Business of Rare Earth Elements: Super Cycle or Bubble?

Rare earth elements (or rare earth minerals) have been in the news over the past few months for a variety of reasons, the most important being the fear that China (the largest producer and exporter in the world) is curtailing the supply of these minerals for geopolitical reasons. This reason has led to a big rise in the stock prices of these resource producers in the global equity markets. The controversy surrounding the Chinese has also led to growing attention being focussed on a segment which hitherto was part of the debate of only those in the mining sector and the investment community attached to it. The spill over of the debate into the public domain seems to have created an unnecessary hysteria about the non-availability of the resource for posterity. A natural corollary of this has been that the stock prices of these companies have jumped manifold, mostly in a matter of four months.

What are Rare Earth Elements?

Rare earth elements (henceforth REE) or rare earth metals are a collection of 17 chemical elements in the periodic that comprise of Scandium, Yttrium and 15 other lanthanides. Most of them have similar chemical properties and are mostly found in similar deposits. Rare earths were first found in 1787 with the discovery of Ytterbite (since renamed to Gadolinite in 1800) by Carl Axel Arrhenius in the village of Ytterby, Sweden. REE have gained an increased importance due to technological change has meant that there is now an ever growing need for Rare Earth Elements (henceforth REE) in different spheres.

Their importance stems from the fact they are compulsory ingredient in the manufacture of most high-technology products, nuclear industry, petroleum sector and other sectors so vital to the economy. They cannot be easily substituted. Their magnetic and other important properties means that they find application in electric motors, mobile phones, laptops, automobiles, electric and hybrid vehicles, batteries, missile systems, satellites and communications systems among others. 

Given below is a periodic table and classification of each element. 

“Rare” earth elements are in actuality not as rare as their classification seems to imply. The reason for the name has more to do with the unfamiliarity rather than actual rarity. They are considered to rare largely because they are not found in similar concentrations or individual abundance as those other industrial metals like copper, tin or lead. Some of them (Thulium and Lutetium) are nearly 200 times more common than gold.

Given below is a table that lists the 17 rare earth elements with a brief mention about some of the more important usage. It is important to note that some of the elements draw their name from either the scientists or their geographic area of discovery.

Name	Atomic Symbol	Symbol	Importance/Usage
Scandium	21	Sc	Aluminum Scandium Alloy
Yttrium	39	Y	High Temp super conductors, Garnet. Low heat sensitivity
Lanthanum	57	La	High refractive index glass, oil industry, battery electrodes
Cerium	58	Ce	Chemical Oxidizing agent
Praseodymium	59	Pr	RE magnets, lasers, glass and ceramics among others
Neodymium	60	Nd	RE magnets and lasers among others
Promethium	61	Pm	Nuclear Batteries
Samarium	62	Sm	RE magnets, lasers neutron capture & devices producing coherent electromagnetic waves
Europium	63	Eu	Lasers, mercury vapour lamps, etc
Gadolinium	64	Gd	RE magnets, garnets, lasers, X-ray tubes, computer memory, etc.
Terbium	65	Tb	Lasers, fluorescent lamps, etc
Dysprosium	66	Dy	RE Magnets and Lasers
Holmium	67	Ho	Lasers
Erbium	68	Er	Lasers & vanadium steel
Thulium	69	Tm	X-ray machines
Ytterbium	70	Yb	Infrared lasers, chemical reducing agent, etc
Lutetium	71	Lu	Very rare. Because of rarity and high price stable Lu used in  Nuclear technology and petroleum

Complied from different sources

Some of the common properties of rare earth elements include:

• The rare earths are silver, silvery-white, or gray metals.
• The metals have a high luster, but tarnish readily in air.
• The metals have high electrical conductivity.
• The rare earths share many common properties. This makes them difficult to separate or even distinguish from each other.
• There are very small differences in solubility and complex formation between the rare earths.
• Rare earths are found together, often in combination with other rare earth elements.
• Rare earths are found with non-metals, usually in the 3+ oxidation state.

The significance of REE is that they are not found in significant concentrations and their geochemical properties make them difficult to find in economically exploitable ore deposits that would make them viable to be commercially exploited. They are often found in concentrations that are mostly in combination in other elements thereby making their isolation difficult and costly. The case of Lutetium is illustrative of the nature of REE: it is considered to be one of the rarest of the rare earth elements. It is never found by itself but is found with almost all of the other REE. However, since it is very difficult to separate from others, it is very expensive. Only about 10 tonnes of Lutetium are stated to be produced annually and the cost of the metal exceeds US$10,000 per kilogramme

Economic Importance of Rare Earths

The importance of the REE stems from nature of the technological advancement of the human race and the growing importance that is currently attached to miniaturisation of electronic times and the need for devices to fulfil an ever growing need array of functions. Their added importance stems from the fact that REEs have widespread application in highly advanced military and telecommunication systems. The usage of REE has been increasing in different applications over the years. Hybrid car, Prius contains about 10 kilograms of rare earth, while a typical 3 megawatt wind turbine requires nearly one tonne of Neodymium Iron Boron Magnets.

On the other hand a MRI machine requires the use of about 185 kilogrammes of different rare earth elements. The US uses nearly 75 kilogrammes of Rare Earth elements daily in their petroleum refining process.

This has led to an added urgency for various national governments to an active interest in maintaining a stead supply of the minerals.

The availability of rare earth minerals is concentrated in only a few geographies. The reserves are mainly concentrated in China (36% of the total known reserves), USA (13% of known reserves), Russia (19%), Australia (5.4%), India (3.1%) and many other countries including Brazil, Malaysia and Sri Lanka ( Rare Earth Elements: The Global Supply Chain, Congressional Research Service, p.6.). The major suppliers of REE to the world economy are China (120,000 metric tonnes or 97%), India (2700 tonnes or 2%) which are followed by the rest of the countries. The total supply of REE in 2009 amounted to about 124,000 tonnes.

Till the beginning of the 1990s, USA was one of the largest suppliers of REE, but it has since been overtaken by China, which now accounts for nearly 97% of the current world production and supply. Japan consumes nearly 20% of the REEs exported by China with Europe and USA accounting for the balance consumption. China’s reserves and production are largely concentrated in the Tibet, Inner Mongolia region and Southern China. The Chart below provides an overview of the global production of Rare Earth Oxides from 1950-2000. 

 

  The Demand for Rare Earth Elements outstrips supply by a substantial margin. This is expected to increase over the next few years. The present World Demand for REE is estimated at 134,000 tonnes per year and is projected to rise to about 180,000 annually by 2012. By 2014, global demand for REE may exceed 200,000 tonnes per annum with China supplying 160,000 tonnes.

Issues in Rare Earth Elements Supply:

Despite the availability of REE in nature, their supply has declined substantially over the past two decades. The causes for this decline are largely due to the confluence of three reasons: (1) China’s attempt to gain market leadership in REE supply by driving down prices, (2) Increased environmental awareness and (3) a General Commodity decline that lasted from the mid 1980s to 2001. The most important factor was China’s attempt to gain market dominance, where it directly subsidised producers and turned a blind eye to the environmental impact. Till about the mid 1980s, USA was the largest supplier of REE. By the mid 1990s massive state subsidies led to Chinese producers under-cutting the price vis-a-vis other producers. This combined with lax environmental regulations and enforcement in China enabled it to emerge as the largest supplier of REEs while most of the other companies/countries either went bankrupt or decided to discontinue production. India was one of those countries that discontinued most of its production in 2004 due to the uneconomic prices in the global market.

