bond maturing in 2020 trading at 19% premium to Face Value giving currently 2.5% yield. If interest rates were to become 5% for the residual duration the bonds would suffer a 7% decline. Bonds which trade on basis points, 7% change are a massacre. In response, I understand, the German life insurance industry has reduced bond duration to 6 years to protect against interest rate increase creating an asset-liability mismatch (“ALM”). How do central banks expect to plug this hole?

In India external borrowing to GDP has expanded from 4% to 18% taking advantage of low rates in the international markets and easy availability. This and potential risk on portfolio flows which finance the CAD has got Raghuram Rajan to call for coordinate action to limit liquidity issues. As interest rates rise, it will increase the risk-free impacting equity valuation and hurt property valuation including those of dollarized markets like Dubai, Singapore and Hong Kong.

Only alternative central bankers have to manage the scale of the adjustment is to keep running behind market expectations - too much perfection to achieve. But if this is the likely goal they will be incrementally cautious and run much more behind expectations. Consequently, precious metals and agri commodities (and healthcare driven by aging) will gain with oil becoming more dependent on geopolitical events as global economy is tempered by increasing rates.

Postscript:

Corn  trades at 3.7 (CBT $/bu), Soybeans at 10.8 (CBT $/bu), Wheat at 5.4 (CBT $/bu) and Sugar at 0.17 (NYF $/lbs). These are running at multi-year lows or 40-100% off last 5 year peaks. Implication: invest in a global agri commodity fund, processed food companies which have benefited from the decline will face cost pressures as the cycle turns and global inflation numbers have been benefiting from this decline.

US earnings will see a 2HCY14 rebound driven by low inventory levels which is running at 4 year lows and new order are showing a significant rebound in the last quarter.

Cracking Eurasia while India re-builds

I have been off the air for a while and enjoying our holiday. However, there have been significant linked movements in the mid-section of Eurasia and evolution of events in India.

Mathematically, discrete items maintain their character when separated - i.e. quarter of a tree or an atom is no longer a tree or an atom - but in political events they have a life in both forms discrete and linked.

Iron Dome

And again hostilities have broken out between Israel and Hamas and again each side is looking for ways to break the stalemate. While Hamas has managed to smuggle despite oversight significant rocket stock into their territory which are hidden in the deep underground tunnels, Israel has been relying on its Iron Dome system to negate the rockets launched thus far. The stalemate stemmed from the fact that Israel will need to launch a significant ground offensive (means more casualties) to eliminate this threat for a time period as Hamas can always smuggle in more (beat the Israeli and Egyptian intelligence again). However, Israel has now taken the call to launch the ground offensive. If the current situation endures Hamas may be tempted or forced to launch enough rockets which may overwhelm the Iron Dome system. The Iron Dome system gives Israel a sense of security and which is more near-term until new attack mode emerges and anyways the tunnels which hide these rockets get re-built faster than Israel hopes.

MH17

Ukraine continues to fester as the Russians are and will not be willing to let Ukraine at any cost slip into the western orbit. It is too strategic politically, geographically and from a food security perspective. The Malaysian crash piles significant pressure on the Russians but will it change the way the view the situation – unlikely. Can anyone make them change the way the deal with the situation – again unlikely at least in the next 2-3 years. Russia has and will be a difficult country to deal with.

Mesopotamia

The lands of Mesopotamia which the British divided arbitrarily are coming apart with the Syrian and Iraqi crisis. With the unsettling of the status quo when Saddam Hussein was dislodged, it has come to today’s situation as the Americans were unable to re-build state capacity while Iran manoeuvred to get the upper hand in the situation

It is an extremely difficult situation given that it comes in the aftermath of the Arab spring and American withdrawal in Iraq and now in Afghanistan. It is important that a new status quo is built in the middle-east and that is where the two regional powers Turks and Iranians and the global superpower America will need to carefully play their hands. The Iranian-American rapprochement will play an extremely important role and carving out regional influence will be on the table. Saudis will be in for an extremely difficult time as American no longer need to rely on their oil but the Saudi’s have no other benefactor to turn towards.

With regard to Ukraine the world has no alternative good choices as European energy requirement from Russia makes any significant action extremely difficult. It will be important to restrict Russian ‘illusion for retrospective determinism’ as they will try to bring ex-Soviet countries into the customs union or modify political landscape. Poland with its significant but under-developed shale reserves (as an alternate to Russian energy supplies partly) and location will be a critical country for the Americans and the Europeans. It has been the land route for all significant military interaction that has taken place with the Russians.

