Friday, December 21, 2007

efficacy of the role of education in poverty alleviation

education can be a powerful tool to alleviate poverty in medium term. It is not very obvious in the short term but in the medium term it is one of the surer ways to move out of poverty for a family. Education makes more valuable the only resource poor have in ample measure at their disposal - their labor.
The issue however is that the education is a fairly long term investment. Also poor often are reluctant to let go of the current returns on the labor in return for a better though riskier returns later.

Is there a market mechanism to get the poor to balance this risk as a family?

Sunday, November 25, 2007

so what does one aspire to be?

I did not see it that clearly earlier. The use of lack of it for money. I still believe that money wont get you everything. But now that i have looked into how to help people manage their money, i have increasingly gotten over my other belief that a lot of money can help you bring about a lasting impact on the human civilization.
Money does not suffice. The organization of human society is much too complex for that. If you are enterprising, money will come to you. If you take sufficient risks, money could come to you in great measure as well. However, if you are under the impression that this will solve most of your problems, you would be in for a surprise. Why is that? All moral judgments aside, money is after all a medium to express your purchasing power, it does not point to any solutions. Solutions to? Well, to start with, how to you make sense of your existence, what do you aspire for in life, what do you hold close to your heart, how do you be happy?
Money will not affect it negatively either. It simply has a much limited role to play. Somehow the collective conscious being driven by a large mass of have-nots has led us to value money much more that it is truly worth.
To lead a good life, i will need lot more focus on trying to lead a good life than just collecting enough resources to get there. A lot of thought needs to go into how to make the life interesting, fulfilling and long-lasting. This needs physical, mental and social health as a hygiene factor. Over and above that you need a bit of luck but more importantly, a lot of focus and thoughtfulness. How you handle small matters as well as large will have a lasting impact on what life gives you back. Of course taking it all too seriously may erode the fun anyway. But that said, it is no excuse for letting life just happen to you!

Monday, August 20, 2007

Stock market volatility and the long term investor

I have always thought about writing on this topic. But now seems to be an even more appropriate time to do so. Last few days in the global stock markets have been depressing. Indian stock markets have also reacted with hi-fidelity and nosedived into lower values. Suddenly people are waking up to the risks of equity investing and all the talks of bubble have come back to haunt them.

How should a retail investor react to this melee of events and opinions? I classify retail investors as being distinct from institutional ones on account of the simple principle that the retail investors do not have equity investing (or any investing for that matter) as their day job. They invest to grow their wealth.

To start with, I would like you to ask yourself a question. Why have you invested in equity? Is it because everyone else is making so much money out of it? Is it because that seemed like the right thing to do last year? Is it because you are building a long term corpus and are trying to get higher returns? Is it because it is a good hobby to have and you get a kick out of the ups and downs?

I am addressing here the concerns of the investor who has invested in equity as an asset class to build his wealth over long term. This long term in my view is longer than 5 years at the very least. I am not trying to run away from answerability in the interim. All I am saying is that the arguments below make sense only for this horizon.

When you buy a stock, you essentially buy a piece of a company. Why would you do that? Because at the price at which the stock is quoting in the market, you believe that the company is worth as much or more. And how do you infer that the company is worth more or less? In traditional asset pricing models, you will discount all future dividends from the company and thus arrive at a fair price. You can add to that other valuation models and triangulate your findings regarding the right price for the company. In light of this, why should there be a price variation in the market price of a stock?

That is because individual investors have different opinions of the company’s value. To keep matters simple, if you assume that all investors are using similar valuation techniques and have similar values for risk free rate and risk premia, the primary difference of opinion would come from the degree of faith each investor has in the company’s future. In theory, all the investors have different price points for a given company they partially own or wish to own. This creates the demand curve and supply curve for a company’s stock. The prevalent price is one which matches the demand with the supply of the stock. The stock prices move on account of various factors. To start with, let us focus on just the company. This means the stock market has only one stock which investors buy and sell. If things do not change from one quarterly result to another, the stock price would not move at all. However, real life is never so still. So when there is any news that might have an impact on the company, investors alter their expectations and thus the price they are willing to pay for the company. This shifts the demand and supply curves. The demand curve is built by those who want to own the stock while the supply curve is built by those who do own the stock. A given investor can of course be on either side at different price points (assuming she owns the stock or shorting is allowed).

Now, the news shifts the demand supply graphs and the intersections leads to a new price discovery.

Now add to this the fact that there are a multitude of companies. These companies all trade on the stock market and are individually priced as per their investors’ expectations. At this stage, the other factor that enters the picture is the correlation of the stock price of different companies. Since the investor can hold different companies, she no longer needs to take as much risk as she took earlier with one stock. Without getting into the complexities of the arguments, it suffices to say that the presence of other companies and a broader market allows investors to reduce their risks from a single company. Hence they might be willing to pay higher for a given company all other conditions remaining the same. All it means is that the discount rates used for the valuing a company can become more lenient if the investor is diversified.