The market dynamics have undergone a change since 2008, when China started imposing export quotes on REE supplies. China has also set a production cap of 89,200 metric tonnes in 2010. It has determined export quotas in 2010 at 30,000 metric tonnes, about 18,000 tonnes less than 2009. The supply of rare earth elements became an issue after Japanese and other Western media claimed that China had halted supply of rare earth elements after geopolitical tensions in the South China Seas.  China however, denies that there are political motives involved in the issue. It claims that it is interested in not only preserving the cost of the rare earth resources but more importantly, it wants to curb the disastrous consequences of the environmental impact of decades of rare earth mining. There is undoubtedly a semblance of truth in this with nearly half of the global supply of rare earths coming from a single iron ore mine in north of Baotou. However, the nature of the Chinese state and China’s politics means that one is never sure whether a particular decision has a pure economic rationale or whether the political motive is part of the package.

The interesting aspect of China’s policy towards rare earths has been that it is aimed largely at the supply of rare earth material in its unprocessed form. There are no curbs for those exporting value added items. This raises serious questions about China’s policy, which seems to be a clear policy aimed at supporting its exports move up the value chain. China also seems to be more interested in laying its hands on high technology that may go with the export of items in its value chain. By reducing the supply of unprocessed REE China seems be intent on forcing manufacturers to relocate their high technology manufacturing into China. The Japanese are the largest importers of China’s REE. Most of Japan’s high technology items are manufactured in Japan, which they are not keen at present. Manufactures like TDK believe that their closely guarded high technology techniques should remain a closely guarded secret. Most of the advanced stage manufacturing continues to be based in Japan. China hopes that if the Japanese high technology manufactures are forced to relocate their units, it would be beneficial to their country in the long-run – a process that has already begun in the case of some industries.

China’s strategy of forcing the issue could backfire over the long-run. The Most important reason why REE are critical is not because of the lack of their availability. Instead it has more to do with the fact that because of their similar chemical properties, rare earths tend to be available in different blocks and it is a costly process to extract, separate and refine them. They require exponentially large quantities of water, acid and electricity. The residual waste that is often toxic and radioactive, thereby increasing the cost of production. It has been pointed out that the production of one tone of some REEs requires nearly 850 gallons of water and often produces in excess of nearly 2000 tonnes of waste that is generally difficult to dispose. 

The growing environmental awareness in most of the countries was instrumental in forcing the closure of various production units in USA and Europe. It has been pointed out by the Head of German Commodity agency that alternative supplies of Rare Earth would take ten years to reach the market in sufficiently large quantities.

As the demand for REE and the prices increase (much of it due to Chinese policy and a general rising demand for commodities), a large number of producers which had to shut down capacities will find it more economical to reopen their facilities – a trend that is already underway. India is one such example, which has decided to not only reopen and reinvest in existing capacities but has also started to call for expression of interest to start new ventures. The Indian state of Karnataka is stated to have evinced interest in granting mining permits for those interested in REE. As the clamour for REE increases, national governments are bound to relax the stringent environmental norms – after all there is nothing provides a more compulsive logic than national security.

However, investing in companies/businesses/ETFs that are enable investors to gain an exposure in Rare Earth Elements may prove to be compulsive business logic over the next four to seven years. The investment logic arises due to a number of reasons. The commodity boom is expected to continue for a few more years due to the debasement of the fiat currencies the world over. The companies that produce REE will continue to have excellent pricing power over most of the next decade (unless there is another repeat of late 2008 conditions) largely due to the growing demand for a growing array of smart devices/instruments/applications.

Investors (not entrepreneurs) may be well advised to maintain caution over the short term (6-12 months perspective) due to the exponential jump stock prices in most of the companies (at a global level) that produce REE. Most of the companies have seen prices jump between 100-500 percent since July 2010. Investors desirous of an exposure, albeit more risky structural bet, may consider an exposure to Rare Earth Elements Market Vectors Rare Earth Exchange Traded fund in USA (Symbol: REMX) on declines. There are no listed REE companies, and the first off the block always has a unique advantage. The largest producer of Rare Earth Elements in India is the public sector Indian Rare Earths Limited, it remains to be seen if the government will list the company over the next three years.

US Fed & Quantitative Easing: Will It work?

The US Federal Reserve has just announced a new programme that would expand its balance sheet by another US$600 billion over and above the present US$1.7 trillion. The Programme announced by the US Fed attempts to reinvigorate the US economy by buying bonds from now till about June 2011. The stated amount is expected to about US$75 billion a month.

There are a number of interesting aspects in this decision. At first thought, the Fed seems to have gone beyond the market expectation, but on a closer scrutiny it may not be as widely off the mark as the initial indications seems to imply. Before the decision, it was commonly expected that the US Fed would buy about US$100 billion of US Treasuries a month till about March 2010.

This round of quantitative easing has raised a number of questions (in fact there are now more questions than answers and more questions now than before the actual decision). The most important questions may be summarised as below:
1.    What is the impact of this round of QE2 going to be on the US Economy, especially unemployment and housing?
2.    What is the outlook for Inflation in the USA and the rest of the world?
3.    What is the outlook on the US Dollar?
4.    What is its impact going to be on different asset classes (including currencies, bonds, commodities and equities)?
5.    Will it lead to currency wars due to competitive debasement of currencies by national states?
6.    Will this lead to asset bubbles in different parts of the world?

Era of Rotating Sovereign Crisis & Rotating Quantitative Easing
We are probably living in unique times. There are a number of eerily historic similarities. The reaction of policy makers to different historic crisis over the past century has been somewhat similar. Most of the current policy makers believe that monetary policy can actually provide the solutions without actually undertaking a dramatic overhaul of the system. Infact, one would be tempted to believe that the policymakers in the US between 1890 to 1930 were actually more amenable to taking up drastic structural overhaul that actually laid the foundations for the emergence of the USA as a major power. Unlike those regulators the current regulators seem to believe that policy tinkering is sufficient to reinvigorate the US economy, despite the magnitude of the problem that we have had to face.

The easiest questions to answer are those related to bubbles and competitive debasement. It is beyond doubt this round as well as forthcoming quantitative easing by different countries will lead to new rounds of easing in UK, Japan and even the EU, if not other parts of the world. Cumulatively these rounds of easing will invariably create gigantic bubbles in almost all the countries. The only difference is that now we have entered into an era of not only rotating sovereign debt crisis but also an era of rotating quantitative easing – at least for the next 18 months if not beyond.

The most obvious impact is the new round of easing is that it is now clear that the interest rates are going to remain low well into the middle of 2012, if not beyond. I was one of those who was very clear that we are going to live with low interest rates at least well into 2011, if not beyond. It is clear that inflationary pressures in the USA and Europe will not go beyond the targeted levels till at least the end of 2012.

The more tricky questions about the possible impact of QE2 are in the arenas related to lending, employment and housing. These are analysed in greater details in the following pages.

