IT: Extinction of mass market and the rise of a new class

Recent technological advancements in IT industry are reshaping the whole industry. The march of automation will eliminate thousands of low skill jobs in the sector in the years to come. Already growth has stalled in most of the IT services businesses. Adapting to new measures becomes inevitable for them. Do you remember how much buzz BPO companies were making ten years ago? Observe how they got transformed over time. If not same, similar process is underway for IT industry too. Hiring in big numbers will become a thing of past. When the profitability gets hurt, industry consolidation begins, and that would consume one of the top four IT services companies in India as mergers gather pace. By then you would accept, IT has ceased to be a mass market. But that is only one side of the story. The other part is very rosy.

Take a look at the snapshot taken from Naukri.com portal. In the e-commerce sector alone, there are more open positions in the 50-75 lakh salary range than in the 25-50 range. There are 31 jobs offering a 1 crore + pay per annum. Yes, this is in India. And these are not CxO jobs. But two-three levels down from top job and many of them are techno-functional jobs. When the business opportunity is huge, employers do not mind paying a hefty package. And the expectation is high too. An average IT engineer won’t do for them. He/she should be a geek, with skills of product design and development. In other words, the person should be a world class talent. For those top talents, the pay too is world-class. These high pays will effectively reduce the gap between those working in the US and in India. Employers do not mind the geography but will care for the talent instead, that is the trend which is evident by the pay offered and the number of open positions in that range. Currently this trend is limited to niche sectors but I do expect it to rub on other sectors too, but with a time lag. So in a decade from now, it would not matter if one is working in the California or Bangalore, wage gap will shrink and pay would become comparable (not exactly same due to economic parity) for the same skill sets. A nice trend for those who have right skill sets.

Low skilled jobs will be automated and they will have to move to other sectors and the pay outside IT is catching up too. Keep in mind seventh pay commission amendments. And for the top talents, they need not line up in front of US Consulate office for a visa, they will the get right job and the pay here in India. Did you ever wonder who would buy those Rs. 2.5 Crores villas and the Jaguar, Land Rovers? They will not be limited to CxO and NRI’s, a new class is getting elevated. In the short term, it may look like they are an island in an ocean of poverty but eventually the benefits will spillover as they will take up the domestic economy too with them.

Failing start-ups and the changing India

There is lots of news in the media on the failing startups. Those who survived are downsizing, they are letting the same people go they had hired and trained few months ago. (http://economictimes.indiatimes.com/small-biz/startups/layoffs-in-startups-whats-the-other-side-of-indias-entrepreneurship-story/articleshow/54268511.cms). Some 4,000 employees who lost their jobs have not been paid for the last two months. Situation is bad as many of the startups which had flared up hope are running out of cash.

Very few, probably less than 10% are able to stay afloat and scale-up. Well, this is entrepreneurship and this is how it works everywhere you might say. But before that let us see what is hurting these and why they are running out of money too soon. I am no entrepreneur, do not have first hand experience of running a start-up but the this is what I found as plain facts that are hurting the infant companies.

o   Failing to come up with a marketable product: Though VC’s provide funding to start the startups, they expect these new companies to generate cash flow in a few months time. It is necessary for these start-ups to at least cover their operational expenses. When the product development gets delayed beyond expected timelines or if it fails and the next round of funding does not come in, it is time to shutter down the business.

o Overestimating the market: Steve Jobs had said no market research will help him as no one has seen the products he is building. True, his bets worked out, the whole world became his market and now we call him a genius. Had his idea failed, even his family members would have called his smart phones dumb. Market is ruthless. If product is well received, people will queue up and wait to get the new, fancy thing. Else, it is difficult to get back even the expenses of a product launch. If a product will succeed and if it succeeds, what would be the market size will just remain an estimation. There is no way to know the right market size until you get there. There is always a risk of market research becoming trash. Higher the estimate, higher is the risk.

o Excess Capacity: This is related to above fact but yet the right man-power planning is difficult to estimate too. Let us say there is a new market and there are three players. If one company grows to dominate the whole market, it needs to scale-up while the remaining two will have to downsize. One company had got it right while the other two failed. Like the Mughal princes, they fight for the crown, one will get it and the rest will have to rest in coffin or have to co-exist in a smaller capacity.

Is this a really bad situation? Yes, for those founders of failed startups, employees who have lost their jobs and the investors who burnt out their money. All businesses will have a risk-reward trade off. But the start-ups are like infants and the infant mortality numbers are high in this industry.

Get out of this grim mood, you will notice the changing face of India. We never had these many numbers of new companies getting started in the history of India. Now there are more people taking risks despite the odds of seeing success is slim. Capital is available to realize an idea while it was limited against income or collateral before. Those failing are teaching entrepreneurial lessons to a bigger population who would want to test the start-up industry. The new comers will have to come with better and realistic plans on how to make their idea work and pay their investors and not just their employees.

This phase and pain was part of the evolution which is taking place. I do not expect the number of risk takers to slow down. But I do see that the new business plans will be robust as convincing the investors and employees to believe in them will not be an easy task. It was not easy task before but the checks will become more as the idea goes through more validations. And the strongest will survive and thrive.