This hypothesis makes an even bolder claim. It goes further to say that not only the investors can reduce the risk and price assets better, they actually have to do so because those amongst them that hold the market portfolio can effectively price out those that don’t. Everyone is forced to either diversify and hold the asset at a given price or is left to live with uncompensated risk in a single company (since the agreed price in the market for that asset does not account for the individual company risk).

That apart, around this time, another element that enters the picture is the sheer complexity of the impact various pieces of information can have on the market prices. That would have been all right if it was not for the emergence of another group – namely speculators. The speculators are not betting on what the company is fundamentally worth. More often than not, their interest is primarily in benefiting from the impact a certain piece of information can have on the market price. If the central bank is likely to reduce rates, the speculator would take huge long positions in the stocks affected positively by the rate cut – housing, automotives etc. She is not keen on valuing the companies fundamentally and thus owing them as an asset. All that matters to her is how the fundamental investors are likely to recalibrate their expectations in light of the new information.

The speculator has been the centre of controversy for various reasons. I do not wish to pass a value judgment on the philosophy. All I wish to point to here is the fact that the presence of the speculators adds to the variations in the market prices. It is compounded by the fact that various groups of speculators play the expectations game from across the globe on a more real-time basis than the fundamental investors do. The speculators interest is in second guessing how price revision would take place in a given asset – it matters little what the specific price level is, the direction and amount of change is more relevant. Often enough, in the process, the fundamental buyers of assets are pushed aside and the stock market becomes predominantly a meeting place for speculators betting on the impact on various events. They become a self-sufficient ecosystem because there are enough of them to bet on either side.

All in all therefore the stock market is combination of the market for the assets and market for betting on the price variations of these assets. I do not wish to denounce the latter. I would like to point out however, that if you wish to use the stock markets for fundamentally investing in equity as an asset class for wealth building, you need to acknowledge the presence of the speculators and learn to live with it.

How does one do it? It is straightforward really. Consider investing in the broad market index for instance. You need to estimate the rate at which the corporate profits of listed companies are likely to grow. For today’s India, starting with 8% real GDP growth expectation in next five years, we can estimate the nominal GDP to grow at 12-13% (with 4-5% inflation.). If agricultural growth is 4%, manufacturing and services will have to grow at nearly 10-12% to make the overall GDP growth 8%. Hence the revenues of the manufacturing and services industries will grow by 14-17% in nominal terms. If I were to make two simplifying assumptions that these are a proxy for the listed companies and the productivity growth is nil (so revenue growth is same as profit growth). Considering the upper hand larger listed companies have in garnering the fruits of growth as also the sharper rise in profits than that in revenues, both of these assumptions are conservative at best. All in all, we can expect the listed company profits to grow at 14-17%. That would be your first guess for the growth in the value of your equity holdings if you are going to hold the index. Similar analysis will apply for individual companies.

Where does the speculator fit into this? Well, she is going to speculate that the sub-prime debacle in the west is going to unnerve the FIIs and hence lead to general meltdown in prices. She is also going to bet on the monsoon’s effectiveness and the prospects of the central government and mid-term polls. She might make a killing by getting some of these right as also lose her scarf (losing shirts might be rather embarrassing for women) in getting some others wrong. You on the other hand would keep going to work at 9AM and return home at 8PM and watch some reality TV show with your family and sleep in peace. Five years hence you will take stock (literally) and find out that you averaged 18% year on year (not bad!) or 9% year on year (could have been better!) or some such number.

The difference lies in the way you look at the investing process. Speculation is betting of the sort you will do in horse racing or cricket. Asset purchase is of the sort you will do in buying a house (for renting out). The assumption in asset purchase philosophy is that you do not mind holding the asset for eternity if you had to. The idea is that the asset will generate cash flows enough to justify your purchase price. In practice the presence of liquid stock markets ensures that should you get a better price or change your expectations of the cash flows from the asset or simply need cash, you can offer the asset to some other buyer at a mutually agreed on price. The difference between you and speculator is that the speculator would never purchase an asset with the understanding that she will hold it for eternity if required. Her hope is that the price of the asset will increase because changes in the expectations of the asset buyers or other speculators.

Wadala, 19 August 2007

Saturday, August 18, 2007

Black swan and epistemology

I have bought the book named Black Swan by Taleb and am reading it thesedays. The interesting aspect so far emphasized upon in the book is that we know far lesser than we claim to. The experts are no better than a well organized storage of parts of human knowledge.
The knowledge itself is a small section of the total reality. In any case, the great minds have always claimed that they know only a much smaller sliver of the reality than appears to an untrained eye. I used think that this is their humbleness and it is generally fashionable to make such deep sounding statements when one has intellectually arrived in life. But the more one thinks of it, more one realizes that they are right. It is almost like, the horizons of the reality around you keep expanding as you know more and more of the world. It is not static entity of which you can keep knowing larger and larger proportion. The true reality if any is very highly uncertain. Even in theory i do not think it possible to be able be gauge the extent to which we as humankind have managed to approximate The Reality.
That leaves us with this limited version of reality and our limited understanding of that limited version. In this context JBS Haldane's comment suddenly stops looking like yet another unintelligible profundity and becomes more like a statement of fact.
"The Universe is not only queerer than we imagine, it is queerer than we can imagine". This is what i mean by the double layer of the remoteness of our models of reality from the reality itself. First of these layers is our limited version of steady state reality that we hope to achieve and second of these layers is the extent to which we approximate this limited version itself.

