2011: Important Emerging Global Trends

The last day of 2010 is a good time for us to reflect on the year completed.It is important to note that in the New Year, especially in the first thee months of the New Year, we are likely to see a changed trend in at least three areas. These include: (1) a renewed concern about in the solvency of the indebted nations of Europe, (2) rising commodity prices, especially food and oil, and (3) clear signs of overheating in the Emerging markets. None of these indications are positive for the long-term economic growth of the world economy. It is almost certain that all the above three trends are likely to become more pronounced in the next six months. However, the challenges posed by sovereign debt issues in Europe and the overheating in the Emerging markets are well-known. The more immediate challenge may be posed by the rising commodity prices, especially Food and Oil. The rise in food and oil prices is akin to a direct tax on an already stressed consumer. If the oil prices were to rise above US$100 then it would be a disaster for various countries especially for India and to an extent China.

The bond markets of Europe already seem to be getting queasy about the state of the European economies, if the events of the past week are any indication. The bond spreads of Greece and Ireland are at their peaks and have crossed the panic levels seen in mid 2010. Greece just hit a new high on Friday. Greece is now borrowing money from the bond markets at nearly 12.50 percent – more than the US Junk bonds, indicating that Greece is more or less insolvent and is able to stay afloat only because of ECB. It is difficult to believe that Greece and Ireland can continue like without further bailouts beyond the end of the second or third quarters of the New Year - if they don’t go broke before that. Spanish and Italian bonds too touched a new low and the yields were at all time high, though not yet at levels where we need to panic. However, ominously it is pertinent to note that the last auction by Italy for the calendar year could not raise the planned amount in their bond auction. It also had to pay 1.7 percent to sell Euros 8.5 billion six month bills, an increase from 1.48 percent a month ago. As long as there are only doubts about the solvency of Spain and Europe, there is unlikely to be greater panic than we had in 2010. It is pertinent to note that Spain and Italy may be the centre of unwelcome attention, especially from the second quarter of 2011 – once Ireland and Portugal receive their bailout. The two larger Mediterranean countries are too-big-to-bailed-out and their problems are becoming more pronounced. It has been pointed out that public debt in Italy will rise to 120 percent of GDP, to over Euros 1.9 trillion by end of 2011.

As the Eurozone stumbles from Crisis to Crisis, the volatility in the Euro is likely to rise rather than decrease. The only short-term factor that could rescue the Euro may be the high level of trader short-positions, which will provide only short-term solace. The European Central Bank will have to vastly expand the money supply if they are to stave off an existential crisis in 2011. There three possible problems that are likely to maintain or even accentuate the pressure on the Euro in 2011. First, ECB will have to pump in large quantities of money in their localised version of Quantitative Easing thereby pressurising the Euro to the downside. The failure to pump in large amounts of money would create an immediate crisis. So the option that the ECB seems to have is either to postpone the crisis by pumping in money or simply loosen all accounting rules and regulations so that the banks and other stressed players don’t have to report their problems to the public, thereby prolonging the semblance of normality. Second, one of the highly indebted members is likely to walk out of the Euro forcing the remaining members to restructure the nature of Euro, thereby spreading panic. Third (more of a black swan) is the Constitutional court in Germany ruling that the bailout is illegal creating panic. Though some quarters believe that Germany may walk out of the Euro, I believe that it is in the medium term interest of Germany to have a weak Euro as it gives a welcome boost to its exports. In fact the conspiracy theorist in me would like to believe that Germany has no intention of allowing the crisis to come to a quick conclusion as it would mean that attention would be focused on the USA.

This is not to claim that the Euro will disappear in 2011. On the contrary it is likely to remain due to the simple reason that there are not too many alternatives to the US Dollar, Euro and the Yen - though all those economies are in a bad shape. There is one possibility of the Euro escaping the unwelcome attention  unscathed in the our three scenarios I have pointed out. That will come to fruition, if interest rates in the US were to rise due to growing attention on its fiscal deficit then the Euro will not face such difficulties in 2011 for the simple reason that rising interest rates would be Déjà Vu all over again for the USA. It would destroy the house owners and the commercial property market as well as the banks in one swift blow.
The UK is in a much better position than feared at the start of 2010: Companies raised £10.1bn via initial public offerings on the London Stock Exchange this year, more than six times 2009's £1.5bn – but still nowhere near the record of almost £30bn in 2006. However, it is pertinent to note that the downsizing and fiscal austerity measures that the UK’s government has proposed are yet to bite. Once that start, it remains to be seen how the economy and with that the markets function.

Agricultural Commodities have shot up exponentially during the last quarter of 2010. One does not know if it is due to excess liquidity that originated with quantitative easing or due to fears (real or perceived) of shortages expected in 2011. Each week of the last month of 2010 proved renewed fodder to the fears. First it was Cocoa prices due to political problems in Côte d'Ivoire, then floods in Australia destroying food crops and flooding coal mines and then a drought in Argentina that was expected to reduce Soybean crop by about 21 percent. Imagine what will happen to price of a commodity that is consumed most by the Chinese and add production shortages (as in Soybeans) and I am sure we get the proper picture. Oil price is probably the most important “unknown unknowns” in the world economy for 2011. It has hovered dangerously above comfort levels for most of 2010. OPEC meeting over 1-2 of January should provide a clue about production quotas, which are important though not critical, because invariably OPEC members always produce as much as possible and always above their allotted quotas. This is unlikely to change as the largest producers desperately need this Oil money to bridge their budget deficit. Interestingly, the Net Crude long positions (managed money as per CFTC data) are their highest level since September 2007, though the open interest for the West Texas Intermediate Crude price is not at such dangerous levels. Though on a contrarian basis the high net long positions may indicate a sharp correction in the price of crude, it will remain an important piece of the global macro-economic jigsaw puzzle. Ideally the crude at US$70-75 would provide great succour to a stressed customer, more so as historically, a sharp rise in oil prices has always been followed by a recession.

Among the agricultural commodities cotton rose nearly 80 percent, while wheat and corn prices rose nearly fifty percent, soybeans rose by 35 percent and sugar by nearly 30 percent. The rise in prices of agricultural commodities is due to a combination of factors including demographic changes, declining production, and rising demand. Global Corn inventories are expected to reach 130 million metric tonnes by the end of the current season – a four year low. Corn is especially susceptible to rising demand for livestock and poultry feed as well as Ethanol demand in USA. In the case of Wheat, production shortfall is estimated at least 20 million tonnes. This is likely to rise due to crop losses in India and Australia. Cereal prices are likely to be next to rise due to demand and supply factors. FAO has estimated that the output of cereals is likely to drop 1.4 percent (to 2.23 billion metric tonnes) while demand will rise by 1.8 percent (to 2.26 billion metric tonnes) this season. It is increasingly becoming clear that the only way a rise in food prices may be averted only if there is another meltdown as in 2008. While the world doesnot face a food crisis, as yet, the rising food prices will devastate the balance sheet of individuals, especially in the developing world, where nearly one-third of their disposable income is spent on buying basic food stuffs.

The prices of almost all the commodities touched a new yearly high (if not multi-decade high) during the course of the week. Thomson Reuters/Jefferies CRB index jumped nearly fifteen percent in 2010 and for the first time since 2006, investment in commodities provided better returns than stocks and bonds. Interestingly, commodities, stocks, bonds and the dollar rose for the first time since 2005. Gold closed near its life time peak, Silver traded at its 30-year peak, palladium reached its nine-year high while Copper reached its pre-crisis peak and has risen 35 percent this year. Palladium has nearly doubled in price this year, while silver is jumped by nearly 80 percent and gold by about 30 percent. Gold notched up its tenth consecutive annual gain. Iron Ore rose nearly 80 percent in the year.