Henry Kissinger moment for India

Hope you know how Henry Kissinger, a US Diplomat, had helped China leapfrog into a high economic growth nation by making it a trade partner for his country. That was few decades ago. I do think the same moment has arrived for India as the world’s biggest economy US is opening its doors wide for the benefit of India. Policy shift brings Henry Kissinger moment for India. See the following news items which provide a proof to my claim.

·       Apple to explore making iPhones in India (http://timesofindia.indiatimes.com/tech/tech-news/Apple-asks-Foxconn-to-explore-making-iPhones-in-India/articleshow/54042677.cms)

·       Made in India’ F-16s on radar (http://www.thehindu.com/news/national/made-in-india-f16s-on-radar-thanks-to-fdi/article8756876.ece)

When iPhones and F-16’s are produced in India, they do bring in the technology know-how, create high-skill jobs, unleash a new industry and at the same time, international export markets too open up for goods manufactured in India. If this trend sees further strength, exciting times are ahead.

Why now?

If you follow the international news, you would have observed how relations between China and USA are strained now. Increased trade between those two countries had helped China to achieve economic strengths but lately it has become aggressive too. What is happening in South China Sea is not pleasing the US. Moreover China has developed good relations with Russia. This made US make policy shift towards India. And India seems to be a willing partner as it allowed US’s defense to use it’s naval base. Before this had happened, Modi has made several visits to US and Obama too had presided in India’s Republic day celebrations.

What would change?

Look at trade statistics. http://www.worldsrichestcountries.com/top_us_imports.html.

China’s exports to US are 10 x of India’s to US. Policy shift would move some of this trade (slowly over a decade) from China’s kitty into India’s. That would boost India’s economy. Local manufacturing in India for goods which are imported now will help curb imports and boost domestic job creation. This has potential to turn India from a trade deficit country into a trade surplus nation. What India needs is job creation, skill development and access to larger markets. All these will see a phenomenal improvement when the discussions become a reality. 

Taking a look at the current scenario, it appears India is naturally a best choice for US for geographical and political reasons. So we are seeing the news pieces flowing in. But behind them, Govt’s of two large nations are at work with a serious intention. This would also mean India's relation with Russia would suffer.

Henry Kissinger and his master Nixon had paved way for a new beginning for China with the policies they had adopted. As tables are turned, it appears to be India's chance now. Some of China’s loss will become India’s gain. Not just that, increasing trade would put India into a new potential. That of a superpower, overpowering its neighbors in Asia.

Drivers of economic cycle

While arrogance is an indicator of economic cycle topping out, despair reflects the trough. Hope takes the cycle up and reality brings it down. In between these fluctuations, there lies the trend.

Major political events can lengthen or shorten the cycle. Similarly monetary policy shifts, technology trends, employments levels and change in physical infrastructure will have an effect on economic cycles.

In the last 30 years span, during 1989 there was a peak and the next peak came by 1996 after a gap of 8 years. We had to wait for 11 years till 2007 for another peak to surface. We cannot time these cycles, but going by history, if we can assume that 8-12 years is the cycle time between two peaks, it seems the next peak of economic cycle is waiting to reveal itself.

There are three factors which will act as indicator of such a thing happening.

1.     Monetary system (Inflation-interest rates, Money supply): In the last one-two years, RBI has reduced the rates significantly, some of it is transferred to consumers but banking system drowned in bad debt is not passing the complete benefit. Policy rate reducing is a positive sign but preventing the benefit to be passed on shows that system is not ready yet for a peak.

2.    Employment levels and Wages: Recently seventh pay commission has come into force that leaves more money in the hands of Govt. employees and pensioners taking their spending power up. Money at the hands of consumers will have a better velocity and farther reach than the direct spending by Govt, itself. Along with this wages need a boost in private sector and the total employment levels need to go up. When that happens, it helps to fuel the drive to reach a new top.

3.    Infrastructure development: It had come to a halt during the ending years of UPA-2. But with a new stable Govt in place, it is slowly picking up. Once Banks are able to clear their bad debt mess, they would let more money flow into large infra structures and when those projects gain momentum, it would mark the new peak.

Taking a balanced look at these three factors, it appears like we are out of trough but the upward movement is facing lots of resistances. So this cycle is taking a longer time to reach a new top. But keep watching these factors, it will let you identify the top of next cycle.

Making India flat (reducing economic unevenness): GST will help a lot

In a big country, there will be unevenness in the resources spread. So will be availability of skill sets and wages too. But people migrating helps it reduce the gaps in wages and skill availability. When it comes to materials, good infrastructure and efficient transportation can help reduce the pricing inefficiencies across markets within India. But the earlier tax system, dominated by different outlooks by respective State Govt.’s had made the playing ground unequal especially for manufactured goods. Take the example of manufacturing of a two-wheeler, its assembly plant is in one state but the raw materials, spare parts come from different states. Tyre's, batteries, spark-plug, speedometer, steel to make chassis do come from different states and attract different tax rates. So producing the same two-wheeler may cost different in different states for the same manufacturer. And the final product too will attract different tax rates when it is being sold. These variations would reduce or cease to exist as GST comes into play. States Govt.’s will lose their power to levy more taxes or to promote any segment with less taxes at their will as there will be one tax collected by the central Govt. and states will to have to collect their share from it. But they have not lost their entire power as few major businesses like liquor are kept out of GST. Yet, this is a welcome move in integrating manufacturing and trade in India and making it one platform and one market.