Bernanke believes that resuming large scale asset purchases will boost economic growth by way of lower borrowing costs and higher asset prices. The justification is that this has been the case in the past and is likely to be the case in the present. Undoubtedly sound logic – at to some extent. The peculiarity of the logic is that the US, Europe and Japan have had low interest rates and abundant liquidity for nearly 2 years. If we were to believe the logic propounded by the US Fed then it the question is for how long? It is imperative to ask a pertinent question: If they actually did reduce the borrowing costs and increase growth then what led to growth tapering off over the past six months, despite all the government bailouts and all the abundance of liquidity? The rationale for the present form of QE2 seems to be on weak ground as growth as continued only as long as we have government transfers. The fact that the unemployment rate has been hovering at nearly ten percent despite nearly 2 years of near zero interest rates seems to indicate that the effectiveness of monetary easing is overstated. It is not the case of a lack of funds in the banking system. The problem seems to be that banks are not interested in lending as they are quite sure that the economic situation is such that borrowers may not be able to repay the loans and hence the believe that being prudent is likely to be more profitable than being brave.

Banks are unlikely to lend unless they foresee a long-term improvement in the business landscape, which they current do not foresee. What is likely to cause the banks to actually foresee a semblance of change? While it would be difficult to pin point the reasons, the banks (as well as Wall Street) would first like the US Administration to take up a much more pro-business environment and roll back some of the diluted regulatory measures that the present administration has now put in place. In other words, business would like the government to go back into the previous administration’s policy of back-to-business and policy non-intervention so that they can unleash their speculative fervour.

Interestingly, I would argue that the policy and regulatory regime is actually very conducive for a complete roll back of even the most diluted norms. A conspiracy theorist would argue that these deliberative measures of the banks are intentional and are an attempt to privatise profits and socialise losses.

What is the impact of QE2 likely on unemployment?
The short-answer would be that QE2 will have only marginal impact on its potential to create employment. The issue is not the availability of liquidity in the system. Infact since the inauguration of the credit crisis, it has never been a direct problem related to liquidity. It is more of a solvency issue, which has now morphed into a more conventional crisis. Banks have abundant liquidity; the only important factor is that they are not willing to lend money to non-institutional borrowers (especially individuals). Nothing in the present QE2 could change that attitude. The nature of a banker is stated to be dominated by a behaviour where they lend only when they perceive that there is a high probability that the loan will be repaid. The state of the global economy in a number of sectors does not induce that confidence from a banker’s point of view. The lack of pricing power, lack of demand and the collapse in the margins due to currency and commodity volatility means that the risks far outweigh the profits of lending. Little wonder that they are not lending to small and medium enterprises and consumers. Most of the lending goes to financial speculators or the very large corporations. As long as the banks are not willing to lend to small and medium enterprises there will be no meaningful gains in employment. This is because even in a economy such as the USA, about 50% of the job creation is by small and medium enterprises. Since they are starved of capital, it would be impossible for employment to climb in the present circumstances. Big corporations will face absolutely no problems for raising funds. This advantage for the large companies means that they are now willing to take larger risks, as can be seen from their big forays into the emerging markets and the huge jump in large acquisitions that they have proposed. It is because of this structural change that a US$10 billion acquisition barely makes a ripple in the world of finance.

Considering the fact that the US needs to create nearly 200,000 jobs each month, unfortunately it is still losing jobs. So it would hard to see what would lead to a large spurt in job creation. Unfortunately, the US Economy is still losing jobs. A very interesting illustration by the New York Times is indicative of the long road ahead for US jobs (see graphic below). 

 The present pace of job creation in the USA seems to indicate that it could take till about 2019 to recoup the jobs lost in the past recession, leave alone creating jobs that would be required to accommodate new entrants from the younger generation.

The two diagrams below are an excellent graphical illustration about the state of the current US economy. Major important segments that contributed to the GDP that are unlikely to remain while going ahead, including inventories and Federal government spending-though for different purposes. Federal Government spending is unlikely due to the recent victory of the Republicans.

 Source: Gluskin Sheff

Impact on Different Asset Markets
Bernanke’s logic that low interest rates could lead to higher asset prices is indeed correct, though there is a high probability that he is likely to stoke another bubble (extreme scenario). At a more optimistic scenario stocks are likely to be range bound, as they have been since August 2009.  The S&P 500 has been in a range of 1000-1200 and there are very few reasons why this could change dramatically. However, they could deteriorate dramatically if perceptions change. It is pertinent to keep in mind that in the financial markets, perceptions change very rapidly – the year is quite emblematic: in January 2010, everybody was very optimistic and by September QE2 was already a compulsion.

The two important perceptions that could lead to a decline are: (1) if inflationary pressure rise over the next six months, and more importantly (2) it becomes apparent that QE2 is not working, which is likely by May-June. The other major issue that could upset the apple cart of the whole asset prices is volatility on the currency markets, which is likely to be compounded due these factors. There are no inflationary pressures in the US economy. The current marginal uptick in the prices has more to do with the rise in commodity prices (a large part of it has to do with speculative trading demand) rather than due to demand/supply factors. The rise in inflation marginally in the USA and EU may have more to do with the rise in costs rather than inflation caused by the rise in inflation. If the commodity prices do reduce then the actual deflationary pressures in the USA that have been caused by the collapsing demand may actually create panic – surely something that Bernanke would like to avoid and hence the need for QE2. Among the commodity prices, the price of food and oil has been largely responsible for the rise in inflation. There has been no improvement in the capacity utilisation in the USA since the start of the credit crisis. Considering the fact that the capacity utilisation has been helped by the inventory restocking, going forward we are unlikely to see capacity utilisation remain at the current levels. The inflationary pressures are likely to be exported: to the emerging markets, which are basically the commodity producers.

It is pertinent to note that inflation however, need not be concern for the next one year (at least), where the deflationary pressures are likely to plague the US economy. The reasons for this are more due to the nature of the global economy, where those with excess capital are likely to seek different types of investment opportunities. The nature of investments is likely to sharply divided and the debate about the direction of the asset classes is likely to increase rather than decrease. I believe that money is likely to flow into US Treasuries, commodities and as well as emerging markets (over the very short-term). Money will flow into US Treasuries for two reasons: US bonds continue to be under--owned among the US households, especially considering the US demographics. Moreover, profits from present portfolios are likely to be added incentive as to why investors may continue to hold bonds. Deflationary pressures mean that the interest rates are unlikely to rise and hence the high level of comfort for the bond investors. Moreover, those who continue to be risk averse may be more keen to stay in the USA rather than rush into emerging market bonds, where the chances for tightening in the monetary policy have just increased.

The commodity markets are expected to be beneficiaries for three reasons. One the fact that the commodity markets actually are thinly traded means that any incremental increase in the rise in money moving into them may actually have an impact on prices that is far in excess of what is desired. The last two years are instructive. New money flows of approximately US500 billion into the commodity markets over the past two years has led to a sharp jump (almost doubling) of prices in most of the commodities.

A second more important reason for the rise in the commodity prices may have more to do China demand. China which is sitting on nearly US$2.65 trillion of reserves (which is expected to reach US$3 trillion by early next year) has reinvented the economy over the past 25 years as the workshop of the world that needs to consume huge amounts of commodities just to survive. QE2 will debase the dollar and therefore demand a rethink by China on its reserves. Andy Xie has pointed out that only about half of China’s reserves are capital surplus with the remaining being mostly hot money from expatriate Chinese. China would find it more profitable to gradually increase its stockpiles of Commodities so that their manufactures continue to have some bargaining power (economically as well as geopolitically). There is however, a catch: Chinese are extremely savvy market players and hence they are unlikely to be in a hurry to ramp up. Instead they are clearly aware of the bargaining power that their purchases have, hence they are likely to be buyers of commodities in case of panics – as the past two years have shown. Hence it is likely that the commodity markets are bound to remain range bound or at best increase in sync with the increase in monetary easing rather than simply shoot up.