While all this and more (China in South China Sea) happens it is critical that India remains neutral or does not get involved while it puts its economy and military back on the rails. It may, anyway, have its share of issues as American withdrawal is completed by December 2014 from Afghanistan

Meanwhile, economic sentiment in India continues to improve as does the stock market. The budget unfortunately was a whimper possibly because of upcoming assembly elections and likely need to understand the full depth of the issues. Besides that there has been no significant bummer from the new government. Stock market continues to expect significant action from the government to drive economic growth and corporate earnings. It is likely in the near term as the Fed stops asset purchases we continue to see strength in the dollar helping exporters (IT, Pharma). It is clear that optimistic budget assumptions will not work out restraining government push on infrastructure. The government needs to figure out a mechanism to attract capital to fund core infrastructure. With banks being undercapitalized and low domestic savings, channelling international savings (if possible on a rupee basis given where global interest rates are likely to head) is the only option. Companies supplying into infrastructure asset creators (like equipment lessors) or as factories ramp up capacity their consumable suppliers (like refractories or gas suppliers) will be initial beneficiaries.

The events in the Middle-east and Ukraine connect to India in 2 important ways – Middle-east is the largest supplier of energy and Russia is the largest supplier of weapons – and India needs both in an uninterrupted manner.

Politics….Linked….Discrete….Linked….Mathematics

Framework of thought for the new government

The advent of Narendra Modi as Prime Minister marks a significant change in 3 aspects:

• It signifies a break (if not a complete turn) from the fragmentation we have witnessed over the last 25 years with the rise of regional parties. This five year gap from power may impact the survival of few of them like the NCP or RJD;
• Congress Party adopted the politics of the British with regard to managing different religions and caste sub-groups to occupy the centre of Indian politics and allowing it to combine with the left and marginal right as long as it never threatened its existence significantly to govern. This will change as first time we have nationalist party at helm and depending on the change one may the Congress being forced to re-invent or destruct. Vajpayee government was in many ways a continuation of the Congress paradigm;
• The third will be the likely manner of governance where accountability of ministries, technical support teams being attached to key ministries and once again the Prime Minister’s Office becoming supreme.

The rise of Narendra Modi is also identified by young aspirational India which does not have the patience or desire of understanding the subtleties of religion or caste, independence movement or remorse of partition, they seek out an India which provides them opportunities, choices and one that can surpass the benchmarks formed via their open access to information and shared beliefs created on social platforms.

In August last year I had written about the 3 conditions that will bring him front and centre - current social contract frays (high inflation, corruption, lack of employment etc), building aspiration, developing a local franchise in the states of UP & Bihar where people can associate with his world view. I will let the reader judge what transpired in these elections.

In this backdrop, getting the economy back on the rails becomes the key focal part of the incoming government. A lot has written about resolving environmental clearance, reworking power PPA’s, dismantling APMCs, rationalizing subsidies etc so I will not delve into them. This is what the public voted for, while delivering this it is the statesman’s responsibility to think long-term. I had written last year in October – “In effect the 4 key tenets of the state – security, governance, economics and unity - have been undermined, corrupting the functioning of the state.”

As Narendra Modi pursues the public agenda he will needs to start creating a long-range plan to address the 3 other tenets. The package will in essence define whether he leaves an indelible mark in Indian history. As a broad framework I would suggest the following in order:

• Buy or suffer peace as long as it does not threaten core Indian interests in the short-term with the neighbours;
• Accelerate the delayed defence plans and enhance intelligence capability in key states like Afghanistan / Pakistan;
• Get the economy back on its rails in the next 12-18 months with the functioning of key ministries and expert groups in place to guide growth;
• Bring economic interest and with it political capital of key players US, EU and Japan in play;
• Invest massively in building (not over-building) infrastructure especially rail and sea based links while generating resources in parallel through divestment;
• Address in earnest the naxalite / internal security problem;
• Make long range changes in governance – changes in incentives to the states based on achievements from central contributions, move to a system of regulators than ministries, judicial and police reforms (difficult one I guess);
• Finally, remove various quotas with a parallel push towards enhancing government contribution to health and education.

While this is a very ambitious agenda but I would address as more of a framework to work on to create a new India. I am sure the man at the center of this all has many pulls and pressures but withstanding that is what greatness is all about. He has to also overcome what Tocqueville wrote in 1945,”But a democracy can only with great difficulty regulate the details of important undertaking, persevere in a fixed design, and work out its execution in spite serious obstacles. It cannot combine its measure with secrecy or await their consequence with patience.”

Force = Mass * Acceleration

Aristotle described force as anything that causes an object to undergo unnatural motion. Then, came Newton after many centuries and postulated the above formulae but he also missed a few aspects which were then improved upon by Einstein when he developed his theory of relativity and therefore added aspects like gravity to the equation. One additional aspect that matters importantly for our discussion in the above formulae is the direction of the acceleration. This concept works in the physical world but there is a parallel in the political world.

