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Rates too heavy ?

Every heady bull run has excesses. From stocks being valued on eyeballs, junk bonds being rated AAA or NINJA ( no income no job no assets) loans being distributed by banks, these parties have seen them all. A notable common factor towards the latter phase of all these bull-run periods have been Fed interest rate hikes.

 

In fact a simplistic view of the situation could make a case that the Federal Reserve prompted the subsequent crashes through the interest rate hikes. Eventually, borrowers could not pay higher interest rates and defaulted or money stopped flowing into stock markets attracted by higher bond yields. It appears that this simplistic view is being taken seriously by none other than the Fed itself. This cannot be dismissed as mistakenly assuming correlation for causation.

The debt levels of today’s world are incomparable to those of earlier eras. Money is literally cheap today. Frighteningly, making it so does not bring inflation and growth. The interest rate hike announcements had been necessary for the Fed to signify that the economic situation was benign as dilly-dallying in the wake of supposedly strong employment and wage data would have been suspicious. Yet, it is impossible for it to deliver on its rate hike promises without precipitating a crash.

Earlier long-term bull-run phases had real earnings pick-ups which allowed the Federal Reserve to raise rates and rein in inflation. The markets did crash but only after years of growth. In any event, stock markets are cyclical. Now we are in an era of tepid growth and tepid inflation in much of the world. Corporate bond defaults are at multi-year highs as are student loan defaults. Yet, the S&P 500 has risen more than 200% since its ‘09 lows and is still rising. It’s a rally whose lifeblood is liquidity, something interest rate hikes are supposed to suck out. This is possible to achieve without immediate negative fallout during strong economic growth periods; this is certainly not the case today.

Regrettably, the Federal Reserve is in a situation where it cannot raise interest rates by more than a percent or thereabouts as it is painfully obvious that the heavily indebted businesses of today would not be able to afford much higher interest rates and neither can it hold firm forever as it would be giving live to its claim of a booming economy and a robust economic environment.

 

Imagine Janet Yellen trying to lift a big zero shaped boulder towards the sky. You get the picture. She is no Hercules.

P.S: Gordon Gekko said,” Greed is good.” Janet Yellen says, “Debt is good. ” We know how the movie ended.

 

A lot of things are very different today in the world of finance. However, what has prompted me to write today is the imminent demise in the developed world of something which was at the very foundation of the course on ‘Financial Management’ I studied during my Masters- the concept of the risk free interest rate.

The risk free interest rate is basic opportunity cost. It is traditionally taken as the yield of a long term sovereign bond or some other such asset which is guaranteed by the government. The concept is somewhat ideal as sovereign defaults do happen but it is definitely true that sovereign bonds of first world countries have a good credit history.

The developed world is now a place of either Zero Interest Rate Policy (ZIRP) or Negative Interest Rate Policy (NIRP). In a world having inflation, both policies mean that a person buying a risk free asset would lose money over time. While ZIRP makes its way felt through creeping inflation, NIRP is more direct as a direct debit on your bank account. Effectively though the message is clear, there is no risk free asset that delivers a return. No FD in a sovereign bank or long term sovereign bond that preserves your capital. Even to preserve capital, investors would need to take risk.

The removal of risk free interest rate has far reaching implications, especially on cost of equity. Taking an example, let’s assume that the 10 year Government bond is the risk free interest rate in India. Currently, its yield is approximately 7.5% and an investor’s equity risk premium is also 8%. This means that the cost of equity is 15.5%.

However, in ZIRP, the cost of equity would just be the risk of investing in equity, the equity risk premium i.e 8%. Thus theoretically, it also means a lower expected return from equity.

It is a terrible situation to be in; the inflation indicators are benign in most of the world but the truth is that food, housing, medical bills and education are getting more expensive year on year almost everywhere. If one has to spend in the future on any of these things, one has to save and this means that getting a return is important. However, with no risk free asset, one is literally forced to dabble in the markets. Thus with more demand, equity asset prices go up.