A third factor that may actually increase the demand for some commodity markets is likely to occur due to an increase in the rise in investment demand from exchange traded funds and other institutional investors. This is likely to be the most important source of demand. This increased demand is likely to occur only because of the debasement in fiat currencies of the world. The case of the gold and silver markets are instructive. The rise of physical Copper ETFs and silver ETFs should be closely watched. Further quantitative easing from UK, EU and Japan may actually lead to change in the demand dynamics for commodities, especially the precious metals market. Hence, I believe that investors should be open to the idea of accumulating precious metals on declines.

While the above analysis is more fundamentally oriented, on a technical basis, most of the commodity markets need to be approached with abundant caution. They are ripe for a bout of profit booking once the initial euphoria about QE2 abates. However, over the next few years commodities, especially precious metals, should become a part of ones portfolio as they are probably one of the few hedges against debasement.

A directional call on the equity markets has become more difficult. The interesting aspect of the stock market movement has been that investors have been actually withdrawing money. ICI numbers in the USA. They have pulled out nearly US$89.4 billion out of equity funds, while the S&P 500 has gone up by 45%. There has been a substantial withdrawal of money from Money market mutual funds, which seems to indicate the liquidity upsurge in the emerging market funds and the bond funds.

If money is moving out of equity market and going into bond funds, what would explain the sharp jump in commodities? Infact one would be tempted to ask where is all the money that is going into bond funds, commodity funds, as well exchange traded funds coming from? The only possible explanation for the source of such large sums of money are (a) the central banks of the world and more importantly (b) money coming out of the US money market accounts. Investors who fled all the markets in the aftermath of Lehman and placed their money in money market funds have started withdrawing the money. In the beginning of 2009 the total amount of money in money market funds in USA was about US$3.922 trillion. It now stands at US$2.806 trillion (4 November 2010). This may be one of the main answer to the rise in the commodity markets. In the case of the equity markets, the fact that there has been huge short covering (along with some investment buying) along with large scale programme trading by the big banks may provide some of the answers.

Understanding the euphoria of the equity markets is difficult to digest considering the fact that the structural changes of the past two years is actually detrimental to the long term corporate profitability. It is difficult to fathom how rising commodity prices and declining margins in the midst of a massive debt deleveraging cycle is positive for equity markets. Valuations are quite stretched due to different reasons in different markets of the world. In the case of the USA, the valuations may be high due to the high expected earnings of the companies (which are unlikely to be met) while in the case of the East, especially in countries such as Korea and India, they are stretched due to the sharp run up in the prices. The case of India is illustrative: the price earnings ratio of the BSE Sensex is in excess of 25. Interestingly Indian markets sell at a 29% premium to the Chinese stock markets.Chasing returns in the emerging markets at the present juncture (as on 4th November 2010) is not a good idea and never has it been in the past.

Problems likely in the Currency Markets:
The problems posed by the rotating sovereign quantitative easing is going to immediately impact the currency markets. Over the next two years almost all the currencies will be debased. The only question is when and to what extent. Currencies are likely to be the next arena that is going to lead to friction among the nation states. Unlike in the past, central banks have decided that the best form of devaluation is to simply increase the supply of money. The US is no different. It hopes that it would drive the dollar down and would simply lead to an increase in the exports thereby enabling their companies to increase their profits, which would then enable them to repair their balance sheets and then increase investments. However ironic as it may seem, companies are making profits and repairing their balance sheets, but they are not investing in USA instead they are investing in other countries, especially in the emerging markets, where they are aggressively buying assets. In case of any investment in the USA, they are not investing in green field ventures instead they are simply buying existing assets.

The depreciation of the dollar is actually creating another set of problems namely pressurising the balance sheet of those who are in deep trouble: households. The rising cost of imports means that they have to pay more for food stuff and oil, which is akin to a daily tax on their pockets. Unfortunately, unlike the traditional tax, this does not stay within the national boundaries, but is instead going to the resource producing nations of the world. Their currencies have appreciated over the past one year: they face a problem of plenty. This has led to a dichotomy between the two world: a few countries facing deflation while the others face inflation. Depreciation of the US dollar will destroy the economies of the troubled European countries, especially those which are already troubled. Within six months we are bound have greater pressure on the European Central Bank, the Bank of England the Bank of Japan to start their own easing as their exporters will be trouble. This is bound to set off a chain of competitive devaluations: something that has actually been happening over the past two years. The only countries that cannot afford that are the Emerging Markets.

While the above is a likely scenario, the above scenario may not span out if the problems for Greece, Spain, Ireland and Portugal get out of hand. Therefore the key to the global economic recovery is the bond markets of USA and Europe. If there is a re-run of the sovereign debt problems (there are already murmurs about Ireland needing a bail out within 3 months). That would mean more money printing thereby leading to a fall in the Euro, taking the world economy to square one.

Buy the Rumour, Sell the fact?
However, the technical picture (especially one for the next three months) is completely different. It indicates that only is the dollar close to the bottom and the Euro is close to the levels that should already be setting off pain for their exporters. The long positions for the Euro are the highest point since early 2008, indicating that most of the bad news for the US dollar (over the short-term) may have already been factored into the price. However, if the US Dollar Index were to decline below 74 (Current level as on 4 Nov 2010: about 76) we are likely to witness a new decade low of about 70. However, very early indications are that the US Dollar may be close to a bottom. One need not be very surprised if we have a scenario where traders indulge in the classic buy the rumour and sell the fact, once the initial euphoria of the Fed easing dissipates. Hence the early part of the next week is likely to be a critical time for the financial markets of all hues.

Problems for the East:
The easing by the US Fed is likely to create problems for most of the emerging markets. These problems will be aggravated for those countries that are dependent on natural resources exports. Not only will those with an abundance of natural resources face the Dutch disease, but it will increase hot money flows leading to greater inflationary pressures (already high due to the commodity prices). The rising hot money flow means that the Central banks of the Asia-Pacific region (excluding Japan) will have to take up substantial tightening. RBI governor has clearly stated that inflation will be completely controlled in 2012 only. 

There is a extremely high probability (in my view above 75%) that the major emerging markets are likely to witness their largest bubble in history. There are both positives as well as negatives in this: the positive is that it would mean that savvy investors have opportunities to take advantage of the rising tide. The downside is that, policy makers have never been able to deal with a bubble without causing pain. The larger the bubble the greater the pain that these countries have to suffer over the next couple of years. It is likely that the problems for global economy are going to be very similar to those suffered over the 2005-2008 period, though for a variety of other reasons.

Investment Strategy:
It is pertinent to note that there is going to an exponential rise in volatility across different markets and different asset classes. Volatility will only increase rather than decrease. While reflation trade may be back on the centre stage for the next few weeks, be extremely cautious. It would probably make a lot of sense for investors to actually take a serious look at various exchange traded funds (for commodities and currencies) rather than taking a direct route through the futures and options.