‘Mass’ of a nation is a composition of the factors that a nation is endowed:

• Geography – A relatively static factor defining a country. Like the Himalayan ranges provide protection towards the north and east, the Rhine provides excellent navigation capability to the German industrial heartland reducing transport costs, US Mid-west provides vast agricultural lands and, therefore, sufficiency in food;
• Population – The fact that the French could wield 1/3^rd the army of Germany in the Second World War was a critical factor as the declining population of Japan, Russia and Western Europe will have on their ability to ensure adequate manpower for industry and for their armies;
• Resources’ including energy – Japan is a major importer of all mineral resources and oil. This leaves Japan at the mercy of suppliers (e.g. rare earth from China) and security provided by maritime power for its shipping lines (e.g. US). Germans are dependent on the Russians for c40% of their energy supplies. But having the resources itself is not a sufficient enough i.e. inability to use the same like India’s coal reserves or Chinese shale reserves or Congo’s uranium reserves

The acceleration of this mass is in essence provided by national character and leadership. While this may tend to be a bit vague it has an undeniable presence in determining the force of a nation. For example, one may have the resources but industrialization or creating requisite infrastructure is part of national will and leadership. Similarly, the Russians are known for their ‘rugged persistence’, Americans for their general reluctance for war and inventiveness, British for their common sense and Germans for their thoroughness and efficiency. While I will come to India in a bit, the reason that these views are there is because this displayed as a regular feature of their lives and in the most difficult moments. British foreign policy since the Second World War has been conducted with a complete understanding that they are no longer the pre-eminent power. Germans in the thoroughness forget restraint and want complete victory; had they understood their limitation in their conquest of Russia the outcome may have been different.

Leadership of a nation has three important aspects: understanding of power, statesmanship and diplomacy. While understanding of power needs no further elaboration, statesmanship is about looking and achieving long-term interest of the nation which may be at divergence with current popular mood and the ability to mould the popular mood. Diplomacy is the element which multiplies raw power of country e.g. how Jaswant Singh worked with the US administration post the nuclear test to lift sanctions or how Chamberlain prior to the Second World War blew it.

However, the most critical aspect is the direction of acceleration. Hitler won phenomenal victories both diplomatic and military but the continued attack to achieve complete control over Russia resulted in suicide, the American’s post the collapse of the Berlin wall became the sole super power which since then has squandered significant gains by their acts in Middle East and Afghanistan – it allowed a period for Russian’s to resurge and free hand to the Chinese, India has in the last 5 years has lost complete control of foreign policy in its near-abroad – inability to look at long-term interest versus alliance politics in Sri Lanka and Bangladesh, inability to counter Chinese influence in Maldives  and Nepal.

India’s over-population tends to be a significant challenge as the resources of the nation are not sufficient and what is there of the leadership is focussed inwardly on dealing with the diverse challenges like naxalism, water and regionalism. Like Germans are known for their thoroughness and efficiency, is there a common Indian character? I have not come across any literature that ascribes a unique character to India as a whole, it is always known for its diversity. The Indian nation as today existed was resembled closely only during the Mauryan dynasty, then during Shah Jahan / Aurangzeb and then the British controlled it through alliances with local kings / zamindars. As nations go we have a very short and dispersed period of shared experiences to form a unique national character!

“Also unlike a planet, an electron—if excited by heat or light—can leap from its low-energy shell to an empty, high-energy shell. The electron cannot stay in the high-energy state for long, so it soon crashes back down. But this isn’t a simple back-and-forth motion, because as it crashes, the electron jettisons energy by emitting light.” – Sam Kean, The Disappearing Spoon: And Other True Tales of Madness, Love, and the History of the World from the Periodic Table of the Elements.

It is important that we morph from being an electron constantly needing external stimuli. We have the mass (good geography, resource base of agriculture and minerals but albeit a large population and surely no nation has the perfect mix) but the pace and direction of acceleration can come only through transformational leadership which shapes national character, a shared perception and aspiration.

Demographics and Capital

India is among the youngest population in the world with a median age below 30. While the net addition to the working population is the highest in the last decade (2000-2010) but the overall working age population will continue to rise until the early 2030s. Simultaneously, it is also adding significantly to its old (60+) population which will be more than its addition to the working age population.