That is theory. In real life too, the US markets have enjoyed a speculative rally fuelled by debt. However, something is seriously wrong when the Dow and S&P 500 reach lifetime highs without any meaningful increase in economic indicators and investors have to bet our life’s savings on the hope that this continues because they simply have nowhere else to go. This is bad because if there are no savings, one can only borrow. Borrowing is based on the premise that one would earn more in the future. Is that really guaranteed when wages have been stagnating in the developed world for decades? Don’t take my word for it, read Michael Lewis’ ‘Liar’s Poker’ that mentions starting 1980s salaries in the USA in Wall Street and it is difficult to believe how little the salaries have changed even in nominal terms. Yet, cars, houses and tuition are phenomenally more expensive now than then.

How do central banks tackle the crisis? They try to remove the ‘risk’ from the equity risk premium by playing to the market. Witness the efforts of the central banks of China, Japan, the Euro zone and of course the US. It is working so far: basic concepts of Financial Management be damned.

I sincerely hope that the rate easing cycle in India never reaches ZIRP in my lifetime but I am afraid the odds are against me.

My PreciousZIRP

The ring is too precious to let go

 

As equity markets wrestle are in another bear market, it is perhaps time to turn our heads towards the likely bull market in precious metals. Precious metals have been in their own bear market since April 2011 but there is very high degree of probability that their bottoming out process has culminated.

International gold chart since 1973

International gold chart since 1973

This chart is even more longer term and adjusted for US inflation

This chart is even more longer term and adjusted for US inflation

Historical Gold Prices – 100 Year Chart

Why invest in a non interest bearing asset?

There are several reasons why investing in gold could be a good idea but the biggest is that gold is synonymous with wealth. While it no longer serves directly as money, it has done quite well as an asset class in terms of returns ever since the final abandonment of the gold standard in the 1970s. While it is debatable whether it serves as a hedge against inflation, it provides a long term hedge against wealth destruction. In times of hyperinflation, gold is the best store of wealth by far but such instances are rare and are not expected in India for many years.

However, the biggest reason to buy gold is that it can generate fantastic returns, even better than equity; this happened in the first 11 years of the new millennium.

The rise and the fall

The rise and the fall

Gold vs. silver
Gold has some use as jewellery and in electronics but most of its demand comes as a store of wealth. Silver on the other hand is a widely used industrial metal and increasingly it is losing its coupling to gold and behaving like a cyclical commodity. What this means is that in times of economic turmoil, silver cannot be relied upon to generate returns. Silver’s status as a precious metal is under threat as the gold to silver ratio has broken down severely. Before the twentieth Century, 16 ounces of silver bought an ounce of gold i.e. 16:1. For most of the twentieth Century, the ratio has been around 50. Currently with gold at $ 1250/oz and silver at $15.55/oz the ratio is 80: 1. In effect, silver is not being considered precious any more.

The extra edge gold has in India

While both gold and silver have seen multiple bull and bear market patterns in international markets, it has largely been a smooth upward trend in India. The exception is the recent period of past several years when gold has seen sharp ups and downs.

Why does gold fall only marginally, stay flat, or even go up in India even in time periods when international gold prices are falling? The answer lies in the USD/INR exchange rate. As gold prices are set in the dollar denominated international trading markets, a rising dollar makes gold costlier in terms of Indian rupees even if gold as an asset class does nothing. Thus gold acts a hedge against dollar appreciation for those who are likely to spend in dollars for education or foreign travel.

5 Year Gold Performance in India

5 Year Gold Performance in India-Note the milder price fall

Ok, got it, how do I invest

There are multiple options today and all have their pluses and minuses.

Buying jewellery is an option but making charges etc. may make it unwise from an investment perspective. Yet, if periodic buying of jewellery is common in your family, it is smart to time the market a bit and buy when prices seem low. Gold jewellery will always have value.

Buying direct gold as coins or biscuit variants too is an option if storage is not an issue. At present, an investor pays an extra 8% of the metal cost on account of taxes like VAT and duties. This is tangible and there is something to feeling the metal in your hand but selling gold in a hurry could be difficult in an illiquid market.