At the surface level, GST is a great tax reform. It reduces pricing variations and thus promotes trade. That is economics. But it will affect social structure over the long term as it will reduce variations in wages too. Now average incomes of those working in West Bengal and Goa vary a lot. Similarly employment levels are not the same in Kashmir and Kerala. That was because trade was unequal in those states and some of it was due to different tax policies adopted by their state Govt’s. As those taxes get scrapped and the benefits of GST begin to spread, those states who lacked advantage would find themselves at the same level playing field with those states who dominated trade before. So both trade gaps and income gaps will begin to reduce across states making India a homogeneous country economically. India needs to remain diverse in cultures but not in incomes. And GST will help promote it.

Rockstar is gone to make way for a political bandwagon

Rajan was a pleasing personality. He had his own views and opinions. He was loved by media and public in general. Surely that did not go well with the Govt. who does not want to share the credit of a good story. And in the closed door meetings of big public sector banks, they seemed to be unhappy with Rajan’s move to clean-up banks. All public sector banks had to act tough, write-off some of bad debt, put more money aside for provisions, and finally show losses in their P&L statements. It made those bankers look bad on the way they did their jobs. They secretly wanted Rajan to go. It is party time for them and their prime customers, big borrowers who wanted their loans to be recast. Crony or not capitalism is back in business with the exit of Rajan.

What changes one can expect in the policies after he is replaced with someone who will be obedient to Finance ministry and caring to big capitalists.  Here is a list of changes I expect to happen.

• Forex reserves to come down by $20 -30 B. This is to help pay those bonds maturing and not to put pressure on Rupee and banking system.
• Policy rates to come down 50 bps to 100 bps.
• Cash Reserve Ratio (CRR) to be cut up to 100 bps. This would quickly happen if the new Governor comes from banking background. They (Banks) think 4% CRR results in lots of idle money and affect their profitability.
• Regulations on NPA to loosen considerably. Infra and Power sectors to come out of the list of troubled sectors.

Immediate beneficiary of these changes will be:

• PSU banks as their profitability improves and theor management gets a considerably free hand in doing their business.
• Infra, power, real estate etc. sectors which had huge debts but had trouble in recasting their loans. Pressure on them would reduce to a larger extent. Some of them may get fresh loans too.
• Consumers in the short term as interest rates come down.

But the consequences of those policy changes would result in the following:

• Inflation catches up along with the liquidity increase so the trend in interest rate reduction will have to stop and reverse at some time.
• Undoing some of good things – banks will carry forward the bad loans and if they drop their due diligence, bad loans may rise further.

We like it or not, we have lost Rajan who was giving bitter pills which would improve the health of economy. After him, some of the changes would look like a relief or a good thing for economy in the short term. So those opposing Rajan will get ample opportunities to prove themseleves right. But history is going to be kind towards the efforts of Rajan.

Driverless cars, people-less factories and automated call centers

Man has evolved from generation to generation, from stone-age to modern age. He used different materials and developed new tools with every passing generation to ease his work. But the present evolution is aiming at replacing the man himself with machines. For example, take driverless cars which are already at advanced stages of testing phase. They have cameras to do the functions of eyes, sensors to replace the nervous system and a processor makes decisions and the car moves on without a driver.

Robots have been in use for many decades but the modern day robots are self-learning. They can be taught to do repetitive tasks which they will do tirelessly with same precision and produce quality output without exchanging stares with their production shop manager. Employers surely love these robots as they do not ask pay rise every year or won’t go on strike, so more and more robots are replacing the jobs previously done by humans. Many large scale factories are automated where robots do material handling, machining, welding, riveting, painting and packaging etc. tasks. These factories employ very lean human staff and getting close to be labeled people-less factories. These factories will rollout cars which won’t need drivers!

The recent advances in Natural Language Processing (NLP) and Artificial Intelligence (AI) has led to development of bots which can talk to (or chat with) customers, receive their complaints, provide information which were typically done by a customer care or call center employee. Not much time left for those in BPO industries before they are replaced with bots. The algorithms used in these bots understand the human language, the way we converse naturally along with our slangs. In the coming years you can employ a bot as your personal assistant, to schedule your calendar, to answer your calls and to plan your travel.

The corporate world will surely love these bots and robots as they improve business efficiency and improve profits. Will that lead to economic growth with fewer jobs? Probably so. And that is a bad news for half the world’s population which goes hungry and do not have a job to do. But the developed world would not care and the march of automaton would not stop. In the near future, most of those in developed world need not do physical work and they are reduced to just feel as all physical tasks are outsourced to a bot or robot. And the jobless will see that their chances of getting a job are further reducing.