Where does that leave us? We as human beings have always had many roles - which increasingly got split over time as society evolved. I guess in early days, the same individual who gathered food and protected his family did not have much of time left to ruminate about how much he knows of the ultimate reality. Nor did he probably have very crystallized urge for the same. However, one can't rule out any urge in this direction altogether. Otherwise, we would not be thinking about this today.

The complexity of human mind in today's days is a curious combination of the survival instincts that brought us thus far in evolution and the not-so-directly-relevant-for-survival urge to know more of our surroundings. To be sure, not all of us share it. A vast majority goes about the survival part pretty much without the need to understand universe around them. This is not to pass a value judgment on them. It is just to say that even today, despite the split of roles which enabled some of us to think of such higher pursuits, we have a limited understanding of the true nature of the universe around us.

Black Swan claims that the issue which is emerging now is the misplaced arrogance of the seekers of knowledge. The experts are getting smug and have lost the humbleness of the previous generations. Is this a structural change? If so, it would mean that for a long time to come, the limited resources mankind employs in seeking higher knowledge would be restricted in the ideas they are likely to fund/support. Are the mainstream knowledge explorers becoming prisoners to their own attitudinal limitations? Is there any way we can transcend these limitations?

Another more demoralizing possibility is the physical limitation on the human brain in terms of what all it can manage to imagine and thus explore. In quantum mechanics and relativity we have managed to transcend the boundaries of our natural intuition regarding objects (e.g. the particle wave duality is impossible to imagine for us, though we believe in the theory). I cannot fathom how far this can be stretched. And as we go farther from the intuition, how reliable are our theories going to be? The instruments we use to support our claims have their own limitations. Thus in turn, in the domain of knowledge of the physical aspect of the world, our instruments of experimentation are going to limit the boundaries of our knowledge. On other fronts such as dealing with the non-physical aspects of the universe, i am not sure what can be relied upon if not intuition. How can we refine the processes of knowledge gathering without relying on the intuitively appealing concepts? Is there a mental equivalent of the experiementation instruments which can come in handy to test several theories and claims of modern epistemology?

Wednesday, August 08, 2007

Too much of laisseze faire

Having read the comments of several champions of the market economics and laissez faire, i have come to grow a little weary and wary of their arguments. Government is bad at this and worse at that and leave to the markets, individuals, entrepreneurial initiatives and so on. I am not a fan of interventionist government. However, i do not think the answer is in saying that let there be nothing instead! Of course several sections of the economy would like to be left alone today - to their wishes and fears and greed. I do not care if stock market tanks. Though if interest rates are going to go up because the mad rush of capital in my country has led the RBI to tighten money supply, and that in turn increases my home loan EMI, i am bound to be justifiably worried. Who wants this capital? Is it creating the value it was expected to? Or is it yet another ploy of the proponents of laisseze faire to blind me with arguments of market efficiency being in the best interests of all in the end?
I do not know the answer. All i am saying is that we need to stop saying "leave the markets alone and the market forces will take care of everything". They will take care of a minority of established interests and probably few lucky ones new to the system. Apart from that it seems like a novel system to perpetrate the existing inequality under a new guise. If we have overcome the shackles of state dominated socialism with so much effort, it is not for letting the aristocracy of the capitalists to take charge instead in the name of efficiency. As participants in the economy, the masses need to understand that the ideologies are just that. Finally, everyone is going to be driven by self interest and unlike what the market proponents claim, it does NOT result in a socially optimal solution. The only chance we have is to transcend the ideological boundaries of being in the capitalist camp or communist camp and really take on the basic question of maximum happiness for maximum number of people. The ideology should then evolve from that and not the other way round.

Sunday, August 05, 2007

The Limitations of Capitalism

Capitalism broadly stands for the system of beliefs in efficiency of self-controlled markets. The central tenet of capitalism seems to be “leave the markets alone” to the extent possible. The expectation in turn from markets is to send the right signals to right parties and to allocate resources in the most optimal manner. It is possible to debate in detail the shortcomings of this expectation as has been often shown empirically. However, I do not wish to expound on market failures. Because a study of market failures starts with the underlying assumption that markets are expected to work everywhere and then we are studying where they did not. My disagreement is with this belief. I am revisiting the more basic question of the mechanism of resource allocation.