Gold Exchange Traded Funds (ETFs) are a smart option with the ease of electronic buying and selling of gold at the click of a button. The overhead costs are initially not as high as buying physical gold but with a catch. ETFs have administrative costs and the expense ratio is usually around 1%. Add brokerage costs and taxes and over a few years, ETFs could be a costlier method of purchasing gold. However, liquidity is rarely an issue with them which means that it is much easier to move with the market if one is in ETFs as against physical gold.

There is one key philosophical drawback with ETFs though. They do not confer the right to redeem the units for actual gold. This partly defeats the purpose of investing in gold as a permanent store of value even in times of crisis because the investment becomes coupled to the financial risk of the institution issuing the units of ETFs. If the institution goes under as might happen in a 2008 type situation, the virtual ETF units would vanish too.

The National Spot Exchange (NSEL) issued e-series units offering demat gold, silver and platinum a few years ago. The exchange offered easy conversion to physical form whenever the investor desired. For someone could buy and trade 20 grams of gold and when one wanted the metal, take physical delivery from the warehouse. It sounded too good to be true, and it was. The detection of fraud at the NSEL means that only gold ETFs offering investment via routine NAVs remain today.

Investing in silver

Bought cleverly, sliver too offers the opportunity to make good gains when global markets are doing well. It is much more volatile and spikes up faster than gold. However, silver is much tougher to buy. It can be bought physically as bullion from local traders but there is no electronic mode of investment except short-term futures. There is no silver ETF in India. Thus, for the retail investor, investing in silver is difficult. Investing indirectly by buying it as silverware or jewellery is an attractive option but buyers must beware of often steep premiums being charged on simple silver coins or statues by retailers. Buy bricks directly from wholesalers.

Silver price chart since 1985-note the volatility

Silver price chart since 1985-note the volatility

Endnote

While there is no guarantee that gold’s recent low of $1050/oz would hold, it was a 40%+ correction from the 2011 highs and with a long-term bottom forming process over multiple years. The international price levels are at levels where one could say that they were buying at multiyear lows. Gold has rebounded sharply from its lows to $ 1250/oz and has been one of the best performing asset classes of 2016. For silver, the bottom may not be in as it has not shown the same bounce back from lows. An investor could try to time his/her gold purchase at this time but must consider investing in this must-have alternative asset.

laissez_faire_tshirt-r1548cba22898438698985ed0e06d4b5b_8nhma_324

Laissez-nous faire“(French)- “Let us be,” literally “Let us do”

There is a widespread incorrect public perception In India that it has a very large public sector. If anything, the public sector is too small. The US employs persons or approximately 15% of its workforce in all levels of government. The UK employs about 18.5%, 5.6 million of a workforce of 29.7 million. India’s statistics of 17.6 million employed in the public sector of a total workforce of 474 million i.e. 3.7% seems miniscule. Even among those employed, the majority are semi-skilled or unskilled whereas the majority in Western countries are skilled, as is necessitated by the needs of providing health and social welfare benefits. The Indian government employs 162.3 government servants per 100000 persons as compared to 768.1 in the U.S. In an article in 2012, The Hindu, in fact, called the government anaemic.

Why then the public perception?

The problem is that whatever government that exists is so inefficient and corrupt that the little there is seems to be too much. There is a severe shortage of skilled personnel to work in sectors such as health, education, public works etc. but there is no ongoing effort to create such a workforce. Instead, hiring has been, more or less, frozen since 2011 as the government is said to be ‘too big’.

This, when India is actually an example of classical laissez faire. People are left to their means; those with money and power prosper and enjoy resources and facilities while those without attempt mere survival. There is no concept of social security. Even the ability of the state to maintain law and order is not applicable everywhere. Large swathes of the country have only the token presence of a state. On the whole, people are left to do as they deem fit.

'You can't make laissez-faire mandatory!'

‘You can’t make laissez-faire mandatory!’