Welcome to the new world of automation. You may think it is still far away in time before you face a bot/robot or interact with it. But in less than 10 years, they would have made inroads into your lives like how a cell phone made it into your pocket.

Not just Oil and Monsoon, Rajan and Modi too have done their bit too

We say thanks to low oil and not a bad monsoon for keeping inflation low. Many think that because of this situation Rajan and Modi are getting the credit. But I think they too have done their bit.

Absence of large scale corruption: First with Modi, lower price helped his Govt to get away with fuel subsidy and run the show with a lower fiscal deficit. True but there are other things to consider. Remember the days of UPA-2. None of the big scams like 2G or Coalgate which happened those days are not happening or at least so far. Larger scale corruption is not seen or seems to be cooking. That avoids the flow of balck money into the markets, especially the real estate. So real estate prices are in a check along with inflation. Avoiding the temptation to offer welfare policies helped to curb the fiscal deficit and thereby inflation. Many of his moves like ‘Make in India’ have remained a talk but even if a little progress is made in that direction, it would reduce import load for a large domestic consuming nation of ours. Even if he does not achieve much, he is surely not draining the national resources.

Fight against crony capitalism: Rajan (Governor of RBI) has put great effort in rebooting the banking system. Earlier Public sector banks mostly helped big businessmen; they gave big ticket loans and were never tough in recollecting their dues. But now they are forced to take tough decisions. It is surely a fight against crony capitalism. Apart from that he made the decisions and regulations transparent, linked the interest rates to CPI. His communications are consistent, policy stands have become predictable. More people know about the roles and responsibilities of a central bank now than before. Even if he leaves soon, he has already put a system in place which would help decisions of RBI in his absence.

So considering these factors apart from lower oil prices and a good monsoon forecast, are surely helping inflation to remain on the borders of 5%. Modi has three more years for him but Rajan’s continuity is in in doubt. If he too gets another three years stint, expect inflation too to remain in check and interest rates low. India’s economy would be in safe hands and may do consistently well too like the people at command.

I sincerely hope this good sport dos not get spoiled any time soon.

Technology readiness vs Market acceptance

Technology changes the way we live and the way we do things. It is the need or curiosity which results in innovation, new products and technologies but they may not always be readily accepted by the end market. There are few winners for which market was waiting so in no time they get into mainstream and many others have to wait for their time while the rest will be left out and forgotten. Economics of adopting new technology should make sense for the new innovation to live on.

Few success stories:

For example, agriculture was dominated by cattle farming few decades ago but now the use of Tractors and the related farm equipment has reached the most interior rural regions. There was a need for higher farm output with finite labor force available so the tractors have become a necessity.

Similarly, in the construction sector, labors carrying loads on their head is being reduced and replaced with the use of equipment. Thanks to these earth movers, they do what is impossible for human hands. Advances in the construction technology are being adopted seamlessly as the market was waiting for it

.

Few struggling technologies:

PV Solar seemed to be a godsend technology to meet the energy deficits. Though technology is maturing and there are many product offerings available, it is not replacing the existing sources of energy generation. Reason is the costs are high. Take out the Govt. subsidies, PV solar does not look attractive and for few projects it is not economically feasible. So despite attracting lots of attention, it is not getting into mainstream. In other words market is not ready for it. It has to wait for its time to come.

New technologies testing water soon:

After the computerization and internet revolutions, the IT industry is getting ready for the new wave of technologies such as Internet of Things, Artificial Intelligence helping to produce robots which are capable of doing most of mechanical things that humans do. There are driver-less cars, drones to transport goods or deliver pizza and lots of efforts are done in improving the battery technology to store significant energy for longer periods. Take a look at this video in which a Robot regains its position after being kicked and continues do its job. It is a cool thing to watch.

So will be driver less cars, technology will soon make it happen. But the question is whether market is ready for it? The success of these products depends on at what price they would become available, how many could afford it and what problems they solve to score over existing arrangements? There is a huge income-wealth gap across the world and within the countries too. In many Asian countries, hiring a driver would be cheaper to owning a driver less car. Similarly the smart robots may not be economically feasible to replace human labors for many years to come.

Though technology makes it possible, costs can become a barrier and these innovations may have to wait for longer periods to become viable and get adopted by the larger market. Until then, they might remain as fashion toys for the ultra-rich.

Drag of the Dragon

Do you know why iPhone sales did top out last quarter? Apple said look at China. Do you know why Jaguar and Land Rower sales have dropped affecting our Tata Motors, the owners of the brand? Look at China. Why copper and iron ore prices are low and who has stopped buying? China. Who would be responsible for steel dumping in India? Why global trade is shrinking? Where are the big bad loans in the world? This can go on.

China was a driver of global economic growth and now has become a drag. Its currency is off the hook. Capital flows are reversing. Their forex reserve has come down by almost a trillion USD. Growth is steadily dropping. Dragon is wounded and bleeding. Probably this should have happened a couple of years ago. But China’s central bank and the Govt. decided against it. They tweaked many policies for a soft landing. But it appears like they were not entirely successful as their economy seems to be touching the ground hard and crushing many before they can steer it from export driven economy into a consumption based economy.

