Revisiting January 2007

I wrote a newsletter in January 2007 at the height of the global easy money boom. http://atyantcapital.com/wp-content/uploads/2007/12/atyant-capital-newsletter-issue-19.pdf

It seems like everything that the media is talking about today is what should have been worried about then. The time to be fearful was then. Now is the time to be greedy.

I've posted my piece from the newsletter here:

From Rahul Saraogi, January 8th 2007
The Year the Bubbles Grew Bigger
 
Traveling to Hong Kong for New Year’s Eve was an interesting experience. Having visited after a gap of a few years and nine years after the handover to China, it was amazing to see how a former British city has transformed into a Chinese city. No one seems to speak English in Hong Kong anymore and the cabbies don’t even seem to understand sign language. Hong Kong is booming. It is packed to capacity and packed with Chinese tourists. International tourists are conspicuous by their complete absence. Everything in Hong Kong, the food, the events and the shopping is morphing itself to cater to the mainland Chinese tourist. Hong Kong, it seems, has its hands full with visitors from the mainland and doesn’t seem to need anyone else.

What is driving this boom in Hong Kong? Dare I point a finger at the Federal Reserve and the central bankers of the world? By keeping monetary policy too loose for too long, they have created asset price bubbles everywhere.

Mainland China’s stock market, after lying in doldrums for the last three years was up 98 percent in 2006. An article in the South China Morning Post on December 29th titled “Bull Run Fuels Blind Rush for Funds” by Jane Cai had some interesting observations about the phenomenon. The article discusses the frenzy among common Chinese people for investing in mutual funds. According to the author, in the larger Chinese cities, the traditional greeting of “Have you eaten today?” is being replaced by “Have you bought into any managed funds lately?” More than 6.73 million accounts were opened with fund management companies in the first 11 months of 2006, almost three times the number for all of 2005. Everyday, Chinese are being lured by their local bank branches to invest in funds. Given recent returns in the markets, the annual deposit rate of 2.52% is looking increasingly unattractive. The author quotes a local branch manager who states: “You should buy funds.
 
Their returns are much higher than deposits and bonds. All of ourcolleagues have bought them. You’d better make a decision as soon as possible. Nowadays a new fund is fully subscribed in just one or two days.” She writes about a 62 year old Beijing housewife who withdrew 20,000 yuan from her time deposit account and invested all but 700 yuan into managed funds. The remaining money was for the month’s groceries. On being asked about the risk of losing money, her response was: “Aren’t the profits as certain as treasury bonds? Is it possible to lose money?”

The article mentions the views of a Shenzen based fund manager who states that “people have finally found a way to share in China’s robust economy and use their savings to make good investments.” The same article discusses the views of a finance professor at one of China’s top government think-tanks. According to him “the foundation for a long-term rally is not solid in China because most listed companies have not made convincing progress in improving their quality.”

The perils of loose money and their related asset bubbles were seen in Saudi Arabia, Dubai and other Middle Eastern countries where stock markets, driven up by naive investors and cheap oil money, fell more than 60% in May of 2006. That 2.52% for a one year deposit is an excessively low interest rate and to keep rates that low the People’s Bank of China is printing excessive money is clearly evident from the article above. This cheap money is overheating China and blowing asset bubbles of all kinds.

Asset Price Inflation vs. Consumer Price Inflation
 
According to economic theory taught in colleges, an excessive increase in the money supply causes an increase in both asset prices and consumer prices which then lead to a debasement of the currency. If asset prices are the first ones to appreciate then, the monetization of those assets for consumption by their owners subsequently creates a pull on the demand for goods and services causing an increase in consumer prices. One of the big conundrums of recent times has been the non-transmittal of asset price inflation to consumer prices inflation. There are numerous theories, including but not limited to the argument that the world is going through a supply shock of both goods and services because of the inclusion of India and China in the free market system. I neither have the qualification nor the ability to agree or disagree. However, I will offer some food for thought. If assetsare nothing but stores of future consumption, then shouldn’t they have some kind of a future convergent relationship? Whether asset prices will fall to justify current consumption prices or whether consumption prices will rise to justify asset prices isanyone’s guess.

G7, BRICs, and the India Story
 
The markets in the last couple of years have become increasingly story driven. This trend accelerated further in 2006. The theory that three billion new producers and consumers have joined the free market system and that economic leadership will move to the BRIC (Brazil, Russia, India, China) countries by the year 2050 is now a part of popular rhetoric. It has led to the launch of numerous BRIC funds and has made it fashionable to invest in the China Story or the India Story or the Resource and Commodities Story etc.

In my opinion, we are at the fag end of Story based investing globally. It is true that population in the G7 is aging and that they are unlikely to witness roaring economic growth. It is also true that the emerging block of countries are likely to produce most of the spectacular economic growth and investment returns in the years to come. Financial markets however are always manic depressive. They either price in a rosy and obstacle free growth outlook until Kingdom Come or price in doom and gloom all the way to Armageddon. Economic reality however moves at its own pace, two steps forward and one step back. We are unfortunately in the former position at the start of 2007 and easy money has marked up prices of assets to levels that leave no room for disappointment.

