Time to pay heed to fiscal health!
Ageing population

The fiscal liabilities associated with the ageing of the population raise serious doubts as to whether the positive trends can continue. Within the next 10–15 years, a dwindling share of workers will have to start supporting a ballooning share of dependants in all major industrial countries. In order to maintain current levels of pension, healthcare and other welfare benefits, total age related spending would need to increase significantly over the next few decades. Clearly, taxes will have to be significantly raised to match the expenditure.

Growth & inflation

According to Bank for International Settlements (BIS), global output is expected to decline from 4.8% in 2006 to 4.3% in 2007. The pack of Advanced Industrial Economies (AIS) will take a hit in 2007, as the growth is expected to slowdown from 2.9% to 2.3%. United States deserves a special mention, as it is believed that the economy will expand by a meager 2.1% in 2007, compared to 3.3% in the previous year. The inflation outlook also remains uncertain. Energy and other commodity prices have rebounded since the beginning of 2007. Moreover, underlying inflationary pressures are still visible in major economies.

Fiscal imbalances

Overall speaking, the fiscal balances in AIS finally showed signs of improvement in 2006. The financial balance (deficit) of Euro area is set to improve from 1.6% to 1% of GDP, same is the case with public debt which is expected to decline from 76% to 74% of GDP in 2007. The financial balance (deficit) of US will worsen further to 2.7% of GDP, while the public debt will remain at 62% of GDP. Australia is expected to post a moderate improvement in terms of public debt.

Living on the (h)edge!?!?!
Hedge funds have to be regulated massively to prevent a situation where global economies could vapourise

This must be the umpteenth time that we’re using James Bond in our articles... Oh well, this must be the umpteenth time we’re barking out our vitriol driven intellectual (allow us this immodesty!) criticism about the global investment scenario & hedge funds. Akin to the ease with which Bond betted blindly in the movie Casino Royal, hedge funds during their inception began similarly betting on currency; then they moved on to metals; & obsessively jumped steps ahead to start gambling on gas & (Ripley would be proud) even violins; & as commodity & financial markets move into a highly volatility stage (if not a structural collapse; read the cover story on the US economy facing collapse), the stage is set where capitalism could lose its very existence.

Two hedge funds have collapsed in a span of less than a year, shocking even the hardest of analysts, & how! Blame it on the markets or one the high water marks (a clause which states that fund managers would not receive incentive fees unless the value of the fund exceeds the highest net asset value it previously achieved), hedge funds have created a lot of news because of all wrong reasons. But first, the first.

The Amaranth Hedge Fund lost steam & got completely charred in September 2006 after betting on natural gas. Amaranth, which had large positions in the US natural gas derivatives markets (the fund was also accusing by SEC for distorting gas prices), suffered massive losses thereon, to the tune of $6 billion, as prices of natural gas took an about-turn.

But rather than learn from one benchmark failure example, hedge funds went berserk trying to out beat each other. In the most recent case of Bear Sterns, two of its hedge funds – which had significant exposure in Collateral Debt Obligation (CDO) market, & which were backed by sub-prime mortgage loans – collapsed. And the situation that led to it? Astoundingly, the gearing of their funds was as high as 5 times, wherein an initial corpse of $2 billion was used to borrow more than $10 billion to confirm high value deals in the CDO market – the underlying assets being sub-prime.

Though in the case of Amaranth it was the abrupt reverse trend in natural gas prices, in the case of Bear Sterns, it was the sub-prime lending that played the spoilsport. According to the Bank for International Settlement (BIS), sub-prime mortgages made up more than half of the $503 billion in collateralised debt obligations sold in 2006, but another $524 billion in ‘synthetic’ CDOs (if the CDO acquires primarily synthetic assets by selling protection rather than buying assets for cash, it is a synthetic CDO) were also issued. Bear Sterns was required to pump in $3.2 billion in one its funds to bail out the funds, the biggest bailout since hedge fund Long Term Capital Management (LTCM) collapsed in late 90s.

No one with the exception of Barclays came to the rescue of Sterns; compare this to the 16 Wall Street biggies who infused more than $4.5 billion in LTCM. Sanford C. Bernstein, founder, Bear Sterns, shared his belated views & fears, “More than a Bear Stearns issue, it is an industry issue. How many other hedge funds are holding similar, illiquid, esoteric securities? What are their true prices? What will happen if more blow up?” According to BIS, the total notional value of global derivatives in existence has grown by now to an unbelievable $415.2 trillion, which is almost 800% of global GDP. What does it mean? It means that if all derivatives were to collapse, forget economies crashing, forget currencies vapourising, forget GDPs becoming non-existent, the fact is that capitalism would, uhh, end!

So what’s the solution? As Bond would say, very simple Ms. Moneypenny. Just ban notional trading & start regulating hedge funds like nobody’s business. There, we said it first!... Or did we?!

Germany’s bending to ‘Peer’ pressure
Peer Steinbrück, German Finance Minister, gets some right & some wrong

“We would work very hard to get our views accepted,” said former German Finance Minister The odor Waigel in 1996. The odor was advocating that the Maastricht Treaty (MT) formalize a fine of 0.2-0.5% of GDP for countries that exceeded the limit of 3% of budget deficit. Peer Steinbrück – current German Finance Minister – must be a relieved man today, because had the EU Commission accepted The odor’s viewpoint, Germany would have been the first country paying fines. A country that pays $53 billion as interest annually, would have ended up paying a $15 billion fine.