If other regions of the globe were doing well, China would have turned this around smoothly. But US Fed wants to restore normalcy after providing easy money for years that has triggered the reversal of capital flow from emerging countries. Thanks to China’s huge forex reserves. It sold off around a quarter of it to pay for these reverse flows. But the investment void cannot be filled easily. China’s debt is already high. To keep its economic growth, it built roads to ghost towns. And money is not returning from those projects. They have potential to end up as bad loans which will make the economy suffer for long times to come.

In a highly connected world, China can impact the global trade hugely. It can hurt the sales of US phone maker which in turn can take the chip makers in Taiwan and South Korea down who will further impact the entire supply chain under them. When China was booming, it created mining barons all over the world. Bellary, a town in Karnataka came to prominence with the price it received for its iron ore from China and became home to many political king makers but soon lost its shine when the iron ore prices dropped with reducing demand in China. Be it technology or metal commodities, China was an important end market. As its appetite is lost, it is hurting global trade. India’s growth or US becoming a steady economy is not helping to offset the lost sales in China. So along with China, everyone else is revising down their growth numbers.

In 2015, oil producing countries were biggest losers with a sharp drop in crude oil price. But it benefited other economies by bringing the inflation down. When China loses, no one gains significantly. Probably some jobs will move back to US and China’s neighbors would tear away some of the growth towards them. But that does not take global GDP up. Global markets had a bad start in 2016 and the trend is likely to continue for some more time in this year.

If you think otherwise that there is no problem with the world economy, which country do you think will drive growth and why?

Lost half-decade for the world markets

Japan’s lost decade is a well known thing of the past and studied by many. But now it is time for the entire globe to witness the same. 2010-2015 seems to be lost five years for the financial markets. Be it Dow Jones or DAX, they are already at two at years low and breaking the long term supports which may open the gates to another 20-30% fall in this year that will take them to where they were in 2010. 

Copper is going back to 2008 levels and Crude is already below that. For crude it is already a lost decade. For others it is not yet, but if the slowdown continues for couple more years, 2009 to 2019 has the potential to become a lost decade for world’s equity and commodity markets.

Reforms of Modi or Obama, policies of Bernanke or Rajan would have helped their respective economies from getting worse but they do not seem to offer any resistance to the market forces which are at play now.

If you are an equity or mutual fund investor, your investments would be showing negative returns. Accept the reality, you knew stock market investments were risky. And playing for a V-shaped recovery may not be wise. Probably it is time to sit on the sidelines for indicators to turn around.

King of bad loans and the ending domination of PSU Banks

If you follow the stock markets, you know that Bank Nifty (an index of 12 Bank stocks) is at two years low. It has lost 25% from its top. Markets do not go in one direction always. What is happening in global markets is affecting India too. But it does not mean there are no issues in Indian Banking system. It is plagued by bad loans. Thanks to the king of good times, he is the king of bad loans too. He is not alone; he is followed by many who are not as flamboyant but yet owe big money to banks. Steel, Power and Infrastructure companies have a bigger share in causing depression in the banking system. But again the bad loans are nothing new. They are bothering the banking system for couple of years. Banks were writing off these loans in small proportions taking hit in their profits. But Modi getting elected in 2014 with a big agenda of reforms had brought fresh wave of hope, so Bank Nifty too had seen a new high. But all that seems to be deflated now as we are getting back to reality on the ground. When the credit growth has taken a hit, bad loans still remain bad, how do you write-off bad loans without capital erosion? Forget profit making, capital is being lost, no wonder Bank Nifty is gong back to where it was two years ago.

If you look into the details, it is Public sector banks having higher bad loans, so when some of the capital is written-off, Govt. will have to inject capital (from tax payer’s money) for these banks to continue their normal business. But anyway their domination is lost to the booze. When they come out of hangover they see that they are left far behind in the race.

The irony is, irrespective of you consume alcohol or not, your money was paid for the mistakes of liquor baron and his alike. This is India, a land of contradictions. This is where Gandhi and Swami Vivekananda were born and so many bad souls too.

US interest rate up by 0.25% but equity markets are down by 20-30%

This would look weird. After US Fed raised interest rates by 0.25%, all emerging market currencies (including Rupee) started their downfall and equity markets all over the world are falling sharply, they lost 20-30% after the Fed’s announcement has come in. How can this small change in capital costs have such a big impact on the stock markets?

Reducing money supply in the system

My hypothesis is, it is the liquidity contraction in US which is causing the damage and not the interest rates directly. Here is my attempt to explain. First we need to understand that, all central banks decide the rates first and to ensure market follow that rate, they adjust the money supply or the liquidity in the system. Increase in the money supply will make rates drop. Reducing money supply will cause rates to rise. So when US Fed increased its rates, it had to cut its money supply in order to ensure interest rates catch up with decided rate. Let us look at the data.