Interestingly the net long positions in most of the commodity markets (including gold, copper and other commodity indices) are close to their 3-5 year highs (depending on the commodity). Similarly the net long positions of the non US dollar currencies are close to the highest points they have reached since 2007. This would indicate that there may be limited upside to these asset classes and infact there could be more downside risks over the short term (next two months). The only place where the long positions are not at their all time high’s despite the run up in the price are the US Treasury markets. However, if there is a sharp bout of profit booking, it would be safe for investors to accumulate precious metals. A 10% downside could be a good time to warm up to the precious metals and commodity markets. The bigger the fall, the better.

If QE2 doesnot work (it is unlikely to work beyond a 9 month horizon) be prepared for the bottom to fall out from most of the risk assets. Unfortunately, we will get an indication of that only at the end of the May 2011.

Is Pressure from Below Working?: Government Reaction to the Micro-finance Crisis

As a researcher who is keenly interested in the operational dynamics and scope of finance (macro as well as micro level), the recent crisis in the micro finance industry and the government response has been fascinating for a number of reasons. The first reason for the interest is that on close scrutiny if the government response to the crisis were to be sustained without any dilution, then investors in micro finance companies may be better off designing new business models for their companies. The existing business models are at a risk of becoming redundant if the recently promulgated Ordinance in Andhra Pradesh is implemented in letter and spirit. The micro finance business in its present form is probably facing its first important regulatory challenge as the Rural Development Minister, Mr.Vatti Vasanth Kumar has stated that he has directed District collectors to see that MFIs stopped their weekly collections forthwith and immediately switch to monthly collections (The Hindu, Hyderabad Edition, 24 October 2010) - like most of the formal and many informal financiers.

The Ordinance (officially titled “Andhra Pradesh Micro Finance Institutions (regulation of money lending) Ordinance, 2010”) is far reaching in its scope and this probably why the MFIs are vigorously lobbying the Ministry of Finance, Government of India to use their good offices to dilute the AP Ordinance. Some of the excellent and important features of the ordinance are reproduced and analysed in the following lines. MFIs claim that they do not fall under the purview of the State Government and instead they are under the purview of the Reserve Bank of India, which peculiarly has chosen to take a bureaucratic way: appoint a committee that would go into the problem. The MFIs do not seem to understand that these MFIs are breaking other clauses in the Indian Penal Code and importantly law and order as well as people’s welfare is a state subject. While credit delivery to the poor is an (or more likely was) an important contribution of the MFIs in the past, usury and harassment are not.  

 

All MFIs will have to register within 30 days from the commencement of the ordinance with a registering authority in each district. No MFI will be allowed to grant loans or recover loans without registering. Each year the MFIs will have to apply for renewal of the registration. The Registering authority will decide within 15 days whether they should grant license after due verification of the performance of the MFIS in the field level and after objections (if any) from the general public regarding extension of registration (Clauses 3(1-4)).

The importance of these clauses is that there is a welcome scope for public pressure in future that could emerge as an important source of pressure that would force public representatives to take cognizance of the intimidation by MFIs in future. Nothing works better on the political class than pressure by voters and outcry in the media. The fact that the MFI has to renew its license every year means that it is here that the government has exceptional leverage as they can deny the renewal of the license if there are any complaints. While it is likely that in most cases the licensing authorities may find means to profit from renewal, it would be problematic for those that have a history of intimidation and having an elastic conceptualization of the law.
 

Clause 6 of the ordinance states that no member of an SHG shall be a member of more than one SHG and in case they are members of more than one SHG they have the option to retain membership of one of SHG and terminating the others. They are expected to repay their loans within a period of three months from the commencement of the ordinance.

This is an important attempt by the government to see to it that MFIs don’t push credit to people who cannot simply repay it. It is pertinent to note that MFIs have of late been pushing credit in order to meet their targets and importantly they are pushing credit to those borrowers who don’t have any hope of repaying it. It is indeed surprising that the culture of borrowing that these MFIs have created has actually led to greater indebtedness rather than reducing it. It is indeed shocking that there are instance where MFIs have lent more than one lakh to agricultural labourers (a few of whom subsequently committed suicide to escape harassment from the thugs of the MFIs).
 

Clause 9(1) states that No MFI shall recover from the borrower towards interest that is in excess of the principal amount. Clause 9(2) states that those who have repaid an amount equal to twice the amount of the principal shall stand discharged and the borrower shall be entitled to a refund.

Whether the MFIs refund the amount of not, the fact that this problem seems to have been widespread enough to force the government to react is in itself indicative of the usurious nature of the MFIs. The Government, especially the Reserve Bank of India should realize that they should not encourage the creation of a corporatized version of a usurious money lender.
 

Clause 10(1) states that no MFI shall extend further loan to a SHG or its members where the SHG has an outstanding loan from a bank unless the MFI obtains the prior written approval from the registering authority. Clause 10(4) states clearly that no MFI shall grant loan to a member of SHG during the subsistence of two previous loans irrespective of the source of the previous two loans.

This measure, if properly implemented, would go a long-way in restraining (at least partly) excessive borrowing from members. This is not to mean that there will be no other lender. I would not be surprised if MFIs themselves take a leaf out of the books of the informal financiers where they lend without official records.
 

Clause 11 is probably one that actually lead to a successful prosecution of an MFI over the long-term. Various clauses state that the MFI is expected to maintain clear accounts of their books, provide very clear information about the loans taken, interest rates charged and the repayment schedule as well as actual repayments made – something which most of them clearly do not. This not peculiar to the MFIs alone, it is in the very nature of the informal finance business.
Clause 11(6) lays down that all tranches of the repayment shall be made by the group at the office of the Gram Panchayat only.
Clause 11(7) clearly states that MFIs shall not deploy any agents for recovery nor shall use any other coercive action either by itself or by its agents for recovery of money from the borrower; and any form of coercive recovery including but not limited to visiting the house of the borrower shall, apart being punishable under the provisions of the ordinarnce employer the Registering Authority to suspend or cancel the license of the MFI.

Little wonder that the MFIs are jittery. With one stroke the government has removed the ability of the MFIs to coerce the borrowers while collecting the loan. Political society in India and electoral dynamics state that local borrowers are far more important than an ‘outside’ moneylender (even if it is a corporate one). At one stroke the government has also provide sufficient legal ground for the police and other agencies to protect the borrowers, thereby altering the fundamentals of the lending-borrowing business.
 

Clause 12 makes it mandatory for an MFI to file a monthly statement to the Registering Authority before the 10th day of every month giving a list of the borrowers, the loan given to each and the interest rate charged on the repayment mode.

This makes backdating almost impossible. Considering the fact that RTI is a powerful additional tool for those who are well versed in the law, the MFI business just got more difficult – of course, subject to the condition that it is actually implemented and not diluted.

Clause 13(2&3) gives the Registering Authority the right to search and seize records as well as to summon and examine the officials of the MFI or any person who in his opinion is in a position to furnish the relevant information.

Anybody with knowledge of history would clearly know that it is precisely this power that was vested with the Securities and Exchange Board of India (SEBI) that brought about a semblance of order to the wild west of the Indian stock markets in the 1990s and the first decade of this century. Hopefully, this should give us similar results in the case of the microfinance industry.