What has prompted this is the two sided worry of the misuse of this system by the capitalists and the inadequate attention the underprivileged get in even a well functioning capitalist economy. On the former, the answer from the believers in capitalism is often in the form of regulatory frameworks built and run by the state. The response to latter is that the capitalist societies have often proven to be less hostile in treating the underprivileged than any other system. Both of these are attempts to arrive at solutions from within. However, my intuition tells me that the fundamental forces at work in a capitalist society are very likely to make both of the above basic flaws in the capitalist system and not merely ineffective operationalization of its principles in specific contexts. Take India for example. The advent of capitalistic orientation in policy making has certainly resulted in great many developments. License control raj is receding. There is greater common good being served by competition amongst private enterprises and at times even public ones. Now the question is how reliable is the hope that the effects of these developments are finally going to trickle down to the downtrodden. Also how real is the hope that eventually Indian enterprises are not going to behave like Enrons of the west. Over and above all of this, there is growing concern that materialistic progress alone will leave us as much at the risk of loss of purpose as today’s west. Can we look to evolve a better system of governance and socio-economic organization? Can we target the right parameters as measures of our success? Can we make the growth to developed country status an endeavor broader than one limited to upper middle class?

Why have markets failed India’s poor? The opportunity at the bottom of the pyramid is too risky and the risk return trade off at the top of the table is much more alluring. The enterprise with its focus on making profits can do so very well near the top of the pyramid. Only those with some dependence on bottom of the pyramid populations are making any active efforts in that direction. For others the charity through CSR is enough. There is huge amount of money and resources being deployed at the top of the pyramid in catering to the needs of the well off while the poorer sections are left without even most basic of services. Market failure anyone?

Markets will not get there. Not in the current form. The farmer suicides are an example. The revolutionary tides from the poorer sections will probably sweep the top of the pyramid sooner than the trickle down can take effect in an appreciable manner if at all. The ecosystem of the modern day economic relationships in India is very much in favor of the established ones. It also favors the gifted individuals from amongst the poorer sections. However, the large majority with little extra-ordinary talent can take or leave a limited range of options. You can do white collar jobs or take up a blue collar job if you are in the city. However, if you live in village, you can try your luck at agriculture or a small local service sector or else join the daily laborers bunch. If I am to be a profitable enterprise, I have to make the laborers work at the minimum wages possible in the given demand supply scenario. By the looks of it, the labor supply in India in the unskilled sector is going to be fairly large for a long time to come. Given this, it is unlikely that the real wages of Indian laborer in village or in city will rise in a big way. On the other hand a small section of the lower middle class is moving up through exhibition of its skills. I belong to this group. I have come much farther than any of my cousins. They send me their CVs to apply for jobs which are lower end of the white collar ones or at times even the blue collar ones. The markets have little to offer them. My services are useful because of my extra-ordinary IQ. They are not in demand because what they have on offer is rather freely available. Market has not obligation to create opportunities for them or the others who do not even know what a CV means. Market economics would generally put the argument as follows. Over time, the GDP growth would require workers in larger numbers and that would lead to increase in demand and thus higher employment as well as growth in real wages. The standards of living of these laborers will improve because the rich and poor alike would want more goods and services. In the end everyone is better off than status-quo. Agreed. However the comparison is with the status quo. I can compare it with an alternate scenario where the income distribution is such that it brings about highest amount collective utility.

This gets into the question of the relationship between consumption/resources and utility. The general theory I wish to put forward is as follows. Below the poverty line, utility and consumption/resources are directly proportional. As an individual moves up Maslow’s Hierarchy, her needs evolve and non-consumption factors enter the picture. The relationship becomes somewhat non-liner. In this phase, more consumption or asset ownership may not necessarily bring about higher levels of utility. However, for individuals in this phase, the first derivative of income and assets has a more direct bearing on the utility levels. “Moving up in life” has a stronger impact on utility levels than the absolute level of resources and consumption. There is point beyond this level where the consumption and asset ownership becomes merely a hygiene factor and the utility levels are driven very weakly by the change in the resource level. Very many other factors enter the picture the linkage is nearly lost. What one can claim with some degree of certainty is that this section of population would be miserable if it gave up its wealth but the wealth per se does not add to its utility levels much.

The marginal utility of money is more directly observable and shows clearer trends. The poor of course have the highest marginal utility for money while the richest individuals have close to zero marginal utility for money. Unless it occurs in really large chunks, few more extra rupees are not very relevant to the richest individuals. This probably would apply in % terms as well.

Given this, the market will in all likelihood create a rather sub-optimal outcome in terms of the potential utility levels achievable with the given level of resources and the actual ones realized. The actual state realized, even if is the utopia described by the market enthusiasts, will still have large income inequality and instances of extremely divergent marginal utility of money within the system. What the utopia manages to achieve effectively is a beautiful machine which is probably stable, very elegant in its operations but has unhappy cogs with little choices but to be part of the machine. The market system can in its simplest form have say 10 companies providing goods and services to the economy. These companies employ 90% of the working population while the remaining 10% own the companies. Depending on the relative scarcity of labor and capital, the owners will earn more or less than the workers. If history is any guide, the owners will earn lot more than the workers since the owners always have an option of working should they realize that they earn less as owners. This system is stable. But assume that the labor supply is such that the real wages are 1/100th of the return on a unit of capital for the owner. In essence, the owner can spend her money in spas and collectible item purchases while some children in the remaining 90% could be dying of malnutrition. The rich owner can once in a while have some pangs and pay for a few kids’ food and education and donate to some trust somewhere. The general trend however remains that the laborer is selling her time and skill and will get a price from the capital owner in line with the demand supply dynamics of the market. While the market may be a good answer to the general price discovery, applying the same principle to the incomes of a large majority of individuals participating in the market is flawed.