An important trend that has emerged in 2010, is the rise of financial investors who control huge quantities of the physical commodities. Most often single trader controls a huge chunk of the physical inventory. This now extends to most of the metal markets, especially those traded on the commodity markets. In the copper market, one single trader (stated to be J.P.Morgan) is reported to hold about 80-90 percent of the total LME inventory. Another unidentified trader holds about 90 percent of the LME aluminium inventory. Among the other metals where single traders hold more than fifty percent include Tin, Lead, Zinc and Nickel. Another successful trader, Anthony Ward (often referred to as “Chocfinger”) holds nearly 241,000 tonnes of Cocoa beans that would suffice to make nearly five billion Chocolate bars. The rise of Exchange Traded funds means that financial investors are likely to hold most of the bargaining chips in the commodity markets. This is trend is likely to become more accentuated in 2011. Gold Exchange Traded funds have been particularly successful. The holdings in the largest Gold ETF (that trades under GLD Symbol in US markets) held nearly 1280 tonnes in early December 2010. Its holding of gold exceeded all but five countries of the world.

The third trend that is likely to become more pronounced in 2011 is the one related to Emerging markets. Most of the Emerging markets are in the throes of dramatic overheating. China has made its intention clear on Christmas Day when it raised interest rates as it has now realised that its incremental measures of raising the reserve ratio of banks is unworkable. It is clear that the Chinese economy will not slow down sufficiently to increase the comfort level of policymakers before their February annual holidays. This is because companies are likely to continue their present production trends in order to meet the expected jump in demand before the nearly 300 million people disperse for their holidays. China will have to increase interest rates to curb inflationary pressures, indicating that its growth has run into a major predicament that is symbolic of most of the emerging markets, including India and Brazil. Inflationary pressures require a sharp rise in interest rates, but the soft global economic conditions mean that growth would be hurt if there is a sharp jump in interest rates. It is imperative for the emerging markets to grow as they have to continuously absorb the growing number of youth who are joining the labour force annually.

China’s economic growth has increasingly become the anchor around which a number of countries in Asia and Africa have moored their own growth figures. It has been pointed out that China consumes nearly 40 percent of the world’s base metals and a top consumer of corn, cotton and soya beans. If China were to slow down (or if there was a hard landing) then the consequences are likely to reverberate through out the world.

China’s investment-led export model seems to have reached its logical culmination. Unfortunately, inflationary pressures within the country are only of the many problems that China faces. China’s largest trading partner is the Eurozone, which is on the verge of tipping over into the abyss. China has set its growth target for 2011 at eight percent (the same as 2009) while it has raised its inflation target to four percent, against the 2010 target of 3 percent, indicating that the government does not expect inflation to decline to 2010 target level anytime soon. China has marginally reduced the bank lending targets for 2011. Professor Victor Shih observes that banks have lent the equivalent of $1.6 trillion to local state entities, often for projects that are not commercially viable. He estimates that China's public debt will reach 100pc of GDP next year if counted properly. It is probably these problems that the Chinese stock market seems to be discounting. It is down by about 14 percent in 2010, while the property segment is down by more than twenty five percent.

Inflationary pressures abound in India, Brazil and other countries. Taiwan is the latest country to have increased rates (after Brazil, India, China and South Korea) and imposed capital controls (after Brazil). India’s NSE Nifty has returned nearly fifteen percent. These returns may be difficult to match on an annual basis in 2011. Since the markets are priced to perfection, any nasty surprise could have swift repercussions. In the case of India, the Black swans could be political uncertainty and even another drought. Those two events, if they actually emerge as the perfect storm, could spell the end of the India growth story. Almost all the observers in India have confused current economic growth with sustainable economic growth created by a unique growth model. Anecdotal evidence and my inferences from such evidences seem to indicate that a large part of the India's consumption story is dependent on the government spending (especially through National Rural Employment Generation Scheme) and bank loans (useful for continuation of the middle and upper class consumption). This may not be the case. Rising taxes, rising inflation, rising oil prices, while declining margins for most of the business creates perfect conditions that may lead to stagflation, which seems to be as yet in the realm of impossible.

There is one important note on which I would like to conclude. Remember, the markets have a history of doing the exact opposite of what the consensus expects. It is for that reason that I have pointed out that the only certainty of 2011 will be an increase in volatility over 2010.

Financialisation of Commodities

One interesting trend that has emerged in 2010 and is likely to remain dominant in the next few years, if not decades, is the growing trend towards financialisation of commodities and the centrality of financial investors in the commodity markets. I have collected some interesting details about the growing importance of financial investors in various commodities

This financialisation of various assets and commodities is an ongoing process as we have highlighted in a previous post. Most often single trader controls a huge chunk of the physical inventory. This now extends to most of the metal markets, especially those traded on the commodity markets. In the copper market, one single trader (stated to be J.P.Morgan) is reported to hold about 80-90 percent of the total LME inventory. Another unidentified trader holds about 90 percent of the LME aluminum inventory. Among the other metals where single traders hold more than fifty percent include Tin, Lead, Zinc and Nickel. Another successful trader, Anthony Ward (often referred to as “Chocfinger”) holds nearly 241,000 tonnes of Cocoa beans that would suffice to make nearly five billion Chocolate bars. The rise of Exchange Traded funds means that financial investors are likely to hold most of the bargaining chips in the commodity markets. This is trend is likely to become more accentuated in 2011. Gold Exchange Traded funds have been particularly successful. The holdings in the largest Gold ETF (that trades under GLD Symbol in US markets) held nearly 1280 tonnes in early December 2010. Its holding of gold exceeded all but five countries of the world. 

Source of Strength: Banks' Exposure to MFIs

A conference call by the stock market brokerage, Motilal Oswal Financial Services, on 27 December 2010, provided some fascinating views. The 'expert' who participated in the investors' conference call was Alok Prasad, CEO, MFIN, the self regulating organisation of the 37 MFIs. He seems to have indicated (based on the views released by the company in the report), that the microfinance business would be back to normal by the middle of 2011 (the exact phrase that they use is: "New normalcy phase by 1QFY12") and they it is likely that the Central government would pass a law to regulate the MFI sector in the next 4-5 months.

Either the market players are privy to information that the others are not or they have not read the submission of the AP government to the Y.H.Malegam sub-committee, where it has made some forceful arguments as the MFIs are no better than private-moneylenders and hence a constitutional right of a State Government to regulate such activity. The Motilal Oswal Report has provided detailed break of each bank lending to MFIs (which is given in the table below).

Estimates of Total Banks Exposure to MFIs

Name of Bank	Exposure in Rupees Million	Exposure in Rupees Crores	As % of Loan Book
ICICI Bank	24,000	2,400	1.2
Yes Bank	3,000	300	1
IndusInd Bank	3,800	380	1.6
Andhra Bank	3,000	300	0.5
ING	2,500	250	1.2
Bank of Baroda	1,500	150	0.1
Axis Bank	13,000	1,300	1.2
Bank of India	4,000	400	0.2
Punjab National Bank	9,000	900	0.4
State Bank of India	8,000	800	0.1
Syndicate Bank	5,000	500	0.5
Dena Bank	800	80	0.2
Central Bank of India	10,000	1,000	0.9

Source: Motilal Oswal Financial Services Conference Call, Expert Speak, 27 December 2010

The above figures need to be looked in conjunction with  various other estimates cited in the newspapers which point out that 11 percent of the households in AP have borrowed from MFIs, while the aggregate loan outstanding per person in AP is around Rs.22,000 and the total outstanding loans of the MFI industry in the State by the end of November 2010 was Rs.7,257 crores. The Indian Banks Association has requested that the RBI allow one-time rule waiver that would enable the banks to restructure loans to MFIs. This would enable them to avoid classifying loans to MFIs as non-performing assets ("IBA may seek one-time waiver on MFI loan restructuring", The Financial Express, 29 December 2010, p.18). 