US M0 Money supply. Source: Tradingeconomics.com

Data shows that M0 money supply in US dropped by $24B in the last month. That much money disappeared from the system. When we get next month’s data, we will see that trend is continuing. This reverse money flow triggered a serious sell-off in the equity markets and damaged many currencies as the money had to be converted into US Dollar before it got back to US central banks and finally disappeared from the system. Even a sell-off of $5B can pressurize the equity markets as there won’t be buyers for such a big sum sitting on the sidelines, so that leads to price erosion very quickly. As selling intensified (remember this money will not come back into the system), equity and currencies saw a bigger damage.

How it all started?

If you see the chart, Fed’s balance sheet started expanding after 2008 financial crisis. Their decision to print new money (through QE) to save their economy led to increase in balance sheet, from less than a $1 trillion to $4 trillions in a five years period or so. At the end of 2014, they decided to stop QE’s, so balance sheet expansion had also stopped from then. And in the end of 2015, they decided to raise the rates. This reversal led to contraction in money supply now in the beginning of 2016. Whatever went up with easy money, is seeing a reversal too but the correction is very quick.

How long it can go on?

If Fed raises rates again, we will see further contraction in money supply in the US and it adds to pressure in global equity markets and currencies. If they delay their plan, markets would see a breather. If they announce a fresh QE, markets will see a new high. Most likely scenario is, they will raise the rates in a slow manner. That would mean markets may not come back quickly and remain depressed for some more time or throughout this year. Whatever air was there in the markets, probably it is gone by now.

Is there a new recession around the corner?

No. Since US economy was doing good and employment levels were high, US Fed decided to raise the rates. But the adjustment in money supply resulted in revaluation of asset classes. Dollar gained at the expense of other currencies and a rout in commodities. This correction may not be indicating any problems with the economy but those who depended on easy money would do badly.

What will happen to Rupee?

Rupee, commodities and real estate will see headwinds until the turbulence in internal market calms down which is likely to last for the entire year. Comparatively India is doing good but that would offer no big relief to Rupee. Though Rupee may not see huge damage from here, it may not go back to 60 (for a dollar) levels any time soon. 65-70 will be the new norm. The financial markets made a bad start in 2016 and the data suggests that there would not be any strong reversals and 2016 is most likely to remain a depressed year for market participants.

How Gold bonds would win over physical Gold?

Last few years Gold as an asset or investment has not done well, it had negative returns. Though demand and supply decide the price equilibrium for most commodities, Gold’s value depend on multiple factors. It is an alternative currency, so it has inverse relationship with US Dollar. When dollar does not do well, Gold will do better and vice versa. In the last few months, Dollar is gaining so Gold is not. US Fed is set to raise rates and most of the developed world is facing deflation (not inflation) are the other reasons for poor performance of Gold.

Looking at India as consumer base, we import around 1,000 tonnes of Gold every year. That is approx. $40 B of import bill a year. Majority (60%) of that goes to making of jewelry. Around 30% is in the form of bars and coins which is the target market for Gold bonds. Govt. aims to reduce the physical gold bought for investment purposes with proposed bonds and save precious forex. If Govt. and RBI succeed with this plan, India would save around $10-12 billions of imports a year which would reduce our trade deficit by 10-15% a year.

This has some hidden benefits that intrigue me. India is one of the biggest gold buyers in the international market. And if we reduce it by 30% (or 300 tonnes bars and coins), it would impact the demand situation of gold (global demand is around 4,000 tonnes/year) and it may result in softness in price. Other benefit is, reduced import bill will help Rupee. This would mean, Gold price in Rupee terms have higher chances of remaining where they are or soften rather than see an appreciation.

This would mean last few years bad performance in Gold would continue for some more time. And the Gold Bonds offering a consistent and positive return would become an advantage over owning physical gold. I have a wishful thinking that consumers will surely notice this and if they curb some jewelry demand too (and start giving a mix of gold bonds and jewelry as wedding gifts), it would reduce gold imports further.

India has around 20,000 tonnes of Gold with its citizens. As Gold’s bad performance is about to continue and due to that, if some of this reserve gold comes into trading market for monetization, the need to import Gold further reduces for India. Though this trend may take long time to catch up, it is not completely improbable and when the time comes, momentum will be difficult to stop.

The summary is, gold bonds will keep the gold prices in check and reduce the pressure on Rupee. When and how this gold bond scheme will be implemented is something we need to wait and watch.

RBI loosens the grip on low cost housing loans

There were minor modifications announced by RBI in the risk weights for housing loans. (Link: https://www.rbi.org.in/Scripts/NotificationUser.aspx?Id=10063&Mode=0)

I am providing a snapshot herewith.

Source: RBI

The first change was increasing the slab to 30 lakhs from 20 lakhs. The second change is risk weight is reduced to 35% from 50% for lower LTV ratio categories.

Few primers before we begin. LTV is loan to value ratio, for a house costing or valued at 30 lakhs, one would get a loan of 80% that is 24 lakhs at 80% LTV. For this 24 lakh loan, if risk weight assigned is 50%, then 12 lakh amount of loan is at risk which needs to be covered with a Capital Adequacy Ratio (CAR) set at 9%. That comes to Rs.1.08 lakh which banks needs to set aside as reserve for each Rs. 24 lakh loan.