Market implies that the owners treat employees indifferently and strive to make a profit by offering goods and services to customers. The market economy is a well oiled machine to get the manhours from the employees, the capital from the owners and put it together to create goods and services which people in turn pay for out of their returns on time and/or capital. The system does seek stable optimality. The issue is that it seeks a systemic optimality which seems to be an end in itself. It ignores the individuals which are the whole point of it anyway. It is also structured too much in the manner of buyers and sellers – which in the end does not always lead to a socially stable and optimal result, when viewed in terms of utility. It is a system very much in favor of capitalist today since the stage of socio-economic evolution that we are in is characterized by a strong tilt of balance in favor of capital. Maybe if the tables were turned and capital was too widely available and labor is scarce, the returns on labor might exceed the returns on capital. The point however remains that the results of the market mechanism are always a good result from the point of view of systemic optimization. It does not incorporate explicitly the fact that ultimately the economic system is a means to an end which is furthering human happiness. It is a marvelously stable solution to an optimization problem that human economics is. Whether it is human enough a solution is unclear.

Monday, July 30, 2007

black swan

The recent release of the book named the black swan got me thinking about the whole deal about induction, scepticism and the lot. What the intro of the book talked of is how we mistake the map for the territory.
Our evolution has programmed us to try and make sense of what happens around us. That however puts a certain limit on our ability to fathom some elements of existance which do not lend themselves to routine thought frameworks and are not crucial for our survival.
An example is quantum mechanics. We have there a system of thought in which we are not using intuition or analogies from sensory world. The ideas are mostly abstract and rarely can be "pictured" in the traditional sense. Now is the faculty of thought that held us in good stead so far become a limitation?

Thursday, May 31, 2007

Of Power, Purpose and Achievement

From early on, I have wondered what would constitute success. Also, what would make a good purpose in life. Having wondered as much I have given a deep sort of thought to purpose and have concluded that purpose needs to be manufactured. If you are not capable of doing it for yourself, someone else or something else will do it for you. It is covered in greater details in one of my earlier posts.
Yesterday, I saw a movie - Shootout at lokhandwala. It appears that a lot of people claim to have a lot of power on account of various tools - weapons, connections, intelligence, position and so on. I could not help feeling how neat it would be to be "powerful". And that feeling I guess in its amplified manner is what drives the so called hunger for power. Noone quite knows what power is - though i presume a lot of powerful feel so and that is how they know it! From outside, it might appear like a trivial or at best less relevant thing in the scheme of a higher human society. We are nowhere near a higher human society and here and now, the power is what matters.

Then i remembered the discussion i had had with my brother on the way to nasik few weeks back. We agreed that the meek can only act in groups and a visionary has to either wield power or have leverage with the powerful to be able to put his/her vision into reality. We were of course a little confounded by the obvious concern that in a bid to attain that power or leverage, the visionary stands a very strong chance of losing his/her vision and get into a endless pursuit of power! The visionary needs to stay uncorrupted despite being in the dirt and playing with it - at least as long as is needed to make him powerful enough to be outside it and yet influence it.
The philosophical rumination can of course be if it is fair to the visionary as a sovereign person. What a person desires at a given point of time is his wish! And so if the visionary has turned corrupt, that is because he wanted to and all is well at least on his personal front.
That however, is cheating with the person that he was when he started out. So i guess it a inter-temporal unfairness of the same human being (is it?) which may make a case for the visionary trying to stay so all along. But that apart for the society and civilization it is always better if the visionary stays so - to a large extent that is.

How would the visionary's program look like towards such a goal? ie. getting to a position of power without getting drunk with it. How does one maintain the spartan view of the world while still being the mover and shaker of things big? How does one build a vision strong enough to last a lifetime?

Friday, May 25, 2007

Yuan and Dollar

Much has been debated about how yuan is undervalued vis-a-vis dollar and how that is a subsidy enjoyed by Chinese exporters. Economist this week (America's Fear of China) has a very insightful article on the same. It claims that the yuan undervaluation claims are shaky at best and their impact of US economy is overrated.
The crux of the matter is that US consumers will replace Chinese goods with some other country's even if the yuan is "correctly" valued and the issue lies more with the American consumerism and low savings rate rather than the yuan dollar exchange rate. It goes on step further and claims that appreciation in yuan is good for chinese economy which is reeling under the pressure of having to maintain the exchange rate where it is - in the form of having to keep low interest rates despite break neck speed of investments (else more hot money will flow into the economy), which leads to suboptimal investment decisions and eventually NPAs. I wonder if the Chinese banks are sitting on huge piles of potential or actual NPAs.

Where Chinese stock markets may go is an entirely different story. The anecdotes of retail investor frenzy are scary. I don't know if it is one off instances or a general trend. If latter, there is a lot of heartburn likely at all levels of society as and when the stock market correction takes place. And what with Greenspan passing his value added CP on markets across the globe!