In fact, for the first time in 2006, since the start of 21st century, industrial recovery, private consumption & relatively better fiscal management helped Germany meet the more lenient MT budget deficit guidelines. And the celebrations are in order, due to Germany’s ‘surprise’ GDP growth of 2.8% in 2006, with which the economy was resurrected. But more surprising were the unemployment figures, which declined from 11.7% to 10.9% in 2006, its lowest level in past 12 years. “Upswing in the labour market is good news for German household consumer spending, since disposable income is rising,” confirmed Alexander Koch of HypoVereinsbank AG, the leading German economics research firm, to B&E. Al though IMF does warn in its working paper ‘Tax Reform & Debt Sustainability in Germany’, that measures like increase in VAT, reduction in payroll taxes & corporate income tax might help in the short-run but growth too will be sacrificed. Worryingly, the positives of raising the statutory retirement age & lowering the contribution rate to unemployment “will be counterbalanced by the misdirected & ultimately counter-productive reform of the financing-side of the statutory health insurance scheme,” says German Council of Economic Experts, a German government think-tank. And despite unemployment rates falling, the fact is that skilled labour is becoming rarer. “The danger of capacity bottlenecks & of high wage settlements is, therefore, increasing,” adds Koch to B&E. Clearly, it’s not just about ramping up Germany’s training & education focus, but in reality, achieving structural balance through the measures taken by Peer Steinbrück ‘will’ result into efficiency losses. A more logical way would be straightforward expenditure cuts & entitlement reforms, in combination with measures to broaden the tax base & raising indirect taxes. It’s that simple Mr. Steinbrück! But then, wasn’t economics supposed to be that?

Disaster awaiting?
Are fears of critics really founded?

(column by Gyanendra Kashyap)

The expenditure on the prevailing pension system, which caters to a mere 13% of the workforce (majority of them being government servants), if continued, would exceed over 5% of GDP in just a few years. It is estimated that India’s pension bill will rise to a most worrying Rs.350 billion by March 31, 2010. It is in this perspective that the announcements made by RBI for management of pension funds (viz the National Pension Scheme – NPS) by banks is hugely laudable. But critics are shouting hoarse that this is extremely dangerous in the long term for pensioners. Are their fears founded?

Frankly, no! A foolproof mechanism – consisting of failsafe measures like the bank’s net worth not being less than Rs.5 billion, CAR (Capital Adequacy Ratio) not less than 11%, RoA being at least 0.6%, net NPAs being less than 3%, et al – has been laid down leaving minimal scope whatsoever for mismanagement. Moreover, the banks will be required to form a subsidiary (with investment limited to 10% of its paid-up capital and reserves), which will maintain an arm’s length distance from its parent. No doubt, there have been occasions in the past wherein not only the regulated but even the regulators have failed miserably – reason enough for RBI and PFRDA (Pension Fund Regulatory Development Authority) to continue their Big Brotherly control.

But critically, the absence of a guaranteed minimum pension for participants and the partial mandatory character of NPS can certainly prevent the early achievement of sufficient critical mass to stimulate financial market development. The success of NPS will highly depend on the relative attractiveness of the scheme. Much more of competition should be induced in NPS (as currently there are only four players, SBI, LIC, IDBI Capital & UTI AMC). This will surely help even decrease the relative volatility of the parallel equity and corporate bond markets and improve resilience to shocks. What say to this Dr. Y. V. Reddy?

(End of Gyanendra Kashyap column)

ZzzzzzEBI...zzzz
SEBI was caught red handed!?!?

June 2006: An article in the very same magazine currently in your hands advocates for a cap on corporate investments in mutual funds (MFs); too coincidentally, a few days later appears an editorial in one of the newspapers, which talks about imposing restriction on corporate investment in mutual funds new fund offerings (NFOs). Ironically, SEBI – the capital market watchdog – in a bulldog like fashion, stubbornly refuted such suggestions, and gloatingly expressed, “SEBI has no proposal to cap exposure of corporates (sic) in NFOs.”

Exactly a year later, when the MF industry is commemorating the $100 billion AUM (Assets Under Management) mark, Johny-come-lately SEBI wakes up from self-imposed Rip Van Winklish slumber and garbles up one Mr. Damodaran who lambasts the industry with a historic statement – “The mutual fund industry seems to be prematurely patting itself on the back. The question is: who has made what sort of growth?”

Don’t worry! We made as much sense of this as you... in short, nothing! More lucidly for you, in a vituperative and most belated attack on the tendency of mutual funds to accept bulk amounts from corporations to boost inflows, the SEBI chief said that liquid funds should not be the only way to grow & that MFs need to look beyond liquid and money market schemes, as large funds from corporate houses invested in MFs could generate Possible conflicts of interest. Uhh ohh. One just keeps wondering where was SEBI for one straight funny year. But better late than never. The fact is that Damodaran is right. Digest these figures – liquid schemes, which are there to provide easy liquidity and preservation of capital accounted for 30% of the AUM as on March 31, 2007, as compared to 27% a year ago. The figure is disturbing considering the fact that every other category of MF scheme has either remained constant or has declined over the previous year. For 2007, Jan-March quarter, liquid schemes by MFs more than doubled and accounted for 83% of total sales and we know who the investors were! India Inc. of course.

ere is only one way to go; and that is that SEBI should put an immediate cap on such corporate investments; and as an extreme case could also consider banning such investments through the short term. One just hopes it doesn’t take SEBI till July 2008 for action. Zzzzz...