While the MFIs seems to exude confidence that the RBI and court's would take a sympathetic view, the banks seems to think otherwise.

2011: Deja Vu or New Highs?

As a student of Economic History, I prefer to look at the "future through the prism of the present" (even in the sphere of personal experiences, nature, economy, markets, etc). A number of friends often respectfully disagree with my outlook. I am often considered, I believe wrongly, to be a perpetual pessimist - which I am not. At different points of time, I am very bullish on certain commodities, products, assets, etc while concurrently being extremely bearish on others. At the current juncture, if I am asked to be bullish on certain assets (on a macro-basis for the next 3-5 years), then it would be Coal, Food and Silver. Oil would be the next. The problem with oil is that it has a different set of dynamics. My optimism on these assets is mostly on the basis of what I perceive to be a structural shift. My bearish list would probably be ten times longer than the bullish list. Top of the pessimistic list for the next three years include China and Europe (which a lot of people would concur). What makes me particular worried is that if one were to look at the newspaper stories at the end of 2007 (without the date) then they could be forgiven to think that they are reading the newspapers over the past month. Optimism pervades through the popular press (usually a contrarian signal that suggests caution). It is almost certain that by the end of the first 3-6 months of 2011, every body would be boldly declaring that Great Recession has been buried in depths of history (which I hope will actually happen, though I am not so sure). 

A more interesting perspective is indicated by looking at the Charts (Technical Analysis). They, very curiously, seem to indicate that the time has come to look at things in two diametrically opposite methods: either the markets are heading for new highs or new lows. Such indications, to if my memory serves me right, have been emitted only once: late 1999. I am therefore reproducing charts of some asset classes and indices. Interestingly, there are some anecdotal factors that seem to indicate that we have some similarities with various past major turning points. The warnings by Cisco (the last two times they warned about earnings was in early 2000 and mid 2007). Shanghai Composite has not been moving (see long-term Kagi Chart given below). 

It is pertinent to note that moves on the Shanghai index has traditionally preceded moves in the other global indices.

The other charts are more interesting (all of them are based on closing values for the week ended 25 December 2010). There are two ways to interpret the Copper chart (below).

The weekly Chart (above) of HG Copper traded on COMEX. It seems to indicate that there is a possibility of a huge up move. It seems to indicate that copper could be headed for its more immediate target of 4.4 (it is now about 4.26) and above that to 5.08 and in the best case scenario 6.60 over the next 1-2 years. However, there are huge negative divergences on the chart. The Relative Strength Index has been witnessing lower tops and when they appear on the weekly charts, there is a high probability that they could head for new lows. 

The chart of India's National Stock Exchange's Nifty Index is similarly placed. 

The weekly Kagi Chart is placed in a manner that a 3-4 percent up-move could trigger a long-term buy signal that has the theoretical potential to take it up to the old high and, if that is broken then it has the potential for a phenomenal rally over the next three years that could take the index to even 10,000 point level. Like HG Copper Chart, the massive negative divergences seems to indicate that there is a high probability of a new low, unless things change dramatically over the next 2-3 months in the global economic fundamentals.

It is imperative to think that these are theoretical probabilities based on my interpretation of the charts, while I hope the upside analysis comes true, at the end of the day, I don't know if they will come true. The markets have a knack of doing things that are the exact opposite of what people think they will. This reminds me of the market adage: Don't follow the crowd they are usually wrong.

I would speculate that new lows and new highs are possible in the next 3-5 years. It is possible we are heading for a sharp down move that would be triggered by events in EU and other countries. In order to combat these troubles, Central banks are bound to loosen the spigots to unprecedented levels, which could lead to an era of hyper speculation. While it is easy to speculate on somebody's speculations, one should probably be more sympathetic to the Central banks, who have to fight the worst crisis in a century with their hands tied to their backs while driving blind.

History has a knack of repeating itself, if not in toto, by rhyming. Hence it pays to keep track of historical developments. The chart below shows the eerie similarities of the market movement in aftermath of the crash of 1929.

Microfinance: Broken Promises & Unchanged Methods

A cursory glance into history of the Microfinance business reveals a string of broken promises accompanied by a string of unchanged business methods. Interestingly, most of the observers seem to have overlooked the nature of the violations and the promises by the Microfinance business in the aftermath of what is commonly referred to as the "Krishna Crisis of 2005-06". As we have pointed  in a number of our previous writings we have noted that the practices adopted by the business are nothing new. The only change has been the national and international attention that the present crisis has drawn. That could be largely a consequence of the fact that the business has grown exponentially since 2005-06. 

A cursory glance of the news stories in the popular press seems to indicate that the business model as well as their methods have not changed since the 'Krishna Crisis'. Neither has the role of the banks in the business, and it seems clear that the banks clearly know that the practices adopted by he MFIs despite claims of innocence. It is now clear that the bankers donot really care - at least as long as their loans are repaid by the MFIs. By September 2006, the MFI's operating in the  business had lent nearly Rs.1600 crores in five districts of Andhra Pradesh after borrowing this money from the banks (for onward lending). The image below from a the largest circulating Telugu Daily, Eenadu, reports that the MFIs had promised to reduce the interest rates to 15% after outcry over the methods adopted by the MFIs and the high interest rates that they charged (which at that time too was 24-35 percent). 

The article claims that the banks had provided a written undertaking to the government promising that they would reduce the interest rate to 15 percent. Interestingly, there were calls by various political parties and civil society groups that the Central Government should intervene and pass laws that would limit the interest rates that an MFI could charge. 

After the Supreme Court made it clear that violent methods were not to be used for collecting bank loans of any kind, one wondered for a time where all the agents of the private and foreign banks had all of a sudden disappeared. It was only in late 2010 that we got the answer. The MFI sector had taken them on board en masse. Or it could be that the same set of hoodlums operated for both the banks and the MFIs before the Supreme Court decision but have now gone full-time for the MFIs. Violent arm twisting is not a new development and it is not restricted to only a few of the MFIs. Press reports at the time clearly show that cases were booked against SKS, Spandana and other MFIs - all of which have been involved in the crisis this time too. The fact that they got off lightly last time gave them confidence that this time would be no different. The article reproduced below  (from Andhra Jyothy 27 September 2006, p.3) shows that MFIs tied up a lady who could not repay the loan and insulted her. Numerous articles pointed out that more than 20 women had committed suicide because they could not repay the loans and due to the pressures by MFIs.

It is clear that the government should consider promises by industry bodies about future good behaviour to be nothing more than a joke. They had promised similar things in the past. Ironically it is the same people - Vijay Mahajan of Basix. The news paper clipping from the Business Standard elaborate the "Model Code" that they claimed would be enforced (see Image Below: Click on the image to enlarge).

Based on our historical experience it is clear that the MFIs will make promises, which they clearly do not intend to keep. Ironic as it may seem, Mohd Yunus was from those days suggesting that we need a clear legal framework around which the MFIs can operates (See Image Below). This seems to have been ignored.