Exchange rates, monetary policy, real and nominal interest rate and finally the real GDP growth rate make up an extremely interesting and relevant matrix of variables - all of which closely govern our lives - directly or indirectly. I guess the complexity is only going to increase with time as more markets open up to the ever increasing stock of capital! In the steady state one may expect either the monetary policy or exchange rate policy to become entirely irrelevant - some sort of global eurozone!

Overheating, Exchange Rate and Real GDP Growth

The recent debate in India over the inflation vs growth led me to probe the topic a bit deeper and find out why China continues to enjoy low inflation rate, high FDI inflow, high current account surplus and high GDP growth. Their overheating occurs at 11% while ours starts at 9% itself. Why is that so? Considering the huge inflow Chinese economy has in term of foreign capital, and the fact that yuan is kept down artificially, how come they do not have the issue of inflation on account of money supply growth?

The answer lies in rate of real GDP growth. Inflation is the difference between growth of money supply and growth of real GDP. To some extent these two have different drivers. Money supply for example can grow due to govt spending using printed money, foreign capital inflows and increased lending by banks domestically. Real GDP grows on account of investment and consumption. Hence there are no obvious reasons why money supply should always grow any faster or slower than the real GDP. Given this, and a similar rate of money supply growth, an economy with higher real GDP growth will be able to accommodate more of the money supply increase than one without. This to extent explains why Chinese inflation remains low despite the strong build-up of forex reserves, while India is forced to choose between inflation and exchange rate - because the expected money supply increase by holding exchange rate constant will lead to excessive inflation.

The question is not inflation vs growth - it is a choice of steady state real GDP growth rate that we want to run with. If we run with 10%+, we will need to worry much lesser about the exchange rate because we can build reserves with the surplus and hold the exchange rate low without causing money supply growth in much excess of real GDP growth. On the other hand, if we stick to a lower growth rate of 8%, we will be forced to choose either inflation or exchange rate - and in choosing inflation control and letting exchange rate be, we will reduce the export growth. China has mastered the art of exchange rate control without inflationary worries. Since Chinese growth is 10%+, they can hold the exchange rate low, let the money supply increase at 3-4% above real GDP growth and then further sustain the GDP growth on account of exports and sustain the FDI inflow on account of investment demand.

The solution: attack supply side bottlenecks on priority. Channelize foreign money inflow into infrastructure growth - and do it very very very aggressively. Also let the inflation be where it wants to be in the short term and target exchange rate instead to bolster exports. As the supply side infrastructure bottlenecks ease and industry invests in capacity and the economy starts exporting significantly, real GDP growth will climb up easing the inflation pressures in a manner far more sustainable than increasing interest rates and squeezing credit supply.

I fully support inflation control through increased supply of goods instead of controlled demand!

Linkage between Indian equity market volatility and capital account openness

I recently read a simple but powerful idea about how the hot money really affects emerging markets. At some level the well informed people tend to know this. But the actual numbers put together make it quite stark.
The emerging market cap as % of total global m-cap is less than 10%. India in particular is not more than 2-3% if I am not mistaken. Now, the world has been a quiet place for some time now (financially speaking). And post 9/11, on account of two factors, global investors have been more courageous in investing.
First of these is the slowdown or lacklustre performance of developed markets - especially US and Japan. These markets are not only giving very meager returns, they also seem to be structurally stuck to a sub-10% returns regime. Coupled with this, the investors are increasingly more organized in the form of mutual funds, pension funds, hedge funds - across all sections in individual and institutional domain. This has led to a hunt for more attractive returns. The traditional fears of investors were overcome by the other strong motivator of greed and they looked increasingly to the emerging markets - mostly in east Asia. Add to this the perpetual money mining machine of Japan which is churning out low cost funds without a very strong appreciation of its currency. Last but not the least is the emergence of petrodollars in every rising quantities. Considering the fact that oil production costs have not gone up by anything close to the appreciation of oil price, one gets a sense of enormous rents that the producers are collecting. The money needs to go somewhere and it is as much on the prowl for good investment opportunities as is the Japanese and American money.
Second factor is the relative stability and robustness of growth stories in the emerging markets. China has never looked better and now has 20 years of performance record to back it. India is looking like the next China (in terms of growth rates - not much in the details of growth drivers), South-East Asia looks like it has recovered mostly from the 1997 crisis and buoyed by oil price, Russia is not a bad idea either. There are of course numerous others which have been rediscovered including East Europe, Australia, Turkey, Brazil, Mexico and the like. Point is - the emerging markets have never looked better than this.
Bottomline: There is a lot of money looking for good investment opportunities outside of their home country and then there are lot of good investment stories around the globe.