Now let us rerun the math for the change in policy. Since risk weight is reduced to 35% from 50% for two categories, for the same Rs. 24 lakh loan, amount at risk reduces to 8.4 lakhs (from 12 lakhs) and the reserve required comes down to Rs. 75,600  (from 1.08 lakh). This differential money banks can use to lend that will increase their profits in the range of 10 bps to 30 bps (0.1% to 0.3%). Banks can choose to pass on this benefit partially or fully to the consumer too.

Changing the slab from 20 lakhs to 30 lakhs was necessary as land and construction costs have gone up. Personally I do not think houses at this price range carry the risk of 35% price drop in adverse situations. But banks and RBI need to be conservative. Probably measures like this have protected India from situation like subprime crisis when housing prices dropped significantly in US during 2008-09. Though it seems still high, reducing risk weight from 50% to 35% to low cost segment is definitely a welcome move.

Now with this change, consumers buying a house valued up to 37.5 lakhs (then the maximum loan will be 30 lakhs at 80% LTV) can benefit and banks would chase this segment as target base. Housing loans are a lion share in most banks loan portfolio and this change will improve liquidity and improve profitability too. If consumers borrowing less than Rs. 30 lakhs get a small rate differential, it would save them a few hundred rupees a month in the interest outgo. But not being denied the loan (even when eligible due to liquidity reasons) is the real benefit. Don’t be surprised if you begin to get calls from bank marketing channels offering you a housing loan at competitive rate. That is expected in the coming months. Distressed realtors too would roll out a red carpet when you go for a site visit.

Though RBI is aiming to make it easier for borrowers of low cost housing, we can observe that it has reduced risk weightage for loans above 30 lakhs too to 35% if LTV is at 75%. This would mean those making a 25% down payment on the houses costing in the range of Rs. 30 to 75 lakhs would also find it convenient to get loans. When credit growth at multiple years low, bond yields reducing, and improving liquidity situation, banks would not turn down the qualified customer. Instead they would outbid each other.

If we have affordability and need but don’t own a house yet, it is time to go out and build (or buy) our own houses. Lower rates, pampering by banks are cyclical. Consumer’s party has begun now and it is likely to stay for couple more years. Take benefit as long as it lasts and pay-off as much debt as possible too. When rates come back, it would not pain you as your loan principal would have been reduced. If you already own a house and have a loan, visit your bank to ensure you are getting revised lower rates. If not burdened, do not reduce your EMI, choose for reducing the loan period. In a 20 year loan period, one can see 3-4 cycles of rates going up and down. Keeping the EMI constant when rates are low helps to offset the burden when rates are high.

If you think all of this does not matter much, you will end up working for the bank more than for your home.


[I am not from banking background. I wrote this post to understand the policy changes better]

Rupee will have more takers with policy changes

Apart from 50 bps rate cut, RBI made few more changes to monetary policy. All of that will lead to multiple benefits such as improvement in liquidity situation, lower interest rates for both Govt. and retail segments, lower SLR for banks and increase in the demand for Rupee in international financial markets. Let us look at them in detail.

Foreign money in Govt. bonds

Foreign institutional players (FPI) have already exhausted their limits in holding the Govt. bonds indicating there was unmet demand. As RBI increased those limits (Link: http://www.dnaindia.com/money/report-allowing-higher-fpi-in-g-sec-cross-currency-trade-positive-steps-2130183), more foreign money will flow into Govt. securities in the coming months. Deposit rates are close to zero in many developed economies so it is natural for the fixed investment funds there to find way into India. But it was only restricted by the policy set by our central bank, which it revised now and has also committed to review or increase this limit every six months in the future. As the demand for Govt. securities increase, bond yields reduce so capital cost for Govt. will decrease marginally. Any savings will help. It also leads to reducing SLR (Statutory Liquidity Ratio) which is mandatory investment imposed on local banks, currently set at 21.5%, which will come down gradually. At least by 25 bps or so every six months in the near future. This will release huge amount of funds into banking system which it can lend freely to retail segment at slightly higher rates. That helps banks to improve profitability. As this freed up capital chases the same consumer base in India, competition among banks will intensify and the interest rates reduce. Banks profits will not come down as the lending rates to retail will still be higher even after reducing the rates (at 8% to 9%) than Govt. bond yields (less than 8%).

Rupee bonds in foreign currency

IFC toyed with this idea last year and it was fully subscribed. Encouraged by the enthusiasm, RBI is allowing more corporate to issue Rupee denominated bonds in foreign markets. Indian companies can borrow and settle in Rupee terms. They do not have to worry about forex fluctuations as that risk or reward wil be transferred to hedging companies. The companies which borrowed in Dollar terms in the past when Rupee was trading at 50 a dollar are in trouble in paying back their debt as they need 65 Rupees to get a Dollar now. With Rupee denominated bonds, Indian companies will not suffer the same risk as settlement is in Rupee terms. Idle money in the foreign markets will get into these bonds and hedging Rupee against other currencies will become a big business too. It helps coprporate to get funds at lower rate which is a feature of the developed market. The benefit for Indian consumer is, rush to borrow from banking system in India from the corporate will reduce. That helps interest rates to reduce.