Hopefully, Y.H.Malegam Committee would look at the problems of the Microfinance sector in a historical perspective and would clearly draw a line, which hopefully will not be a line in the sand. They should also avoid thinking in terms of the problem loans that the banks will be left holding if something goes wrong with the MFIs. This will only increase. In 2006, Vijay Mahajan claimed that the banks would lose Rs.1000 crores, now it has reached Rs.30,000 crores. After all the description of a police officer in Vijayawada in 2006 that described the moneylenders as 'modern day shylocks' is after all not far from the ground reality. The only difference is that these are 'corporatised' moneylenders who decide to "unlock value" by listing of shares (and probably rigging their prices) in the stock exchanges.

Microfinance & Private Equity Investments

The AP Government has suggested to the YH Malegam Committee that MFIs be forbidden from accepting investment from Private Equity. The Image below provides the origin of this rush by the PEs to invest in MFI firms. The 100% recovery, which was largely based on peer-pressure to people desperate to borrow was construed as great business model - until the first blow. 

Microfinance: Making Government Regulations Unworkable

 SKS Microfinance Borrows a Leaf From Goldman's Book

 

It is now the turn of the bankers to throw off all pretences of concern about the lending practices of the Microfinance sector. They are reported to have asked RBI to bring the sector under its purview so that their lending to the sector can be rescued ("Banks ask RBI to Control MFIs", The Economic Times, 23 December 2010, p.1.). The bankers fear that if the sector is not under the purview of the central bank, then it is likely that each State will pass its own laws, which would be a disaster for the microfinance sector. One banker is reported to have told the RBI (and the press): "Let the government, banks, MFIs and RBI sit together to decide the course. The Andhra Ordinance is no solution. Even the state government doesnot have the administrative machinery to follow the recovery process laid down by the new law". The RBI on the other hand is reported to have placed the onus on the banks to see to it that the MFIs do not charge more than 24 percent to borrowers.

SKS Microfinance on the other hand has decided to borrow a leaf from Goldman Sach's Strategy book. During the course of the Financial Crisis inquiry commission in the USA, Goldman was criticised for either not responding to requests for information or would send truckloads of information, so that the Commission would be overwhelmed. Goldman is reported to have submitted the equivalent of about 2.5 billion pages after calls for information. Goldman's strategy was quite simple: it would be humanly impossible to go through all that information (and other information) thereby enabling the Commission to come to a conclusion. about its culpability. SKS with its abhorrent practices has followed a Indianised version of the same strategy. It claims that it has submitted nearly 1.3 million loan application requests to the government for approval.

 

It is clear that SKS would like to cause maximum administrative inconvenience in the hope that the government would be completely overwhelmed with an over-kill of information so that the Government of Andhra Pradesh would be forced to dilute their opposition. The fact that they can submit digital records of the information may provide vicarious solace to SKS since their business model and market value have all but collapsed. Any dilution in the AP government's stance, especially its submission to Y.H.Malegam Committee that the interest rates be capped at 8% spread would provide the sector, especially the large 10 companies, which account for nearly 90 percent of the business volumes. Moreover, if they are able to force a climbdown by the AP Government, which has great experience and administrative resources, the subtle calculation of the Microfinance sector is that the smaller states would not even think about introducing such regulations or placing any hurdles in the business model of the MFIs. On the other hand SKS seems to be blissfully unmoved about the nature of changes that may have to face in the near future. It is reported to be running pilot projects that will lend money against collateral like Gold and Houses in Karnataka and Gujarat, ironically, activities run by full-fledged Non-banking Finance Companies.

This comes at a time when the weekly collections in Andhra Pradesh are about Rs.28 crores. It has been hit to the tune of Rs.350-300 crores since the crisis started ("SKS Micro to limit portfolio in each State to 10%", Businessline, 24 December 2010, p.6). Invariably SKS has always been economic with the truth, about the cost of their funds. In 2008, they claimed that their cost of funds was 26%, and their margin 1-2 percent, and in AP they were lending at 24% (See the Image of the Interview of Vikram Akula). This is ironic since only recently they have announced that they reduced interest rates and their cost of funds have remained unchanged despite the IPO and their access to private equity.

These strategies should be a cause for greater concern since it is clear that the MFIs do not seem to be interested in evolving a new business model that would enable them to reinvent itself. It is probably the only business in India where there is no chance for arbitration in case of disputes. MFIs have to realise that any business (even the private moneylenders or even the criminal panchayats run by extortionists) offer this practice. A more important reason why microfinance sector needs to reinvent itself is that the Central Government seems to have made it clear that they would prefer banks to directly take up the task of financial inclusion, especially by growing the Business Correspondents model. State Bank of India wants to have 50,000 consumer points spread over one lakh villages by March 2012. It has hired Financial Information Networks & Operations, for providing technology and selecting Banking Correspondents ("Providing Connectivity to picking BCs, Tech Firms do it all for Banks", Business Standard, Section II, 22 December 2010, p.4). 

 

Financial inclusion is set to become an increasingly fashionable part of government policy with the President of India, calling for expanding the scope of inclusion. Ironically, all of them seem to believe that financially inclusion can be extended if they can improve the credit delivery mechanism so that credit can be pushed to the poor. Very of them seem to be concentrating on creating products that would mitigate and transfer risk from the poor. Little wonder that the MFIs find so much support despite their blatant violations of various laws. Pathetically, the state of financial sector has deteriorated to such an extent that when a government does take up a genuinely beneficial law the criticism seems to be quite vicious. However, when the government bailed indebted industrial groups, it was considered to be 'investor friendly measures' - an euphemism for the transfer of public wealth to private hands.

An important broader trend that has often been missed is that the very fundamental justification as it was given in 1991 for liberalisation seems to have been conveniently forgotten. In 1991, it was claimed that all forms of subsidies are bad and the Government should avoid all forms of subsidies and free markets should be allowed to flourish. But the experiences in the aftermath of the Credit Crisis of 2008 seems to make it clear that the heavy hand of the government is always needed, especially in the realm of the financial sector . The  State seems to be especially necessary to bailout or subsidise the speculators who now decide that it is more profitable to speculate on the speculation of others. Welcome to the era of the creation of State sponsored oligopolies.

Vikram Akula Interview in 2008 (From The Financial Express)

(Click to Enlarge Image)

Over Optimism on Indian Markets?

The interesting aspect of the forecasts of 2011 are exactly as they were around this time, last time around. Other than Nomura, there are very few sober forecasts of the Indian markets for 2011. We tend to be far more cautious than the consensus. There are high indications that the Emerging markets are at an advanced stage of a massive bubble. I am not sure if it will burst in 2011 or 2012 but when it does, it could send the Asian region into a tailspin.

Bullishness about the Indian markets is all pervading. However, the Charts speak another story. The chart below of the Kagi Weekly Nifty Chart (the Benchmark National Stock Exchange index) clearly shows that distribution that is taking place in the Indian stocks is at a historically high level of negative divergences, which have always been associated with long-term trends.

I believe that over the long-term the optimism about the Indian markets may be over-optimistic. This is not to mean that the markets are about to crash. They still have a lot of trading momentum which could take the index to even as high as 6800 - if the bulls are right. But from there it could be quite a cliff downward. Who knows what impact a breakup of the Euro would have on the global markets.

Microfinance: The Worst Kept Secret

The Y.H.Malegam Committee is expected to tour Andhra Pradesh in the next one month, while the Andhra Pradesh Government has passed a bill that formalises the Ordinance that it had promulgated to protect borrowers. Close on the heels Dr.Y.V.Reddy forcefully arguing for strict regulation of the sector, another former Governor of the Reserve Bank of India, Dr.C.Rangarajan, has called for a cap on the margins of the microfinance institutions (after similar demands by the AP Government). He has also called for a complete revamp of the business model of the MFIs. Muhammad Yunus has called for a regulatory agency for the Microfinance sector so as to avoid creating a new set of loan sharks in place of the old loan sharks (moneylenders).The AP government has suggested that the margins should not exceed more than 12-13 over and above their cost of funds - a very reasonable margin considering the fact that the banking sector operates on a Net Interest rate margin of about three percent.