In a Western country, the government is everywhere. It is omnipresent through the police, in the security cameras, through the laws that govern public property or through working government helplines. India has no emergency response service to match the US 911 or the UK 999. The government exists, in absentia and lets the people rule the land.

This is amply demonstrated by the way that public land is treated by Indians and the way they throw garbage or spit on the street. They know that they can do as they please and nothing can stop them. The Indian spirit is embodied in the classic Indian phrase ‘chalta hai’. Representative of compromise and adaptability in all circumstances, the phrase masks a public apathy towards excellence and demanding of rights considered basic by citizens of developed economies.

Laissez Faire but not Laissez Faire Capitalism

Considering that fiscal spending is considered to be the primary tool for stimulating economic growth in modern Keynesian economic theory, the sums of money actually spent on Central government schemes are not that large with a few exceptions. However, whatever is undertaken is more with the view to offer classic opportunities for graft to the unscrupulous in the government and thus largely a burden on the public exchequer.

On the other hand, it is very hard to do business in India in the organized sector with an interfering government that could arbitrarily impose tariffs, regulations or even tax retrospectively. Indian labour laws and laws governing the establishment of business are hopelessly out of date and favour an economic mindset that went out of fashion half a century ago.

Western Social Capitalism

Modern Western governments, in fact, much more socialist than capitalist in the classical sense. Governments are not just expected to provide civic facilities; they are expected to provide housing, unemployment allowance, pension, and even bail out funds to the occasional big bank. Whatever the problems caused by these massive welfare obligations, it reflects the acceptance of the fact that self-interest may not match with public interest. This mix of capitalism and socialism is the hallmark of the developed economy and necessitates the existence of government bodies to regulate and govern.

The importance of public sector in the Western world

The importance of public sector in the Western world

Thus, India represents neither laissez faire capitalism nor Keynesian economics, just unadulterated laissez faire. With India gradually gaining more prominence, who knows whether a few decades from now, like this classic French phrase, even chalta hai may be studied in economics textbooks;hopefully, only as a relic.

On 26 August, I watched Gujarat tremble, not owing to an earthquake but something more insidious, fear. In rallies with turnouts between half a million to a million plus, the Patel/Patidar community of Gujarat turned out to demand reservation for their caste over the past few days. Violence is virtually inevitable when such turnouts occur and when it occurred on the 25th, it led to a state wide siege situation that is yet to normalize.

Easy to burn

Easy to burn

The entire act is so disdainful that one can only look to Africa for a fair comparison. The vandals had no compunctions destroying state property belonging to everyone. I wonder how many of these agitators pay their requisite share of income tax. The ‘violence’ that scared people across the state is witnessed in the ordinary UP or Bihar town so regularly as not to merit mention. In spite of this, the population of Gujarat sat paranoid with mobile sms and internet services blocked, schools and colleges closed and with all shops shut including even restaurants. ATMs were closed. Dairies ran out of milk. The army was called in too for an action which, to put it mildly, is not something a soldier signs up for.

48692500.cms

It was an act of open surrender (I am amazed at how easily people are scared) and the ease with which a situation like this can be created in one of india’s wealthiest states astounds me, makes my blood boil and fills me with despair simultaneously. Throughout the Third World, particularly the Middle East and Africa, similar sectarian demands by tribes and communities have created deep rifts which have led to non functioning democratic governments whenever given the chance. Parochial communities who act for their own self interest only and give a finger to the government are a typical representation of strife torn Africa.

Such demands by communities and such prosperous ones cannot be met by any government without causing injustice. Unfortunately, the past gives us examples on how Indian governments have capitulated in the face of violence and muscle power wielded by large narrow minded communities. Our populace is largely more peaceful historically than the Middle East and Africa. This is perhaps the reason why we have not degenerated to the level of civil war like them. However, the vision of a nation living with various communities in harmony is a myth. The communities only find it more profitable economically to trade than fight. It is like the strategy game ‘Age of Empires’ in which you could ally with the neighbouring kingdom/tribe/community or conquer it based on pure pragmatism.