I know more about India than I know about other asset classes and will try and debunk the myth of the India Story. As my colleagues exuberantly enter 2007 with a ‘clear blue skies’ outlook, I will present below some areas of concern.

Complete Failure of Government:
 
India today has one of the worst governments of recent times. The government has not been able to enact any positive reform and has systematically meddled in all free market areas to destroy hard won gains. The government has ruined the oil and gas sector, the power sector, the pharmaceutical sector and the fertilizer sector. The government has continued with its ad-hoc policy of using tax incentives to cause mis-location of industry that severely affect productivity. The completely misguided SEZ (Special Economic Zone) policy is an outcome of an extremely corrupt polity and is likely to result in ruinous consequences for industry going forward.

Endemic Corruption and Failure of Governance:
 
The government has completely failed to reform its bloated bureaucracy and the country is operating under administrative paralysis. The fragmented nature of India’s coalition government has prevented it from reforming administration and there is absolutely no accountability in any part of the government machinery central, state or local. When you combine this with a government that is unable to reform subsidy, the outcome is national waste of enormous proportion. Corruption in the Indian administrative system is so pervasive that it is estimated that only 10% of government spending actually goes to its stated purpose. When one analyses the government’s finances, in spite of a combined deficit of 8% at the central and state level there is no enabling environment being created. This is only to be expected since over 90% of India’s government expenditure goes to meet subsidies, employee salaries and running of the government machinery.

Infrastructure Chaos:
 
India has missed the bus on infrastructure. For all the lip service being offered by the government including projections of $320 billion of investment in the next five year, nothing is happening. In every country that has grown globally, basic public goods have been provided by pro-active governments. It is unrealistic to assume that the private sector will somehow build whatever the country needs. India’s cities are bursting at their seams and basic necessities like water, sanitation, power, public transportation are unavailable to citizens. To believe that India will somehow be able to grow even if it doesn’t plan and buildadequate urban infrastructure for growth is a pipe dream. Complicating matters further is rural and agricultural India that is in complete shambles (see next paragraph). A marginal up-tick in urban growth has caused rural-to-urban migration to grow disproportionately. It has often been said to clean up the slums in Mumbai one has to first improve the appalling standards of living in the Indian state of Bihar.

Rural India in Shambles:
 
The state of rural India is indescribable. Farmer suicides and Maoist (left wing) militancy is becoming a problem in region after region. Indian agriculture is extremely dependent on monsoon rains which are very erratic. It is not unusual to hear of regions that experience drought in one season and floods in the next. The proposal to interlink India’s rivers to create a national irrigation system has been in the works for decades. Absolutely and completely nothing has been done by the government to further this basic need for 65% of India’s population. While the government has excitedly advertised 8% and 9% GDP growth achieved over the last three years, what it has failed to advertise is that India has had three successive years of normal monsoons. One of the primary reasons that India experienced severe slowdowns in 2001 and 2002 was the complete failure of the monsoon rains in those two years. To expect the private sector to build non-remunerative rural infrastructure like irrigation canals, rural roads, rural electrification and agricultural supply chains in poor and non-remunerative regions is unrealistic. When the government tries to build these only 10% of money spent get actually used for its intended purpose and even there, corruption ensures that quality is completely unsatisfactory.

Summary:
 
It has often been said that India has grown despite its government not because of it. This was however possible when there was a lot of slack in the economy. To assume that India’s dynamic private sector and its world class entrepreneurs will be able to create demand and growth continuously despite the government will be a mistake. The state will have to create the supply of public goods that will enable the growth and support the demand it will create. Otherwise the economy will severely overheat and there will be a breakdown of the system. India has repeatedly demonstrated that it only learns from crises. I hope that we will not need another crisis to give the country’s administration a wake up call.

Looking Ahead into 2007:
 
I my opinion, 2007 is likely to be a year of disappointment for asset markets globally. In India as the broad market approaches a market-cap to GDP ratio of 1.2, not much upside remains. India is also severely overheating. Unlike China, India neither has a reckless banking system to cause private mal-investments (fortunately), nor a proactive government (unfortunately) to cause public good and mal-investments. As a result India is facing capacity constrains across the board. India’s labor market has also used up all its slack and salaries and wages are increasing disproportionately. The physical task of bringing untrained and unskilled manpower (of which a lot is available) will take the requisite time and is likely to pose a bottleneck for growth in the short term. The Indian central bank (RBI) has realized this (fortunately) and has allowed interest rates to harden to choke offsome of the demand. In a rising interest rate scenario it seems extremely unlikely that asset prices will demonstrate the same level of exuberance as experienced in the last few years of easy money.

This is extremely good for India in aggregate and for its medium and long term well being. This is also an encouragement for good companies that are good stewards of capital and that are continuing to build competitiveness at a global level. This creates numerous pockets of opportunities for discriminating investors. However, it is not a very healthy environment for across the board “India” exuberance. Slowing down of global growth and tightening of money globally is likely to pose a challenging environment for the asset preference exhibited in recent times.
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