The cycle of capital creation / consumption is the simply the following:

•  0- 20/25 years: Parents spend the child’s food, clothing, education, travel etc. This category is a net consumer of capital;
• 25-35/40 years: This is a category which has begun to work and is borrowing for its first car loan, to purchase a house and is a net consumer of capital again from the system. In India till the early 1990s this cycle never played out as young adults were less mobile living in joint family systems plus retails loan availability was extremely restricted. This is also the segment which is the primary consumption driver;
• 35/40 to 60 years: This is the saving class which is in essence providing capital to all other demographic categories;
• 60+ years: This category is essentially in retirement and drawing upon its savings over the last 20-30 years.

Simply put Indian economy will continue to import savings, despite its high savings rate, for a very long time as both the youth and the old continue to expand relative to its mature working population. Most of the German population is currently in their 40s and one can witness the savings bulge. Urbanization, infrastructure and consumption imports will all need foreign capital.

The Indian currency was Rs.8.4 in 1975, Rs. 17.5 in 1990, Rs.44.9 in 2000, Rs. 45.73 in 2010 and Rs.60 now per USD. Given this continues propensity to import savings and relative high inflation to the developed world, rupee will be in secular decline, except for unusual duration experienced in 2000-2010 when the external environment was extremely benign followed by easy money by the Fed.

As we look into the next 2 decades the Europeans, Russians, Japanese and Canadians will be experiencing a massive surge in the number of retirees. The Americans will continue to have reasonably good demographics as the baby boomers are replaced by the next generation in 8-10 years and by 2020 even the Chinese median age will cross the American median age. In this environment the global availability of capital will decline over the next few decades. This is the period when the need in India for global capital will continue to rise. Having said this, given the pension imbalance in the developed world the last 5 years of low interest policies have created, the need for higher currency adjusted return on capital will continue but this will be counter balanced to an extent by increasing Fed rates. The basic reason for economic slowdown in India over the last 3 years is its inability to keep the investment cycle going which is in turn dependent to a large extent on availability of foreign capital.

In this backdrop, political stability and policies that create a conducive investment environment is critical if we seek to achieve our national aspirations and benefiting from positive demographics. We are probably the country receiving the highest remittances (again savings) globally which means we export a lot of talent. Do we always want to keep exporting talent or use our people to enhance India’s productive capacities?

All across..

In the last few weeks, I have been thinking about the e-commerce space and the impact on the economy. India for instance has developed in the last half-decade a US$3+ bn e-commerce market (excluding travel). This has replaced the typical brick and mortar retailing which means retailing space worth an equivalent amount has been taken out of business (assuming 10% rental cost and 10% cap rate). This has spawned a another industry on the other side of warehousing and logistics which may be taking almost an equivalent proportion of e-commerce cost but delivering customer through an alternate, more convenient, channel. Whether this has made the economy more productive is an altogether different question but it has surely reduced cost to the consumer which at least yet seems to be been paid for by VC firms and the vendors.

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This gets me the next aspect of how the current expected recovery in savings (despite reduced cost of ecommerce purchase which is very small) and form of savings will impact the Indian economy. The economic identity to remember in these discussions in savings (imported or domestic) is equal to investments. In the past decade while we saved at 30%+ rates our capital formation levels have been 200-400bps higher which meant we needed to import savings, a large part of this came through portfolio investments and NRI deposits both susceptible to short term movements. The last year Indian savings has dropped to below 30% levels to ~27%. Savings levels have been severely impacted by the incessantly high inflation levels in the last few years. This should recover as inflation comes off with a decline in food inflation.

But the bigger question is as the new government comes in in May 2014 and tries to push the overall growth levels in the economy for which recovery of investments is critical, Indian savings is woefully short. This will require a massive concerted effort to attract and manage foreign capital as the gap between investments and savings will become much wider in the initial timeframe. And, channelling of foreign capital into the infrastructure sector will enhance the long-term trend growth of the economy. The other aspect is that a large part of the savings in the last few years has gone towards real estate. This should change as real interest rate recovers providing more productive usage of capital.

While household savings have declined, income inequality levels have also risen. The rich do not consume the same in proportion to their income is a fairly well-known fact which means continued pressure on overall demand.

We will continue to have bright sparks in the economy (even Spain has its Zara clothing brand) but the macro needs some able management. In a savings glut world with easy money, problem of under-investment is relatively easy to solve than over-investment in case of China.

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It is almost that the centre part of Eurasian landmass has come to political life all at once…

Russia has annexed Crimea whether the west likes it or not and little it can do about it. NATO is a non-functional organization which leaves US alone to respond. US given its weariness of the last 15 years is finding it difficult to get its bearings but it has no choice but to build a new containment strategy for Russia before we see further capitulations across eastern Europe or Balkans.