All this comes at a time when it is clear that the MFIs were themselves contemplating a change in their business model - one that would have made them no different from the Non-bank Finance Companies (NBFCs). They were contemplating a shift to monthly repayments ("MFIs shift to monthly repayments", Business Standard, 31 August 2010, p.7). There were a number of MFIs that are already gradually shifting as they have reached a critical mass (volume wise) and their growth can now expand only by making every larger loans to credit worthy customers.

One wonders why we need the MFI sector when we already have a dynamic NBFC sector, as the MFIs are now seem to be keen on evolving a business model that is akin to the NBFC sector. One wonders why there is a need to subsidise the MFIs when they are no different from NBFCs. Level playing field  and transparency of government actions has been one of the important claims and the supposed underlying logic in the aftermath of liberalisation. If the government can subsidise the MFI sector, then it is high time they do the same to NBFCs. After all, what is the difference between the two: both are keen on overcharging borrowers, even if they it is usurious rates, and NBFCs too are very keen to attract private equity and list shares on the stock exchanges. This probably the reason why former governors of RBI seem to believe there is a need for the MFIs to change their business model.

Quotes They would like to Forget

26 April 2010
Greece Finance Minister George Papaconstantinou warned investors they will “lose their shirts” if they bet the cash-strapped nation will default.

10 March 2010
Greek Crisis Is Over, Rest of Region Safe, Prodi Says

10 March 2010
 “I don’t see any other case now in Europe. I don’t think there is any reason to think the euro system will collapse or will suffer greatly because of Greece.” - Former European Commission President Romano Prodi.

March 10th, 2010
 “We’re not asking for a bailout, we’re not asking for financial help from anyone. We are taking measures to put our economy on the right path.” – Greek PM

9 February 2010
 “The worst possible signal which we could send out is one calling for outside help”.
“We will tackle the deficit,”
--Greek FM

30 January 2010
“I don’t think that a bailout is the right way because German and French taxpayers can’t pay for Greece,” -- German Economy Minister Rainer Bruederle ruled out a rescue for Greece

30 January 2010
“Officials don’t even want to consider the option of a default.
French Finance Minister Christine Lagarde, also speaking in an interview at the World Economic Forum’s annual meeting.

29 January 2010
 “Greece will not default. In the euro area, default does not exist,” -- EU Monetary Affairs Commissioner Joaquin Almunia

6 January 2010
“We don’t expect to be bailed out by anybody as, I think, is perfectly clear we’re doing what needs to be done to bring the deficit down and control the public debt.
 “There is no Plan B. Greece will do what it takes on its own devices. There will be no need for any outside help.”
Greek Finance Minister George Papaconstantinou 

Hidden Transcript:
“We have lost a part of our sovereignty because of this loss of credibility We are determined to regain this lost credibility. We will do anything necessary.” – Greek PM

The Cost of Corruption

Scams as % of GDP

Year	Name of Scam	Size of Scam	Scam as % of GDP	Size of GDP (in Rs. Crores)
1991-92	Harshad Mehta Scam	Rs.5,000 crores	0.76	654,729
1994-95	Preferential Allotment	Rs.5,000 crores	0.49	1,015,764
1995-96	Fertiliser Import Scam	Rs.1,300 crores	0.11%	1,191,813
1996-97	Sukh Ram Telecom Scam	Rs.1,500 crores	0.11	1,378,617
2000-01	UTI Scam	Rs.4,800 crores	0.23	2,102,314
2004-05	Scorpene Submarine Scam	Rs.18,978 crores	0.60	3,149,407
2007-08	Pune Hassan Ali Khan Tax Fraud	Rs.50,000 crores	1.01	4,947,857
2008-09	Madhu Koda Mining Scam	Rs.4,000 crores	0.07	5,574,448
2009-10	2G Telecom Scam	Rs.176,700 crores	2.84	6,231,172

Source: The Financial Express, 19 December 2010, p.4

Complacency Reigns Supreme

Ironic as it may seem, the world seems to be in a celebration mode, despite all the indications that new storm clouds are gathering in different places. The events of 2008 and even 2009 seem to be distant memories that are now the realm of abstract debates on the part of the academia or at best the blogging world. The fact that this seems to occur at a time when all efforts by the central banks and policy makers seem to eke only a marginal growth in the headline growth related statistics. A close scrutiny of the global economy, on the contrary, would surprise any observer that we have somehow managed to escape an even bigger crisis. This is probably due to the phenomenally supreme ability of our policymakers who seem to have become adept at short-term crisis-management solutions. Unfortunately for them, in their urgency to find quick-fix solutions to the generational systemic problems, they seem to have averted an immediate crisis while leaving the doors open for a larger crisis sometime in the future. Due to their preoccupation with some of the larger issues, there seem to be very subtle changes in the economy, which they have been to take cognisance. Even if they realise that these are important problems they seem to be trivial before the other challenges created in the aftermath of the bursting of the credit bubble in 2008. However, we may have reached the logical limits as to how much longer the world economy could continue to trudge along the bottom with such issues. 

There are a number of indications that the economies of the advanced countries may be entering into a period like the 1970s and early 1980s when there was low growth accompanied by high commodity prices. This is not to mean claim that the economic environment is similar to that era. On the contrary, the world economy seems to be facing a storm that has combined the negative aspects of different eras, which has created more confusion. Low growth and low inflation in some areas that has led to quantitative easing, which in turn has sparked growth and asset bubbles not in the country of Quantitative easing but in the emerging world. The net result of all this may be gradually due to a number of factors, the business environment has faced a deterioration. This means that it is unlikely that the private sector is unlikely to take a lead role in investment, instead it would probably be more content (and profitable) to speculate in the financial markets. I believe that the world economy may have passed its more sanguine moments. A cursory glance at only a few issues is bound to raise more, questions and more confusion.

It is clear that Spain (and after that Italy) are going to be the centre of attraction, albiet for the wrong reasons , over the next few months. The Yields on Spain's 10 year bond have risen from 4.63 percent in November 2010, to about 5.45 percent in its last bond auction for 2010. This is unlikely to reduce unless ECB decides to aggressively buy Spanish bonds. But, even such aggression would only lead to temporary and more importantly marginal improvement, if history is any guide. The ECB has so far bought €71bn of Greek, Irish, and Portuguese bonds in a bid to cap yields (despite Bundesbank objections and probably in breach of EU treaty law) but so far it has done nothing other than give private investor an exit route. They seemed to have dumped their junk on the ECB and exited even if it has meant taking losses. This has raised questions about the solvency of the ECB itself, forcing it to raise its capital base before the bond market get another fright about its solvency. Any questions about the solvency of the EU institutions would be nothing short of a unmitigated disaster. The ECB said it would raise its subscribed capital by €5billion to €10.76billion - yet another temporary solution. 

Even as these short-term solutions are experimented, the problem grows even bigger. It is clear that ECB could face losses on their bond purchases as well as loans worth €334billion to Greek, Irish, Portuguese and Spanish banks. These loans were intended to be temporary and necessary to tide over the short-term liquidity problems. A recent report by Goldman Sachs claims that EMU states hold $760bn (£487bn) of Spanish debt securities, while France has $252bn, Germany $212bn, Luxembourg $77billion , Ireland $62billion, The Netherlands $61billion, and Belgium $48billion. Outside EMU, Britain has $69bn and the US $26bn. Cynically stated it is clear that a number of insolvent nations are holding the assets of other insolvent nations and when everybody is on the same side of the losing trade, nobody needs to care. 