So far so good, but there is a catch in the details. The relative sizes of these two domains - developed markets and emerging markets - are quite different. As mentioned above, emerging markets are a small fraction of the developed markets in terms of m-cap. In new asset classes like real estate, the skew is even starker.
This leads to the scary prospect of hot money wrecking the markets in a crisis. Picture this. In India, the listed companies post a good profit year after year and look like they are going to continue their good run for a while. The economic fundamentals are sound and the country looks a good investment story. The global investors flock to India and invest say 5% of their portfolios in India. This however, amounts to as much as the the existing market cap of Indian companies. Thus the inflow ends up doubling the sensex over 3-4 years. All good!
The trouble comes when there are signs of slowdown. A global crisis - US attacking Iran or another 9/11 or BoJ increasing interest rates - may reduce the risk appetite of investors who would look to pull out of risky securities and park money in the safe havens - gold, (oil futures!), US bonds, US Bluechip stocks et al. The same 5% that entered the country (or a good part of it) would want to leave. Yet again, it would be nearly 50% of the total m-cap (or 30%, but large nevertheless). The markets would tank for no obvious reason (at least internally or fundamentally). Infosys might grow a bit slower and HLL may sell a bit fewer soaps - but their profits would not fall by anywhere near what the valuations would fall by. Why? Because though the fundamentals of the economy remain strong, the investors have chosen to reprice risk and thus now prefer to stay out. Also they want to stay out of risky assets till the storm withers away! They will come back with as much or money to invest once it settles down a bit.
The problem is that they will again bring money enough to double the sensex. And the cycle would continue till such time Indian market becomes say 10% or more of the global market.
Think of it like this - your financial advisor tells you that you should invest in mid-cap mutual fund given your risk profile. You do so. Then election year appears and things look a bit shaky. Your advisor is back and is now telling you to hold off more investments in mid-caps and in fact reduce the existing exposure as well. You would see the logic of this very clearly. And in a similar manner, the global investors agree with their advisors when they pull out of or invest in emerging markets. We - in India - are the world's mid-cap!

Why Alternative Investments for Indians?

Just as the lower end of Indian investors (more like savers actually) used predominantly debt asset class, the higher end stuck to a combination of debt and equity. Over time, real estate also found way as a stable and "real" investment avenue.
All along, however, the investments were exposed to the same set of drivers in terms of value - interest rates, economic growth, monetary policy, exchange rate.
The Indian investor is now waking up to the potential of alternate assets in providing truly diversified returns over a long term. The word truly is based on the observation that within equity markets, you can only do so much of diversification. After all, most of the stocks tend to move together, if you actually draw up the correlations across blue-chip stocks, you are unlikely to find many low correlation options. In the domain of diversified funds, the correlations are even higher.

For an investor willing to take on risks, there was not much of a choice beyond equity till recently. However, increasingly the asset classes such as private equity, venture capital, gold (and other commodities), real estate (more through professionally managed funds) and even hedge funds are catching the attention of investors and investment consultant alike. The reason is straightforward, these asset classes have very low correlation with the traditional asset classes like debt and equity.

One reason for this low correlation is fundamental factors driving the asset prices (in case of commodities and real estate) and in some cases the reliance on the fund manager's skills to generate returns. The different between the mutual fund manager and hedge fund manager is that a large part of the former's returns are explained by the market movement whereas the latter strives to generate market neutral and absolute returns. Likewise, private equity fund manager tries not to diversify away the single stock risk but actively seek it to maximize his returns - his fortunes though somewhat linked to market, are not dominated by general stock market movements (unless they are extreme). The movement is clearly towards skills based return generation.

The trend is similar to one seen in the developed markets. As of now, the developed markets have debt returns not more than 5% at best and the equity returns of 10% are considered quite acceptable. The promise of active fund managers to deliver returns above this has drawn investors to park part of their risk capital with these growth opportunities.

As the Indian stock markets growth numbers come more within the usual ranges of nominal GDP growth + 5-10%, the Indian investors will also start seeing greater value in
seeking returns beyond the market - not above or below but simply beyond. So that they have a return generation avenue independent of the markets.

Alternate investments reduce risk of a given portfolio for a given target return rate. Seen from other side, they increase returns for a given level of risk. The basic argument is built along the lines of efficient portfolio frontier. The more diversified the portfolio, the lesser the risk. The diversification can happen at multiple levels - asset class, geography, within asset class and so on.

The quest for efficient investment management will lead people to seek newer avenues of making the best of their money. Alternate investments of today will become the mainstream of tomorrow and there will be a new set of "alternate" investments! So is the story of economic growth!