Turkey continues to convulse under the factionalism in the Erdogan’s grand coalition with the Gulen movement turning away and multiple scandals breaking out. In the end, Turkey’s elections are about finally controlling the key city of Istanbul which is the economic life-blood (40-45% of Turkish economy).

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Finally, the BJP in continues to be among the favourite to win the election with >220 seats but not by itself (or its pre-election alliance) have enough seats to govern India. While this trend has held for the last few months parties which have been in power with the Congress in the last 2 governments are finding this prospect increasingly difficult and given their support base they will be unable to participate in the next government. This is resulting in the Congress and these parties making more and more acidic attacks (i.e. chop Modi etc). Second, UP and TN seems like the most likely states which will make the difference between a 220 and 240 BJP position. And, politics at the center can be very different based on the distance from the 272 mark. If the BJP misses the 220 mark by a margin then be prepared for a massive dent in investment sentiment.

This one said by Lincoln may sound familiar to Modi governance style, “I do the very best I know how, the very best I can, and I mean to keep doing so until the end. If the end brings me out all right, what is said against me won’t amount to nothing. If the end brings me out wrong, ten angels swearing I was right would make no difference.” So be prepared for the new style..no remorse no recourse..

Cycles are reality

The Indian economy has gone through a full cycle – the bust of the late 1990s, the benign period of early 2000s, the roaring period from 2005-2008, the near bust of 2008 which was rescued by global and local counter-cyclical measures and now the demand destruction of led by inflation of 2012 – 2014. This demand destruction has been led by the inflation bitten urban markets which resulted in high interest rates and slowdown in government tax buoyancy which in turn has resulted in government reducing the rural spends – MSP, volume of purchase and M-NAREGA. With urban demand already down and rural demand slowing in the next couple of years but is the counter balancers in place to address this situation.

There are potentially 4 areas due to which India is likely to see a revival in the economic cycle:

•  Inflation, interest rates and investments – The lower MSP hikes (5.5% in FY14 vs CAGR of ~16% in 2008 – 2013) and rural spend will bring down the food component of inflation, which has the largest share in the CPI basket of ~40%, within a year or so. This reduction in inflation should result in a less than proportionate reduction in interest rates (given RBI’s clear stance on achieving positive interest rates) but a reduction nonetheless. The likely clearance of many delayed projects, replacement capex cycle and lower interest rates should revive the investment cycle within 15-18 months. Further, we have an unprecedented situation of almost no new project announcements in the last 6 months which is unlikely to sustain.
• Recovery in financial saving – The financial saving in the economy have declined to an all-time low with real assets like gold / real estate accounting for at least 70%. With the re-emergence of real interest rates, we will see an increase in investments in equity, bonds and bank deposits. This will allow for greater credit creation and risk capital to corporates.
• Reduction in external vulnerability – Current Account Deficit has come off massively over the last year. For the April-December period it was 2.3% of the GDP, down from 5.2% the same period earlier. This has significantly reduced the pressure on interest rates and the exchange rate. A large part of the reduction has been achieved by duties on gold loans. However, our significant dependence of FII flows, ~$40bn NRI deposits mobilized over the last year at very high interest rates and potential depreciation of the Chinese yuan will continue to maintain pressure on rupee and interest rates.
• Oil prices – Oil prices have been fairly stable over the last couple of years. It is surprising that they have not declined but given the likely reduction in the Chinese GDP growth and also the fuel propensity (better technology and environment consciousness) over the next few years we should expect to see oil prices continuing to remain benign.

While these factors would positively influence the Indian economic cycle, this will also coincide with the initial period of the new government. Unless we have a broken mandate, we should see decisions which would further aid this revival.

As we see the revival of the economy, the heady past and excessive leverage built both at the government and the corporate level needs to be unwound. The Reserve Bank needs to nudge the public sector banks to adopt an aggressive posture towards the NPA’s in the system – this capital needs to be released for productive usage – otherwise we will have a zombie banking system unable to support growth (PSU banks have ~75% market share).

The key economic risk remains a Chinese devaluation. The Chinese economy has grown since the financial crises through a massive expansion in leverage to its infrastructure and real estate markets. This engine no longer has wings and has the potential of triggering banking sector crises if pushed further, maybe already. The likely fall-back massive purging of excessive capacity and reduction in state government leverage through central government recaps or devaluation. The former is deflationary and can potential create political risks. We have seen a trailer recently of the devaluation possibility which caught all market participants off-guard. A Chinese devaluation will trigger an Indian currency devaluation and potential capital flight.

Having said this, India today looks almost like a ‘saint’ in the face of events in Turkey, Argentina, Russia and the commodity intensive nature of Brazil and South Africa.