What is the way forward?

Hello,

 

I am currently half way through the Book – Lords of Finance: The Bankers Who Broke the World by Liaquat Ahamed and its already making me scared. Scared not about the possibility that some day we may enter into another world war but scared that any financial implosion can have devastating consequences on a lot of people in India. People like my dad who after working for decades now is depend upon the bank interest that he gets for the deposits he has made.

 

Like most Indians, he is scared to stocks & has not much interest in investing in real estate which has meant that majority of his mearage savings are in the bank. Right now, he is literally happy to get as much as 10-11% interest on his deposits especially since they being invested in Public Sector banks, carry very little risk. While the bank risk of a bank defaulting & defrauding investors is not a worry I have (it has not happened in the last few decades) but am more worried about the Rupee loosing value to a extent that a default is not even scary.

 

As countries grow and money is continuously printed, the value of money does shrink. Without this, we will have no inflation and hence zero growth & in a way start getting into deflation. But on the other hand, too much of inflation too is pretty bad. On one hand, the value of the rupee keeps going down while prices move in the opposite direction. But interest rates have a limit & above a certain level, inflation can take a path of its own regardless of the underlying fundamentals.

 

For some time now, I have been bearish on the Indian Markets due to a variety of reasons including the continuing saga in Europe. But as I read this book, I realize the gravity of the problem that can crop up if things do not go as per the ECB plan. By removing the Prime Minister George Papandreou, Greece and hence the Euro may have gained some time, but I believe it’s just a matter of time before Greek either defaults or has to be supplanted with more money to ensure that it does not go under.

 

But Greece is the least of the problems, problems are spreading across the Euro Zone and it’s difficult if not outright impossible for the ECB to take evasive action & limit the domino effects that it can have. Interst rates are already rising for other European nations since the Greek episode has made investors wary of financing them cheap. Also the way the Greece situation is being resolved has meant that those who bought Insurance against such a scenario. New York times reports and I quote

 

“The deal to allow Greece to write off 50 percent of its debts to private investors without setting off credit default insurance protection has also left many investors feeling vulnerable”

 

This has meant that if similar procedure is followed in other countries, those long on the bonds despite having adequate hedge by way of Credit Default Insurance may still have to take a significant loss. Since this risk has to be considered & there is no protection, the only way is to ask for higher interest for the additional risk they are bearing.

 

Today,  Mohit Satyanand, a noted Economy / Fianance writer for Outlook Money tweeted that 10-year GOI bond yields crossed 9%. This is pretty high compared to historical standards but since our GDP is growing around the same levels, its atleast acceptable in a way for the time being. On the other hand, a country like Italy which had a GDP growth of 1.5% is now paying around 6.5% for a 1 Year Bond. This is way beyond it’s capacity and its a sure fire way towards disaster.

 

All this is happening despite ECB buying bonds of all the ailing countries as much as it can. The question that comes is how much more can they go and what next. The Interest that ECB is itself paying is going through the roof and it will have its implications. When they cannot sell any more bonds (demand is already down with today being one of the low days when they could just get to fill up the ask), the only option left will be to print notes and buy the bonds. This is what the US Fed did when it faced its Lehman moment and has in a way been continuing to do till now.

 

Unfortunately mindless printing of currency does have implications. Money so created has to go somewhere and the way it went before was to commodities / bullion resulting in strong rallies across the board. This has very strong negative implications for India since on one hand, we are faced with a slowing economy, a rising interest rate structure, a depreciating rupee and if commodities go through the roof, it has to be the final nail in our coffin.

 

RBI is near to exhausting all its mechanisms (normal ones) under which it could bring down the inflation rates without there being much destruction of long term growth. They have tried this despite reforms not initiated by the government which has been the single biggest reason for RBI’s failure to control inflation. Continuously raising interest rates can lead to either of the following 2 scenarios

 

1. Stagflation: Due to continuous rise in commodities (and this will naturally include food based items as well), we will have a strong inflation but growth will either stagnate or worse start to fall off.

 

2. Deflation: I doubt that with the kind of money floating around, we will face deflation any time soon. Deflation can happen if RBI raises interest rate to such an extent that growth goes into the negative sphere.

 

No matter which of the above 2 happens, we will be screwed, but the bigger problem is how our banks will cope with the problem and what effect it will have on the purchasing power of the Rupee. Honestly, I really have no idea what is the best way to preserve our capital since a fall from grace will affect every asset class across the barrier. The only difference will be what will come back & what will not.

 

The above view may look like a dire prediction and may not happen, but remember, Time and Tide wait for none.

 

Cheers 

 

Prashanth