Add to the above problem a new issue highlighted by UK's Financial Services Authority Report. The Report stated that UK's four largest banks – Royal Bank of Scotland, Lloyds Banking Group, Barclays and HSBC – have till date set aside nearly £71bn in provisions (about US$110 billion) but their losses on consumer debts alone will reach US$150 billion if write offs return to precrisis averages and nearly US$225 billion if they rise to the levels seen in the early 1990s recession. This should never have been a cause for concern but for the fact that the tier one capital base of the lenders is about US$450 billion. All that would be an issue if UK consumers were to face problems - which they will because of the government's draconian cuts that have just started. What would happen to UK banks if the Eurozone situation deteriorates? The short answer: They would be wiped out unless there is a massive bailout. The four lenders have an exposure of about £210bn exposure to Spanish and Irish debt – about 75pc of total capital. Another £288bn is in German and French debt, which may suffer if the eurozone crisis worsens. A similar situation for the banks of other countries awaits them. Add to this the fact that nearly €300billion o f public and private debt in Spain needs to be rolled over in 2011 while European banks need to refinance or raise nearly €1 trillion in 2011 and 2012. One wonders where all this money will be raised and what sort of problems will news that there problems have reached a breaking point lead to for the world economy and the financial markets?

Will all these problems come to fruition in 2011? Extremely low probability, unless the EU policymakers shoot themselves (this time not in foot but in the heart). First the Policy makers will invariably change all the laws so that one need not disclose the problem (remember dilution of mark-to-market!). Then they will provide more incremental tranches of aid and last will simply bail them out by introducing variants of 'QE' - like QE1 & QE2, we may have 'ECB QE', 'Peoples Bank QE', etc The net result would be that the world will still be grappling with the same set of problems in 2012, only that they would have grown in proportion and magnitude. The markets will take short-term fright and then recover as the largest players can get enough of liquidity support from their respective central banks. 

A bigger problem awaits the world because if there is such a great requirement of funds then where will all that money come from and where are the interest rates headed. Each passing day seems to raise more questions rather than provide answers.

No Redemption for the PIIGS

The New Year (2011) may not provide redemption for the indebted nations of the Peripheral Europe. The new year may not turn out to be as forebearing of the problems facing Peripheral Europe as 2010. The chart below provides an overview of the major bond redemptions for the troubled countries.

Though, by no means exhaustive, the list shows some of the major months which will emerge as the pressure points for the global bond markets, unless we have dramatic remedial action by policy makers.

It has been pointed out by Lorenzo Bernaldo de Quirós, economist at consultants Freemarket Corporate Intelligence, Spain needs to borrow about €300billion of debt between the private and the public sector (Central Government, Local Government and the Banks). This comes at a particularly inopportune time as the bonds are increasingly queasy that most of these countries may default. The CDS market seems to indicate that suggest there is a one-in-four chance that Spain will default over the next five years, while in the case of Greece, there is a probability of more than 50 per cent, and for Ireland and Portugal more than 30 per cent, according to credit default swap prices.

Microfinance in Andhra Pradesh: Intent on Buying Time

The Microfinance sector seems to have been emboldened by the support they have received from different quarters of the RBI and seem intent to take advantage of the fluid political conditions in Andhra Pradesh. The Microfinance Institutions Network (MFIN), a self regulatory industry body, now seems keen on postponing the passage of a law in Andhra Pradesh Assembly that will make their recent ordinance (Andhra Pradesh Microfinance Institutions (Regulation of Money Lending) Bill, 2010) by demanding the constitution of a house committee to debate the provisions of the ordinance before it is passed into a law. This seems to be a very smart strategy that would buy it sufficient time till the Y.H.Malegam committee submits it report to the Reserve Bank of India, which is expected latest by the end of January 2011. The MFIs seem to be hoping that in case the Ordinance is not converted into a law, and the RBI submits its report, then they are likely to be given a new lease of life. It is likely that the Y.H.Malegam committee would ask the RBI to take a strong view of using violent methods to collect the loans, while continuing to advocate the well being of the Microfinance sector by recommending that the RBI avoid regulating interest rates. As we have pointed out in the past, RBI must be quite concerned with Rs.24,000 crores that the banks have lent the MFIs in different parts of India, of which nearly Rs.7,200 crores in supposedly in Andhra Pradesh ("MFIN wants House Committee to look into MFI Bill", Business Standard, 10 December 2010, p.5). Once the RBI report is published, the MFIs seem to calculate that they can use the RBI report to dilute the provisions of the AP ordinance, which has become a problem in their unfettered growth. It has been pointed out that the RBI might take measures that would provide some relief to the MFIs.

Andhra Pradesh Government has announced that out of 273 MFIs operating in the state, 270 have already registered either with the District Rural Development Project Officer at the rural level and the Mission for Elimination of Poverty in Municipal Areas in the Urban regions.

The MFIN has claimed that they have three major objections to the AP Ordinance.
1. The ordinance insists on prior approval from the District Rural Development Agency for lending to members of the self-help groups covered by the government. The MFIs suggest that credit bureaus should be used to know the indebtedness of the SHGs and allow up to Rs.50,000 of debt to each household, even if it were to mean multiple lending, which the ordinance now forbids.

    * The MFIs seem to clearly imply that they donot intend to change their practices and instead would like to pass on the responsibility of compiling and computing the indebtedness to the credit bureau, so that they can continue to push credit.
    * It is indeed surprising that the MFIs are keen on lending to using the structures (like the SHGs) that have already been established and which are currently subsidised by the government. It is surprising that the policy makers in RBI seem to be unaware that the MFIs are not expanding rural credit delivery to the poor but are instead undertaking business in channels that are already established. If the MFIs are so keen on lending to the SHGs, what is the essential purpose that they serve in financial inclusion, other than pushing more credit to the poor? The MFIs themselves have stated that this means that they will not be able to give any new loans to SHG members or about 1.09 crore members  ("MFIs seek changes in Bill", The Hindu, 10 December 2010, p.4). MFIN claims that they have not been able to disburse more than Rs.1200 crores (approximately US$250 million) through nearly 1.2 million loans due the current problems ("MFIs may have to close down AP Operations", The Economic Times, Hyderabad Edition, 10 December 2010, p.8).

2. The AP government has given the MFIs only conditional approval to their operations as the MFIs were unable to furnish new ration card numbers and self help group names for all the 97 lakh borrowers. Interestingly, one borrower from an MFI confided privately that it was common practice for the MFI to take away the original ration card of the borrower as a security. Incidentally, such incidents were also reported in the media over the past one month.

3. The condition that MFIs shift to collecting their dues on a monthly basis, rather than weekly basis, has hurt them. However, they give a different spin: "... lakhs of poor borrowers were used to repaying loans on a weekly basis for years as their wages were paid daily or weekly. But this ordinance made it a monthly repayment" ("MFIs seek changes in Bill" The Hindu, 10 December 2010, p.4). No wonder everybody would like to speak for the poor.

All the lofty claims of the MFIs that they are helping the poor, seem to cut much ice. The Chairman of the Prime Minister's Economic Advisory Council, Dr.C.Rangarajan joins the ranks of Dr.Y.V.Reddy (another former RBI Governor) has called on the MFIs to overhaul their flawed business model for long-term sustainability. He has reportedly stated: "Unless they [MFIs] change their lending model, they will not be able to sustain their business for long" ("Rangarajan for recast of MFI business model", Business Standard, Section II, 10 December 2010, p.5). He has asked the MFIs to lend more for productive purposes and merely for consumption related expenses, as the current MFI lending was directed. Like the AP Government, he objected to their disbursing multiple lending.