Clause 14 enables any member of SHG or any member of the public to file a complaint regarding violation of the provision of the Ordinance by the MFI before the Registering Authority. Clause 15 also provides for the establishment of fast track courts.

Clause 16 is probably the best consumer protection measure passed in recent years by a government. It is comprehensive, very elaborately and clearly explains that all persons connected with an responsible for day-to-day control, business and management of a MFI including partners, directors, and the employees who resort to any type of coercive measures against SHGs or its members of their family members shall be liable for punishment of imprisonment which may extend up to a period of three years or with fine which may extend to one lakh rupees or with both.

Under this clause it is elaborately explained that MFIs cannot: obstruct, use violence or insult or intimidate the borrower or his family or persistently follow the borrower or his family member from place to place or interfere with any property owned or used by him or depriving him of, or hindering him in, the use of any such property, frequent the house or nay other place where the other person resides or works, or carries out business, move or act in a manner which causes or is calculated to cause alarm or danger to the person or property of such other person or seek to remove forcibly any document from the borrower which entitles the borrower to a benefit under any government programme. In case of any violation of these then not only are the provisions of the Code of Criminal Procedure, 1973 shall apply but the proceedings will be before a Fast Track Court.

With One stroke the MFIs are worse off then the NBFCs and places them on equal footing as the informal lenders, if not worse.

 

Clause 20(2) provides immunity to those who expose in good faith the violations of the Ordinance by MFIs.

An important lesson that the government, lenders and borrowers need to learn is that creating a culture of borrowing and lending that would have their long-term interests in mind would go a long way in balancing the interests of all the stake holders. Lenders should keep in mind that the culture of credit in India is such that a debtor would borrow any amount of money despite knowing very well that they cannot hope to repay it. Lenders should realize that when a borrower is ready to borrow at usurious interest rates they are well on the road to default as business environment in India doesnot generate profits to the tune that may be needed to repay such high cost of carrying out business.

Microfinance Sector in Andhra Pradesh: A Snapshot of the Recent Events

The Microfinance sector has been in the news for all the wrong reasons. It is imperative that readers understand the dynamics of the sector in terms of size before considering other aspects of the sector, including the culture of debt that they have spawned as well as their business dynamics. 

Andhra Pradesh is particularly important for the Microfinance sector as it contributes about 40% of the sectors revenues in India (The Economic Times, 13 October 2010, p.1).

The statistics given below have been compiled from various Newspapers with sources acknowledged where necessary.

Micro Finance Institutions Network, a self-regulatory body of MFIs, claims that of its 44 members  20 of them are active in Andhra Pradesh (who are registered under the RBI NBFC MFI norms) and these members cumulatively have:

• Lent nearly Rs.9000 crores (about US$1.9 billion) to 6.5 million poor borrowers
• Nearly Rs.200 crores (approximately US$45 million) of weekly collections have been delayed.
• if they were to follow the rules stipulated by the Govt of AP, then it would take 60-90 days to collect their dues.(The Hindu, 20 October 2010, p.4. Hyderabad Edition)

The Government should hopefully realise the present problems are largely a consequence of its decade old attempt to encourage the sector. Such harsh methods of loan collection are a natural corollary and are inherent in the finance business. It would not be far from the truth to claim that the government encouragement  till date was essentially an attempt to create a corporatised version of the traditional money lenders.

Using strong arm tactics to collect a loan is not new in India, and there are innumerable instances when the courts and the police had stepped in to put an end to their excesses. Due credit should be given to the AP police, who since 2002 taking a proactive role in curbing the excesses of financiers. Mr.N.V.Surendra Babu, the erstwhile Commissioner of Police, Vijayawada was the first person who locked up private moneylenders, after the excesses of the financiers (both individual and NBFCs). 

In the case of the recent MFI episode, the Director General of Police has stated that 22 persons had committed suicide thus far on account of harassment of MFIs (The Hindu, 20 October 2010, p.4. Hyderabad Edition) and he has clearly stated that the police are thinking of taking Suo motto cases against those who harass borrowers. Vikram Akula has stated that of the people who have committed suicide, 17 have borrowed money from SKS.

The MFI business has extra-ordinary margins even by money-lending standards or thoseof the finance and banking business. Vikram Akula has stated that of the 26% that they charge from borrowers, approximately 8.5% is the cost of borrowing, 9% is the cost of delivery, 1% RBI stipulation for hardship cases, corporate tax of 3% and 4-5%, margins for the company (The Economic Times, Hyderabad Edition, 16 October 2010, p.4). MFIs claim that their rate of interest is not high (especially when compared to the private money lenders) and they are willing to cut the rates to borrowers if the banks lower their interest rates (Business Line, 20 October 2010, p.1). Since about 80% of the capital deployed by the MFIs originates from borrowings from banks (Business Line 20 October 2010, p.6). However, the rates charged by the banks to the MFIs are not high considering that personal loan borrowers pay 14% while Small and Medium Enterprises pay from 10-14% if not more. More importantly, the yield on the Government of India 10 year bonds is 7.80%, indicating that the MFIs have been major beneficiaries of bank largesse to the MFIs due to the RBI guidelines that allow banks to mark lending to MFIs as priority lending.

On close scrutiny of the margins of MFIs indicate that while the cost of delivery claimed by MFIs is too high and they dont take into account the fact that economies of scale tends to reduce the costs. The costs to companies to SKS and others also mask the high management benefits in the form of high salaries. Ironically, other NBFCs (especially those listed ones) claim that their margins are a maximum of 3%.

At the end of the day, banking or finance business requires specialised knowledge about the client. Till now it was wrongly believed that MFIs had this specialised domain knowledge. It now appears that their knowledge was (and is) is only as superficial as the big banks. So it may be prudent for the banks to actually reconsider the supposed value of the MFIs. It may be better for the banks to seriously consider the banking correspondents route rather than the MFI route.

What is lost in the din created due to this fresh problems in the MFI sector is the fact that who will be able to deliver credit to the poor. There is a need for objective thinking on the alternatives so that the poor are not starved of credit.

US Housing Problem: A Snapshot

The Housing sector in the USA continues to languish and seems to be playing a lead role in the increasing economic mess that seems to indicate that US is going the Japan way - a deflationary spiral which the policymakers seem to have no idea about. 

The following chart shows the problem of US home borrowers who increasingly find their homes are worth less than the mortgages.

Coal India IPO: Research Brief

Coal India has recently (25th September 2010) filed its draft Red Herring Prospectus with SEBI. This may be a good time to understand various factors that would probably help investors make their decision on the issue. Please note that I am making a recommendation as to one should invest in the issue or not, instead all the positive and negative factors are highlighted in this note so that it would hopefully enable investors to make an enlightened decision. We cover the global as well as the national macro-economic as well as company specific factors in our note.

It is pertinent that investors note that the price of the issue has not been announced but there are a number of stories in the newspapers that expect the issue to be priced in the region of about 225-250 and the issue is expected to open for subscription on 18th October 2010. Investors should keep in mind that price is what they pay and value is what they get and hence the IPO pricing may a critical factor that should go into the decision to subscribe to the issue in the short-term. I personally believe that if the rumoured pricing (i.e. Rs.225-250) is correct then it may be considered to be steep for short-term investors. But those with a 5-10 year perspective should accumulate fundamentally sound coal companies (stocks or assets) over the next few years, in light of the business potential. The fundamentals of the coal business are likely to be dramatically affected only if the World GDP shrinks by more than 2% annually for the next four years – an unlikely event. However, over the next two years, expect extreme volatility in the global stock markets and hence taking a call on coal prices (technically) could be challenging. The technical risks have increased for the simple reason that the US Markets are discounting a nominal GDP growth of about 7% (last seen in 1989) or record high profit margins, both of which are theoretically possible, but practically unlikely.