How rates reduce?

Money in the banking system has three kinds of borrowers - Govt., corporate and the retail consumers. As the borrowing demand from Govt. and Corporate reduces due to policy changes in bond market, banks will be left with surplus funds (higher liquidity) and dependency on retail segment will increase. As all the banks compete for the same customer segment, they will drive down the rates to attract or retain their market share.

Rupee to become more stable

Interest rate coming down further next year is good news for us, the consumers. There is also another benefit. Foreign money coming into Govt. bonds will increase the demand for Rupee. Similarly Rupee denominated bonds too will see the conversion of foreign currency into Rupee. This broadens the holding base for Rupee in foreign markets. It will have many takers in the developed world, in which there is no demand to mention now. While I do not expect this to make Rupee gain against Dollar significantly, at least the downside will be protected. And volatility reduces as Rupee will have many takers in the international capital market. Is this a way for Rupee to get into Top 10 currencies of this world? Probably so, but Rupee has to become fully convertible which will take few years to reach there.

Summary

Essence of this story is, there will be more foreign debt, lower rates and a stronger currency in the times to come. These are clear signs of an economy transforming into a more global, mature economy. We may not beat the toppers anytime soon. But on PPP (Purchasing Power Parity) terms, we would have reduced the gap by a wide margin in the coming decade. Hopefully this translates India into a better society too.

Inflation is low so rate cut was due

Rajan stormed the media again today. When the most surveys expected a 25 bps cut, he unleashed the market spirits with a 50 bps cut. They say it is a pleasant surprise and term it as ‘Diwali Gift’. My opinion is different.

I have been writing on this blog that rate cut was due. Negative WPI and persistently coming down CPI were calling for rate cuts for few months in a row. But the cautious stance held by RBI was preventing the rate cut. Today Rajan let it a go. But still RBI says Inflation can come back to 5%. They are inflation hawks; controlling inflation is their first job. But what one has to note that is, it is not because RBI is cautious inflation is down. To get your facts right, please look around and take note. Inflation is down everywhere. Forget inflation, many developed countries are fighting deflation. Paul Krugman wrote a column on why inflation is good for his country. Many emerging countries and our Asian neighbors all have a lower inflation. Our rival China’s inflation is lower than 2%. When this is the situation and the trend, why India would behave entirely different? Global economic growth is down, so is inflation and interest rate. A normal course which India also catching up. So a 50 bps cut is not any gift and it was rather a delay in the roll out.

Now that RBI is again cautious in saying that inflation (CPI) can come back to 5%, they are most likely to be surprised with what the future holds. India is not overspending like Greece or over investing like China. We have our own issues but inflation situation is likely to ease further than flare up. This rate cut will help in improving the profitability at banks and much of their NPA which were on the edge are set to come back in green when the benefit is passed on to ailing debt laden corporate. Reducing capital costs will ease the pricing pressure across the board. Some of the inventory in housing can reduce with reduction in the EMI as fence sitters finally make their decision. When new houses are occupied, it will stall the rents from soaring which is a big component in CPI. E-commerce companies are giving away so many offers, all your household stuff can be bought at discount, forget the inflated prices. If you drive your own vehicle, you fuel bills are slightly lower than last year so they are not contributing to inflation. Food is a tricky part but monsoon was not bad. Onion prices calmed down as the hype did not last long. Supply situation has improved a lot in agriculture commodities. There is lot of physical infrastructure which has come up in the recent past and has to find utilization. So Schools and Hospitals can’t ask for moon like before as they are likely to lose their customers to their competitors as there are many new entrants. Food will be the only biggest component in CPI pack driving inflation up. Transportation is seeing a deflationary trend. All other components are staying where they are, neither inflation nor deflation. All in all, inflation is likely to remain at 4% and may go down below 4% too.

As inflation surprises the central bank of India, it will reduce the rates further. I will not be surprised if SBI offers a home loan at around 8% next year. It is not because of Rajan or Modi. I am not against them, but you cannot ignore the fact that luck is favoring them.

Interest rates are closer to zero in US. Though they are set to rise, it will go up very slowly. When savers there get nothing, why the borrowers in India will have to pay interest rates (bank rates) of above 10%? Will it not be fair to expect to have a real rate of 1%, (inflation at 4% and RBI rate at 5%) so that an efficient bank would lend it to retailers at 6% to 7% for long term borrowers like in the housing sector or to clean corporate? That will drive investments and infrastructure growth and turns India into an economic power house. There are so many households aspiring for a solid roof over their head. Why interest outgo has to be more than the principal in their loan period of 20 years? Many infra projects will become viable at lower capital costs.

I suppose though there is a delay, India’s destiny towards economic prosperity is not denied and today’s rate cut was a witness that we have not lost the way.