Despite the growing concern about their business practices it is clear that the MFIs will be tolerated and probably let off only with a rap because they now a systemic problem. This will leave them free to continue lending at usurious purpose, while claiming to work for the poor. One migrant from Cuddapah District confided that in their district the MFIs charge an interest rate that runs into nearly 48% per month. Yet, in the current economic environment, the government can ill-afford additional banking losses running into thousands of crores if the business is not given a new lease of life. The AP government has wisely decided to table the Ordinance so that it could be passed into a bill in the Assembly. However, the bill will be taken up for discussion in the next week and is likely to be passed, since most of the political parties are keen to see that there is at least a semblance of order in the MFI sector.

The New Era of Financialisation

“I used to think if there was reincarnation, I wanted to come back as the president or the pope or a 400 baseball hitter. But now I want to come back as the bond market. You can intimidate everybody”
James Carville, Advisor to Bill Clinton in The Wall Street Journal

The rise of the markets as one of the most important foundation of the liberal state in the late twentieth and early twenty first century will probably be seen by posterity as one of the interesting chapters in economic history for a number of reasons. The recurring crisis in the financial markets is but one of them. The financial crisis has led to a general increase in interest about the functional dynamics and nature of the financial world. The crisis has not only spawned widespread interest among the members of the academia but also among the general populace, who hitherto were not well versed in the intricacies of the global and national financial systems and processes. While this interest in an important component of our social and economic mortar deserves to be welcomed, a large part of the debate about issues related to finance are increasingly concentrated on issues related to its complexity as well as the triggers that led to the immediate collapse of the financial system in the western world. Increasingly, popular media seems to believe that the financial meltdown was a mere arrhythmic event rather than a structural malaise that has its origins in the nature and development of the financial system over the past three decades. Academic scholarship has often (though not always) overlooked the process of financialisation over the past three decades.

The precipitous fall and the unprecedented swiftness in the collapses in financial markets that occur with amazing monotony are symptomatic of the consequences of the process of financialisation. The events of the past three years clearly indicates that the regulatory framework may be either too slow to react to the challenges of the process of financialisation or may lack the ability to effectively police an increasingly complex system. The new financial order is marked by business models of financial institutions that are built on assuming ever larger amounts of leverage in order to increase returns. This paper attempts to analyse this process and the problems that it poses for the future for policy makers as well as the investment community.

As a generalisation, the process of financialisation may mean to refer to the growing spread and power of finance and esoteric financial products that have accompanied the growth of the market economy which lays greater emphasis on monetisation of various segments of our economic and everyday life. This growth of finance encompasses the world of corporate finance, national finances and personal finance. The business world has moved away from an era when the production of goods and exchange of commodities provided the greatest source of profits. Financialisation has led to a paradigm shift that now generates profits from the growing circuits of financial circulation rather than the traditional mode of corporate profits. The International Swaps and Derivatives Association (ISDA) has been observes that nearly 94 percent of the World’s Largest 500 companies now use derivatives of various hues.

Nation states are not far away in their use of complex financial instruments for a variety of purposes. The spread of the market has been aided by the growing deployment of advanced computing technologies in the financial markets.

The process of monetisation is now a part of everyday life in a large number of countries including India. Financialisation has enabled speculators to speculate not on real assets (as in the past) but instead on products that derive their value from an underlying asset which they may or may not own. Speculators can now buy tonnes of copper or most other commodities without actually taking physical possession of those commodities through financial derivative products. However, it is only in the last three years that the non-financial world seems to have learnt about some of its functional dynamics. 

Origins and Growth of Financialisation

The origins of the process of financialisation may be re-constructed to the 1970s with the process gaining greater acceptance since the 1980s, especially with the growth of the process of asset securitisation. Asset Securitisation or structured finance, is used by the larger financial institutions to repackage their mortgage loan portfolio to free up their capital and increase lending. The first securitisation transaction undertaken in February 1970 when the US Department of Housing and Urban Development sold a securities backed by a portfolio of mortgage loans through the Government National Mortgage Association (that is now popularly referred to as Ginnie Mae). LiPuma and Lee trace the development of a new culture of financial circulation back to 1973 (Edward LiPuma and Benjamin Lee, Financial Derivatives and the Globalisation of Risk, Duke University Press, Durham, 2004).

The process of securitisation was in the early days largely confined to the housing (mortgages) loans. This process revolutionised the banking business, which for centuries was either considered ‘dull’ because banks essentially functioned as either lenders of money or at the most as money changers. The banks could profit only when they lent their capital cautiously and collected the interest and principle on these loans, thereby limiting the profit potential of the banks. That changed with the process of securitisation at it created a system where a loan (debt) is transferred from a lender (‘originator of the loan’ in finance parlance) to a special purpose vehicle (or SPV) and the originator issuing tradable debt securities to the buyers. These instruments are traded in the market place. The interest collected from the loan is deposited by the originator to the SPV at prearranged intervals. A natural corollary was the extension of the securitisation process from housing loans to various other loans that now includes commercial property, credit card debt, student loans, personal loans as well as all and sundry type of loans. The securities created through the process of securitisation now form the most important category of the debt markets – asset backed securities. The growth of the Asset Backed Securities (herein referred to as ABS) market was aided because often these securities though risky when the economic cycle turns down, carried a higher interest rate than the government bonds or other instruments in the markets.

The most significant advantage of the process of securitisation is that it enabled banks to free up their capital as the loans were securitised to investors leading to the availability of ever greater quantities of capital. Thus freed up capital was channelled to make further loans that enabled the creation of a culture of consumerism based on assuming more debt or to financial speculators. Since debt could be easily raised, the major beneficiaries were financial speculators who found that they could compound their returns many times by leveraging their own capital to make ever larger bets in the markets. This was clearly reflected in the gigantic proportions that the financial sector came to occupy in its contribution to the economy. In the USA (the largest economy in the world) the GDP share of the financial sector increased from 23 percent in 1990 to 31 percent in 2006 while, the share of the financial services industry in the corporate profits increased around 10 percent in the early 1980s to about 40 percent in 2006-07. 

The following chart provides an overview of the growth of the financial sector in various OECD countries:

The exponential growth in the financial sector was aided by the helping hand of a benign or even lax regulatory environment globally, especially the US Federal Reserve under Alan Greenspan. These new esoteric financial products are better known by their generic term, derivatives. One of the most successful investor in the contemporary period, Warren Buffett, who with prescience warned in 2003 that these derivatives as ‘financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal’. However, not all the derivative products are disastrous or lethal. Among the products that enabled rise of the financial sector are swaps, asset backed securities of various genres, collateralised debt obligations (CDOs), Credit Default Swaps and the most recent- Exchange Traded Funds (or ETFs). The importance of each of the above-mentioned product is that they have progressive enabled financial investors to gain ascendancy in almost all the segments of the economy. The rise of these extremely powerful money management firms which control large amounts of liquid capital have not only led to greater volatility in the marketplace but often threatens national governments at a time their greatest vulnerability. At its peak in 2007, the top 500 money management firms controlled US$64 trillion in assets. 

The rise of new financial institutions over the last three decades aided the process of financialisation. During the early 1980s, there were very few financial institutions. They included registered Pension Funds, Developmental Financial Institutions, Endowments, and Mutual funds. Financialisation was accompanied by the rise of new types of financial players. By the end of the 1990s, Hedge Funds of various genres and Private Equity Funds were a part of the growing list of financial player. By the end of the last century, Sovereign Wealth Fund completed the cycle.