Coal: The Global Scenario:
The fundamentals of the coal business have probably never been so good – macro economic basis as well as commodity specific. Almost all the emerging economies are growing at a very fast clip. Capital seems to be more than willing to risk higher return in the East where there are still growth opportunities due to the high levels of poverty and more importantly because investment opportunities have declined in the west. Interest rates are expected to be benign over the next few years, if not for the next decade.

The interesting aspect of the coal business is that over the past few years, instead of a decline on reliance on coal in the electricity generation business, there has been an increase. It has been pointed out that in 2010, 94 gigawatts of coal fired power plants are expected to go on stream leading to an additional 375 million tonnes of annual coal demand. Add to this the global demographics and the existing state of the socio-economic conditions indicate that nearly 3.6 billion people worldwide (2.263 billion in Asia, 921 million in Africa and 466 million in Latin America) have only partial access to electricity. The CEO of Peabody Energy has pointed out that if 2010 demand for coal were to continue, it would lead to an additional (new) demand of approximately 1 billion tonnes of coal every three years , with 90% of the new demand coming from Asia (especially India and China).

The chart below illustrates the New Coal based thermal plants under construction in different parts of the world (in Gigawatts):

The coal story is not one without its drawbacks. There will be increased outcry about the environmental problems related to coal mining and coal based power. However, coal fired power continues to be the cheapest source and would continue to remain the cheapest for at least the next three (if not more decades). Coal is not easily replaceable in the near future. It has been pointed out that it would require about 1800 times present generation capacity, 2.5 billion wind turbines, 1150 nuclear plants, three times present Russia’s natural gas production (70 tcf), and approximately 2250 big dams to replace present coal capacities – most of which are even theoretically impossible. Over the ten year period (1999-2009) coal based thermal plants have produced nearly 46% of the world’s total energy requirements. Instead of a decreased dependence on coal due to global warming considerations it is expected that by 2035 coal fuelled  plants will increase by 90%. Asia is the biggest market for coal and in 2009 it accounted for nearly 65% of the total global consumption of coal, with China and India accounting for the lion’s share. Nearly 13% of the total coal produced is used by steel Industry.

Coal India: The Company:
India accounts for nearly 6.7% of the world’s recoverable reserves. India accounted for about 8% (or about 557 million tones) of the total global production in 2009 and is the third largest producer and consumer of coal.

The company was established in 1973 as a product of the nationalisation of the coal industry and is now the largest producer of coal in the world. As of March 31, 2010, the company operates nearly 471 mines in 21 major coalfields across eight states in India, including 163 open cast mines, 273 underground mines and 35 mixed mines (which include both open cast and underground mines). It also operates coal mines in Mozambique. It is considered to be the largest coal reserve holder of coal in the world. It is in the process of expanding its production capacity. As of March 2010, the company has received the necessary approvals for expanding capacity in 22 existing mines and to start 23 new mine projects. Most of its production was through open cast mining.

Coal India produced approximately 82% of the coal produced in India and it produced nearly 431 tonnes of raw coal. In 2009, the largest consumer of coal in India is the power generation sector which accounted for nearly 77% and it meets 52.4% of the total energy demand in India. By 2032, coal is expected to meet more than 50% of India’s energy requirements. Interestingly, the primary energy consumption in India has grown by approximately 700% over the last four decades. Demand growth is expected for at least the next five years, if not more. The Company estimates that it would not be able to meet the demand and claims that there will be a shortfall in our ability to supply coal from its production to the tune of approximately 110 million tonnes for fiscal 2011 and 235 million tonnes for fiscal 2012 and increase further over the subsequent years .

As of April 2009, Indian coal reserves were placed at 276.81 billion tones. Coal India’s reserves accounted for nearly 64.78 billion tones of which 34.43 billion tones had been considered for mining. The total extractable resources had been estimated at 21.75 billion tones. In contrast US based Peabody Energy holds 9 billion tonnnes and China Shenhua Energy Co Ltd 7 billion tonnes of coal reserves.

The total income of the was about Rs.52,592 crores in 2010, while its profit after tax was about Rs.9824 crores. As of March 2010 its cash and bank balances were nearly Rs.4,000 crores.

Positives:

• Low debt (only about 2100 crores), though it total contingent liabilities are about Rs.10,500 crores.
• The Company had a networth of nearly Rs.15,000 crores
• Sales of more than Rs.44,000
• Equity capital is around Rs.6300 crores while it has reserves worth 9200 crores. 
• 2010 profit was about 8200 crores.
• Most of the coal it produces is thermal coal. 
• Demand for non-coking coal in India is projected to grow at a CAGR of 11.3% from 508 million tonnes to approximately 868 million tonnes by 2014. The demand for coking coal is expected to increase at a CAGR of 9.7% over the same period.
• The Return on Networth as of 31 March 2010 was 38.3% (as per restated consolidated financial statements).
• The NAV/ book value per Equity Share as at March 31, 2010 was Rs. 24.67 as per the company’s restated stand alone financial statements and Rs.40.92 as per its restated consolidated financial statements

 Negatives:

• The unfortunate aspect of Coal India is that it is a near monopoly that cannot wield its monopoly power due to governmental regulations that touch nearly aspect of its functioning. The government is prone to micromanaging the functioning of the company
• Even after the IPO, the Government of India will continue to hold about 90% of the equity thereby meaning that there could be subsequent increase in the floating stock of the company. Considering the fact that the Government of India is pressed for funds any rise in price of the company would make it specially attractive for the government to dilute its holdings further since the government has made known its intention that it would gradually divest its holding in public sector undertakings to about 51% over the next few years. 
• Proceeds of the offer will not go to the company thereby making little difference its financial performance over the short-term. 
• Government environmental regulations are likely to impact its profitability over the long-term(The recent proposal of the GoI to demarcate certain coal-bearing forest areas in India into various categories, which is proposed to include a category in which mining activities are prohibited, may adversely affect our business prospects, results of operations and financial condition.)
• Coal price sold by the company is fixed by the government, though Coal imports are allowed under the Open General License by consumers directly. In 2010 India is expected to import about 67.74 million tones of coal. 
• Problematically the distribution of coal produced by the company has to be in accordance with the prices and in consonance with the policies and goals of the Government of India. The government policy is the biggest black swan as far as the company is concerned. The company was forced to renounce it rights to certain mines in the Parvatpur and Brahmani blocks in the Jharia and Rajmahal coalfields some years back.
• We may add the major problems related to a prolonged global downturn to the list of negatives.

More Questions on the World Economy

The last time I raised apprehensions about the World Economy and asked questions about the economy (late April), the consequences were quite disastrous. A few months down the line, I am no more knowledgeable about the world economy. On the contrary I am outright more skeptical about the economy and the ability of our policy makers. At various points i had very clearly stated that the only long-term solution was in a massive debt write off. Ultimately, I am quite sure that the world will witness such a write off, the only question is who will be the loser and what percentage will be written off. I would believe that the quantum of write offs will vary but it could be in the range of about 40-50% of the present debts. Only such a large write off would create conditions conducive for a recovery of the world economy.