Tough luck, but you were more profitable to kill

Tough luck, but you were more profitable to kill

In the August that marks the anniversary of India’s freedom, it is clear that the freedom is only apparent if all it takes to shut a state of 63 million is a bunch of people burning a few government buses, and led by a 21 year old leader asking the government to bow down to absurd, and risible, demands. The entire fiasco makes a mockery of our tall claims of upholding democratic ideals of justice, equality and freedom.

Washed away

Washed away

Idle minds and idle hands: A macroeconomic issue?

The Patel/Patidar community, a relatively economically prosperous community constituting over 12-15% population in Gujarat and wielding better than proportionate political power is now asking for itself to be classified with ‘other backward castes’. The demand is so ludicrous that the first time I heard it I thought it was part of a slapstick comedy routine. This group has so much money that they could probably buy their own small country if they wished to. The Supreme court has capped reservation at 50% which means that the Patels would have to fight for their reservation among the already crowded OBCs. Are they asking for a breach of the 50% ceiling and thus inviting demands by castes across the country for respective allocations which can only stop at 100% reservation? Frankly, the demand is a reminder that the macroeconomic situation in the country needs urgent reform. A historically job eschewing, prosperous, business community now wants to serve in government positions and study in top government educational institutions guaranteeing plush corporate jobs largely because they think that business is not profitable anymore.

India cannot vie with top developed world countries when its people cling to insular issues like caste. Reservation is an absolute bane which makes sense perhaps for the economically backward in the context of social welfare but is incredibly anachronistic when viewed from the lens of caste.

The country needs more colleges, more schools and more emphasis on creating a force of excellent well-paid teachers to teach its young students. It cannot waste its time on a fallacious system of reservation that suppresses merit and encourages the meritorious to migrate to other countries that give them a better deal. There are only so many government jobs and more can only be created if the country grows. The macroeconomic situation of the country cannot improve with impromptu bandhs that destroy livelihood. Bengal is an excellent example of a state that destroyed itself in this fashion in spite of once being the capital of British India. Let India not become Bengal.

 IRCTC

A couple of days ago, an article published in DNA made quite an interesting read explaining how a man paid Rs. 11904 for booking two premium tatkal railway tickets when he had been quoted a price of Rs. 4334 at the time of booking on the IRCTC portal.

Seasoned users of IRCTC know that availability positions on the website are untrustworthy during Tatkal hours and thus a confirmed ticket displayed the previous second might turn into a waitlist 12 by the time electronic payment is actually made. By extension, a dynamic pricing system too is expected to suffer from the same problem. This is also the exact defence put forward by IRCTC to DNA. In other words, ‘Sorry consumers if the system might seem non-transparent but there are simply too many of you for us to handle simultaneously at that speed’.

Contradicting basic ethics

calvin_ethics

This sort of explanation might pass muster for normal Tatkal tickets at fixed fares but rings hollow in the context of premium Tatkal. The problem is that it contradicts the basic ethics behind a buy sale transaction. Let me explain. Tickets are a scarce resource and IRCTC believes that market forces should decide the price of some tickets so that it could cash in on the real higher price of tickets, similar to what happens in an auction. So it goes for dynamic pricing in which successive tickets are priced higher till they reach an upper ceiling. Very good in theory but unfortunately, in real time, the pressure on the IRCTC servers is such that people have no idea about the price they will be actually paying for the ticket and the allotment of fare is more or less like in a lottery.

The way I see it, IRCTC has priced a certain number of tickets at various prices and systematically matches users to these tickets at first come first serve basis. This is intrinsically different from an auctioning process in which bidding is done by the users at prices decided by them.

Today, a user sitting down to purchase a premium Tatkal ticket knows nothing beyond that he will pay a price between the opening price and the capped maximum limit, currently at three times the base fare. As every moment matters when booking a Tatkal ticket, many users banking with SBI avail the IRCTC quick pay service that skips several important confirmation pages specifying the exact amount being paid. Thus many users will know the actual amount only through informational SMS alerts. Even users not paying through quick pay services are expected to react in fractions of a second as to whether the fare is appropriate as a delayed reaction might result in a lost ticket. On the other hand, tickets once booked cannot be cancelled.