Saturday, April 07, 2007

Capital - and the imminent oversupply of it

I often wonder what will happen to the ever-growing stock of capital in the global economy. I mean, it is one thing that hardly decreases if at all and through professional management is generating more returns than ever before. Especially in a globally integrated economic order, opportunities to generate decent risk adjusted returns on capital are likely to find a lot of takers. With the integration going up with time, often aided further by technology and the zeal of professional fund managers to locate new opportunities.
I am not exactly worried but am just curious about what may happen to this huge stock of globally mobile capital. Will return on capital inevitably come down as a secular trend. Companies will increasingly run out options to invest and will hand over the extra cash to shareholders who would not need much of it for consumption and would invest it elsewhere - only to be told that there are not many opportunities there either. Inevitably they will settle for lower returns and the cycle would continue - till such time that the capital is almost freely available and no-one really has an incentive to postpone consumption. People will save only for rainy days or contingency. Capital will be held by mighty corporations which will jump at any opportunity to generate that 1% return. There would of course be not much of investment. Is this likely?
Or is it that the cost of capital - though it would come down - would never go below a certain level. Savings rate globally would drop but people will still save in large absolute quantities since the incomes will be much larger. The investments would then only be in technological upgradation and productivity improvement since in this world there would be equilibrium in terms of what it produces and what is demanded. Can it ever happen? Can the thirst for consumption be fully satisfied? Will organizations try to generate consumption demand to sustain their growth? Or will consumption shift to higher margin higher price activities such as leisure, spiritual upliftment etc?
My take is that the manufacturing sector would reach a steady state - with little investments required save new technology. Services will stabilize at a higher level. And then there would be a race to innovate businesses and services which satisfy needs of the next order. Consumers will have moved to much higher levels of maslow's heirarachy.
Even if that be the case, it would be driven by services which will be very capital light. So where will the capital go?
Unless major space expeditions are taken up, there does not seem to be much of use for it, does there? In fact, an excess of capital itself could bring in the age of space expedition as a business!!!

The much hyped asset bubble and flawed monetary policy of RBI

Indian economy thesedays is characterized by a quiet revolution - growing investments, growing confidence and growing aspirations. There is - almost as a byproduct - much talk of an asset bubble. A friend of mine summarized the underlying feeling behind this bubble to me the other day - "I feel uncomfortable with the slope of growth curve". This to me seems the primary driver of the perception of the so called asset bubble in India today.
Nobody is quite keen on examining the fundamentals. And of course with selective perceptions there are always events to justify one's stance. My personal observation is that the talk of bubble is stemming from the inability of most Indians to deal with their country's potential. It is the inherent discomfort with non-linear growth however robust it is. One such Indian also happens to be the governor of the reserve bank and has used his power to revise downwards what has been a fairly robust growth story.
There has always been much of comparison between india and china. A key difference often cited is the difference in the governance model. In addition to that, i believe there is a deep rooted difference of attitude. Chinese attained 10% growth sustainably over the decade partly on account of the reforms, partly FDI and partly the sheer confidence to bulldoze growth through resistance to it. Indian policy makers on the other hand get fidgety if growth numbers start to look above their mental blocks. 9% is enough, now let us focus on inflation instead - is the wisdom. Very counterintuitive to me. India has tried the license permit raj for long enough to know that growth is the starting point of any hope for elevating millions of its populace out of poverty. The desperation to control inflation looks more politically driven than by sound and ambitious policy making. India was just poised to break free of the lower orbit growth rate of 6-7% and move to a much useful 10%. But 1% too much inflation was enough to rattle our policymakers into slamming the brakes on a decently accelerating car. Cowardly by a long shot.
The issue is that the growth impact takes much too long to show its benefits while inflation bites much earlier. And makes politicians lose elections as well. I would not be surprised if the real wages have indeed remained constant and have in fact gone up during last three years. If that be the case, who is really worried about inflation - especially if it is tiny 1% more than the "comfort zone" - much arbitrarily defined. Agreed, too much of inflation redistributes wealth - typically against the poor. But reducing growth is making everyone pay as much or more price. It is the age old mantra of keeping everyone poor in a bid to increasing equality. I do not care much about equality. I worry more about the absolute standard of living of the poor. If that is above say Rs. 5,000 per month per person, I am ok with there being a hoard of rich who are getting richer.
Indians can be blamed for complacence - especially now when they should have demanded much stronger reasons (than inflation control by 1%) for putting unnecessary and counterproductive brakes to the economic growth.
8% is good enough for us. 9% is a bonus. 10% is probably too much. Here is where Chinese differ. I presume their policy makers would be saying, anything below 10% is underperformance. It really boils down to the attitude. If you do not feel like growing at 10%, you probably never will. The issue is that the ultimate price for your suboptimal attitude is paid by the millions of unemployed or underemployed who could not find enough work in your low inflation economy!
We have cheaper food, but no money to buy it - problem solved.

Monday, January 01, 2007

brain, emotions, neuroscience

Is there more to emotions than synapses?
Can emotions be brought about by altering things chemically? In that case, can we actually ensure happiness perpetually if neuroscience progresses enough? As in, can their essentially be a pill for happiness?
another one for removing fear, another one for controlling anger? I guess the anti-depressants etc are extreme forms of the same? However, like vitamin tablets, can there be pills for the healthy people, to be taken daily?
The debate may well ensue that this is "wrong" since it would be tampering with nature and interfering in something which is functioning well on its own accord?

but i do not agree with this functioning well. As we have progressed as a species, we have still at loss when it comes to being happier than we were an unevolved animals. We have interfered enough with nature when we have built shelters from concrete and steel and when we have prolonged life expectancy with medicines. This was done to reduce pain, to make people happy and to explore further in life. Then why not go that one step and also attack the problem at its base? As in, when we "feel" happiness for something, why focus on getting the thing rather than just altering chemicals within the brain to get the happiness directly?