In the interregnum, I believe that the world economy is at the cusp of a turning point (more like wilting point). We are likely to have policy level interventions yet again, which would be temporary in nature. Unlike the past (2008) we are likely to have policy makers intervene before things get out of hand. In all likelihood we may witness a scenario where the world would simply drift downwards - a la Japan. Our yesterday's thinking is their tomorrow's idea. There could be innumerable triggers since for the past two months we have been living on a scenario where "no bad news is good news".

I would need satisfactory answers for me to be convinced otherwise. By the way convincing answers have to have a combination of statistics, logic and historical precedent, otherwise I would continue to be a doubting character.

Questions:

1. Despite the historically large interventions by the ECB, why are the Greek Spread over the German Bond spreads at a record (today they crossed the May 2010 level). To place things in perspective, in May it was widely believed that Greece would have to be bailed out and there were also doubts about the survival of the Euro.

2. Why are equity markets so complacent while the bond markets (which traditionally have forecast each and every crisis) are yields that have not even been seen during the Great Depression. The Japanese and Swiss 10 year bonds are quoting at yields of about 1% or less.

3. Do the Governments have any more meaningful (effective) tools that would enable them go beyond the ineffective Quantitative Easing. QE now it comes in Parts: QE 1 was over (and hype and ended with a whimper), they are getting ready for QE2. So we can actually have many many episodes - just like the Soap episodes on the vernacular Indian idiot box - they run into hundreds.

4. Do the policy makers know that they are going to start pumping money at the wrong end (giving it to the banks, who will not lend it) rather than thinking about steps to the consumer in a non-debt format.

5. While the Equity markets are so hopeful about 3% US GDP growth, what do the commodity markets (especially the Journal of Commodities smoothed index) and other Indicators like ECRI leading indicators know about the economy that the equity markets don't know?

More questions later, but incase you have any answers please do enlighten me.

Brother, Can you spare me a Dime: Some Great Depression Statistics

The events of the past few weeks evoke mixed reactions. They vary from ironic relief at being closer than the run-in-the-mill consensus that talked about a recovery for about year and are now ‘shocked’ that the US economy may be on the verge of tipping over, to a reaction of sadness that my prognosis of a deflationary spiral may be too close to comfort-even for an ardent bear. This is because as I noted, it is always easy to earn money in bull market as there will always be a greater fool to buy what we want to get rid of. So in order to help place the Great Depression in a better perspective, I have decided to go back to my favourite discipline (History) to equip myself with the information that would hopefully enable me to overcome the despair that awaits us. For the record, I continue to believe that there is a very high probability that the US will face a double dip recession as will most parts of Europe over the next 1-2 years.

Much has been written about the Great Depression and its comparison with the present problems with the world. The eerie similarities only make it imperative that we have greater awareness of the impact of the Great Depression on different sectors. The reason for this is because I personally believe that if we understand the impact of the Great Depression, we would be able to take advantage of events that may unfold over the next five years. First we are bound to witness a deflationary spiral and then to be followed by an inflationary spiral. Since, I believe that my diagnosis of the problem is mostly right; it would now best to concentrate on the cure in order not to save the patient (which is beyond our ability) but to at least save our self.

In 1929 manufacturing constituted 25.2% of the US Economy, while trade consisted of 15.5%, Finance 14.7%, services 10.1% and agriculture 9.7%. While factories employed10.7 million, wholesale and retail trade employed 6.1 million, transport and public utilities employed 3.9 million, services 3.4 million, finance 1.5 million and construction 1.5 million.

Agriculture was an important component of the US economy. In 1930 rural population in USA constituted about 25% of the total population. The US had nearly 6.5 million farms and agricultural produce was an important 40% of the total US exports. About 2.4 million farms had less than 50 acres. Interestingly one million farm families had a net income of between US$100-300. Little wonder that the US agricultural sector was devastated by the impact of the Great Depression.

As the Depression gathered in intensity, the US Economy went into a downward spiral, which reached its peak intensity in 1933. By 1932, US Gross National Product had dropped by 33% and unemployment soared to nearly 25% (up from 3% in 1929). Prices of most of the goods had been cut in half. By March 1933, manufacturing output had fallen by almost half while wholesale prices fell by 38%. Nearly 3.4 million manufacturing jobs had disappeared along with 1.4 million in the whole sale and retail trade, 688,000 in the construction sector, 567,000 in the service sector, 214,000 in finance, insurance and real estate sector. To place this in perspective the US civilian (non-institutional) labour force was about 49.10 million.

An overview of the devastation shows the magnitude of problem.
•    In the manufacturing sector, the durable segment bore the brunt and it declined by 70-80% in output terms, while in terms of employment it contracted by about 55%.
•    Amongst the manufacturing sectors: shoes, tobacco, foodstuffs, textiles and non-durables fell by a relatively more modest 10-20% while employment in these sectors fell by about 30%.
•    In 1929 the USA produced about 4.5 million passenger vehicles by 1933 it had shrunk to 1.1 million. The sector now employed about 45%  less than at the outset of 1929. However, wages collapsed by 75%.
•    In 1929 the US housing starts numbered 509,000; by 1933 they had reduced to 93,000.
•    Spending on Advertisements plunged by more than 60% between 1929-33 and it did not recover to the pre-crash level until after World War II.
•    More than 9000 banks (or about 30% of those that existed in 1929) failed between 1930-33.
•    The Urban Population of the USA had risen by 27.3% in the 1920s, and it fell to 7.9% during the 1930s.
•    At one point the US Federal Government provided employment to about four million workers as part of its attempt to create jobs through infrastructure projects.

The Great Depression devastated the US agriculture sector:
•    Between 1929-32 crop and livestock prices crashed by almost 75%;
•    Farm incomes declined by 60% and in US Dollar terms they fell from US$13.8 billion to US$6.5 billion.
•    The cash proceeds from marketing farm products in 1932 were about one-third lower than they had been in 1919.
•    Farm foreclosures grew exponentially: I would equate the problem the present day home foreclosures (though it is like comparing Oranges with Apples).
•    Average farm foreclosure rate from 1913-1920 was about 3.2 per 1000 farms, which grew to 17.4 per 1000 farms in 1926 and by 1933 it had jumped to 38.8 per 1000 farms.
•    During 1933 itself more than 200,000 farms were foreclosed.
•    The farm foreclosures ebbed only with the establishment of the Farm Credit Administration in 1933 which began refinancing mortgage loans at low interest and finally after the passage of the Farm Mortgage Moratorium Act (1935) which forbade seizures for a period of 3 years.

The US budget which was in surplus till about 1929 (about US$734 million) tripped into a deficit of about US$2.7 billion in 1932, by 1936 this had increased to US$8.2 billion due to a combination of spending and reduction in revenues. World War II added to the woes of the US budget: it jumped to US$57.4 billion in 1943.

Tailpiece:
•    This is not to claim that the Great Depression was uniformly horrendous. The US illegal alcohol industry boomed: it jumped about US$2 billion since the introduction of prohibition in 1925.
•    Africa was relatively better off: while the value of world exports declined by 66% during the period 1929-34, Africa’s exports declined by 48%.