Now, it is technically correct to say that a user accepts the terms and conditions prior to using the website and users are free to make their own decisions regarding using the website but is it ethical for a monopoly website to behave in this manner?

It is just plain wrong

WRONG

With long waiting lists in trains and sky high air fares, pun intended (if flights indeed are available between the source and the destination), Tatkal is the only feasible option available for many commuters travelling at short notice. Premium Tatkal quota gets its allotment by eating from the regular Tatkal quota that itself gets its quota by eating from the general pool (remember, no capacity has been added) which basically means that there are lesser cheaper tickets available than before. Charging an unknown fare to a helpless and desperate consumer for normal services made artificially scarcer with absolutely no premium features is just, well, wrong.

Raking in the moolah

 money

Sadly, the brilliant B-school mind, that had devised this technique of making the railways more money without raising the general passenger fare, either did not spot or worse, deliberately ignored the incredible unfairness of the system. On a related note, I suspect a similar kind of mind behind the increase of advance booking window to an unreasonable 120 days (from planning perspective in the fast moving 21st Century) and higher cancellation and service charges to cash in on the higher ticket churn this will inevitably result in.

Premium Tatkal isn’t a write-off though: a suggestion

Premium Tatkal is not necessarily a bad idea. Many people are currently paying agents a substantial premium for Tatkal or even normal tickets on busy routes. Premium Tatkal is cashing in on this premium legally and passengers might also be happier with the mechanism as they do not have to resort to touts.

My suggestion would be to chuck dynamic pricing and charge every premium Tatkal ticket the same fare. The fare could be the average price of all premium Tatkal tickets currently being sold for a train. Railways would earn the same revenue but users would know in advance what they are paying.

Railways is supposed to be for the people

The railways may have a corporate objective to make profits but it must remember that it is providing a basic public service on public land using taxpayer money. As no private competitor is allowed by law, it has an ethical obligation to price its services fairly.

According to the WHO Global Status report on Road Safety 2013, ‘wearing a seat-belt reduces the risk of a fatal injury by 40–50% for drivers and front seat occupants, and between 25–75% for rear seat occupants’ and ‘wearing a standard, good quality motorcycle helmet can reduce the risk of death by 40% and the risk of serious injury by over 70%’. This lends credence to the active public campaign by police, media and social groups to make people wear helmets and seatbelts.

Nonetheless, the overwhelming emphasis on these protective measures is inherently faulty as the focus is not on preventing road accidents but only on being better protected against them. This is equivalent to allowing everyone to carry a gun freely and then making it compulsory by law to wear a Kevlar vest.

That's what I mean by protection, baby!

That’s what I mean by protection, baby!

In Indian cities, it has been compulsory to wear a helmet and wear seatbelts for quite some time and if people are still not doing so, then they are exercising a rational choice (for eg.  I could die by not wearing the helmet but the helmet gets me sweaty, hair gets sticky and spoilt).

However, there could be no moral or rational basis for exposing a second person to undue harm by your own reckless driving. Yet, this is hardly policed. Over speeding, dangerous switching in and out of lanes, driving on the wrong side of the road, parking on flyovers/ bridges, unnecessary driving on high beam in cities, blaring of disturbingly loud horns that wreck every driver’s road composure, wanton crossing of roads by pedestrians in between barriers: these go on rampantly. Are these harder to police? Yes. But impossible? No. What makes it even more important to pull up these violations is that enforcement is sure to have a direct impact by lowering these violations, and consequently, accidents.  Sadly, just because it is easier to catch people riding without helmets or without seatbelts and it is so lucrative, almost the entire challan targets of the traffic police are met by these violations of personal protection.

Ok, this one is preventive and protective

Ok, this one is preventive and protective

It is not the responsibility of the government to force people to protect their own life but it is very much its responsibility to ensure the road safety of a person who is careful and following the rules.

( Will be writing a more detailed post on actual road accidents and their prevention shortly)