The growth of the derivatives has been exponential over the past three decades. Their growth was enabled in a large measure various American and European Governments decided that they due to their financial resource constraints increasingly forced many provincial and local governments to fend for their in order to meet their financing requirements since the 1990s. The need to reduce fiscal deficit, especially after the agreement to form the European Monetary Union with a common currency meant that these local and provincial governments increased turned to the banks or the bond markets in order to raise funds. The banks and financial institutions embraced derivatives, initially to hedge their credit and default risk, and later to expand their non-fee based trading incomes.

New Financial Instruments Compound the Power of the Market
A cursory glance at the statistics of the total market size of different components of the financial markets would is clearly instructive of the exponential growth of financialisation and the growing power of the market. However, it is a fallacy to claim that financial institutions form a closed oligopoly that work in tandem scouring the planet, destroying sovereign states and trampling upon national rights. While conspiracy theories abound, it is essential to understand the nature of the market: for every buyer there is a seller and in the end participation in the financial markets is always a zero sum game where for every winner there are one or more losers. However, the nature of capitalism is inherent in that for every winner there is often more than one loser. Financial sector funds are too incoherent as rarely work as organised syndicates because of investment/trading philosophy of a fund may differ substantially. The only commonality that they may have is their urge to profit under any circumstance, which however is motive that is common to every private enterprise.

The Bank of International Settlements (BIS) has pointed out that by June 2009, the global derivatives market boasted of a notional value of about US$605 trillion, down from their peak national value of US$683 trillion in June 2008. Interestingly, the total GDP of the world’s 191 countries by the end of 2008 was about US$60.5 trillions (World Bank estimate). The five biggest dealers (all commercial banks) earned nearly US$28 billion from the largely unregulated derivatives market in 2009. The global market for Swaps market comprised of the largest segment within the derivatives market. The aggregate notional value of the all forms of swaps increased from US$8.133 trillion in 1994 to US$414.09 trillion at the end of June 2009. with interest rate swaps accounting for the largest component.

The growth in the other segments of the financial markets is equally impressive, especially in the USA. The US 401(k) retirement plans now account for approximately US$2.7 trillion and is expected to increase to US$3.7 trillion by the end of 2014. while the mutual fund industry manages assets worth nearly US$10.97 trillion at the end of February 2010. The assets managed by the Global Pension fund industry (in the major 13 markets) had reached US$23 trillion and pension assets account for nearly 70 percent of the global GDP. The statistics for all the countries in the world are difficult to come by. 

Any discussion on financialisation requires a special mention of two important ‘financial innovations’ of the recent years require special mention due to their profound impact on not only the financial world but also the real economy. These two recent innovations are (a) Credit Default Swaps and, (b) Exchange Traded Funds (ETFs). These are among the most important financial products that have the ability (and actually have) intimidated even national governments are Credit Default Swaps (CDS). Though they were designed as a form of insurance protection against default by companies and countries, they are increasingly used by those who have no ‘insurable interest’ to take speculative directional calls on companies/countries. A Credit Default Swap pays the buyer insurance coverage (usually on a contract covers a tranche of US$10 million of debt issued by a company or a country) in case of default, while the buyer gains an annual payment (like an insurance premium). A CDS contract is valid for five years. These Credit Default Swaps, like most of the other esoteric products are not exchange traded and are instead traded privately among two parties based on a written agreement. However, the one party can demand additional collateral in case it is deemed that the counter party’s balance sheet has materially altered. Those who purchase a CDS have an interest in the underlying company or country sink as they would get paid off in case of bankruptcy. It is akin to buying insurance on your neighbour’s house, thereby giving the buyer of the insurance an interest in the destruction of the neighbour’s house.

An Exchange Traded Fund (ETF) is yet another recent financial innovation. It is more of a modification of existing financial investment products. It would not be far from the truth to claim that these ETFs are partly responsible for the price volatility in a number of commodities, including food products. The first ETF was created in 1989 in Canada. The first ETF in USA was created in 1993 and they have grown exponentially since then. In the United States, the assets of these funds had grown to about US$890 billion by the end of October 2010. while they are one of the fastest growing categories amongst the financial assets in almost all parts of the world, including India. The benefit of an ETF is that it enables investors to bet on a particular commodity without actually taking physical possession of the commodity/security. The physical products are in turn held by trustees for a fee. In the more advanced markets, there are ETFs for almost any commodity and asset class, from abstruse products that represent nuclear energy to more common base metals or agricultural products.

Significance of Financialisation
Financialisation has changed the landscape of the world economy over the past decade. It would be a mistake to construe that the phenomenon a developed world feature and India is insulated from this trend. It has been pointed out that the trading on the Indian commodity exchanges has now reached nearly US$2.1 trillion – more than the Indian GDP, an indication that financialisation is an ongoing process even in India. ETFs are one of the fastest growing segments in the asset management business in India. It has been pointed out that exchange traded funds that trade in gold currently manage about Rs.2000 crores in India, while all the ETFs in India are estimated at approximately Rs.5,000 crores. The variety of the exchange traded funds is such that investors can trade in Hong Kong stocks by buying and selling on the Indian markets.

Technological change has only added to the significance of process of financialisation as it has led to an exponential increase in the participation in the financial markets leading to new challenges. Controlling activity in the financial markets has now become extremely difficult even for the regulators of nation states. Financialisation means that it has now become common place to take extremely large directional bets, often running into billions of dollars. This has resulted in billions of dollars of profits or losses . Large scale losses invariably lead to bankruptcy of not only the firm(s) involved but also systemic losses.

Financial derivatives are now a big source of income for most of the major banks thereby limiting the scope for government’s to regulate them. It has been pointed out that the biggest derivatives dealers generate revenues of US$40 billion a year from over-the-counter derivatives . Such profits for the big banks mean that they would be specially protective and would bring pressures on any government that intends to regulate the business. This growth of the unregulated derivatives market poses the single biggest systemic risk for the world economy. The collapse of Lehman Brothers and AIG in September 2008 was largely due to their bets in the derivatives market.

Unlike in the past, trading activity now has a major impact on the real economy. The onset of instruments such as Credit Default Swaps tends to magnify problems, often due the changing perceptions of the traders rather than due to actual underlying fundamentals. The role that CDS’ played during the recent sovereign credit crisis in Greece has come under special scrutiny as speculators as well as others followed the prices in the CDS market. Unfortunately most of these markets are very thinly traded thereby amplifying their supposed impact. Infact during the recent Greek Crisis, on a number days the volume traded were less than US$100 million but a sharp rise in the cost of insurance meant that investors started panicking as they believed that Greece was on the verge of default. Hence in the present highly financialised world, there need not be an actual default, any perception of default is sufficient to create a run on a company or a country. 

The New Year will witness the rise of new Exchange Traded funds in various base metals and agricultural products. The role of CDS in the recent Euro Zone problems is instructive of the future, where perceptions of problems will be enough to send the financial markets and with it the real economy into a tail spin. Increasingly the policy makers have to deal with the fast changing financial flows, which has emerged as the single most important segment. A lament by Jose Pablo Arellano (CEO, Codelco, the largest copper producer in the world owned by the government of Chile quoted in Reuters) sums it all: “Demand and supply of copper ... are not the only ones playing a role we have financial investors having an impact in the price. For that reason we are going to expect more volatility than we are used to in the short to medium term. Unfortunately, it is a long-term trend that may be hard to reverse.