EUROPE: MIND ON THE MARKET WHILE CHARTING A BETTER WAY FORWARD

Posted on April 12, 2015. Filed under: Uncategorized | Tags: , , , , , , , , , , |

In the immediate aftermath, by agreeing to buy Euro 60 billion worth of public and private securities on a monthly basis until September 2016, under its recently launched quantitative easing ( QE ) program, the European central bank (ECB)  has quite clearly distorted the market. Also the initiative has given once in a life time type opportunity to Euro area countries to get their fiscal house in order by borrowing for longer duration and at a record low cost without being able to provide  or required to provide any fundamental justification to the market. And also by showing a willingness to buy European governments debt as low as minus 20 basis points, the ECB is probably attempting to harmonise the cost of borrowing of the EU states. So as a consequence, we are now living in a reality, where Portuguese and Spanish 10 years sovereign bond has a lower yield  than a U.S. Treasury of the same duration.

While the benefits of the QE to the European governments can’t be understated, European financial institutions from the likes of an insurance companies or a pension fund etc, who rely on investment returns to keep their business model sustainable will most likely have to reassess, or redesign their investment model factoring the new reality of low and negative yielding sovereign debt.

The ECB is clearly aiming to push investors out of what is considered safe haven assets, but investors could also opt to very well sell the Euro denominated European sovereign bonds, and instead buy US treasuries as ECB has very limited control over how investors will allocate capital, and the overall directional flow of the capital. Non European companies with stronger balance sheet could also benefit immensely by borrowing at very low rates in Euros, and there are ample evidence of that happening already as more and more companies flock to Euro to raise capital. So there remains an inherent risk with the approach, and capital will likely flow into various asset class outside of the Euro area.

Also in the last couple of years, a sizeable portion of the profits made by euro area based banks came from their sovereign debt holdings, and in the current environment, it will be interesting to see what sort of impact the change in dynamics will have on banks profitability. Although the banks are comparatively in a much better shape than few years ago, they are still struggling to make good money from their traditional day-to-day business.

Going forward, the QE initiative of European Central Bank (ECB) should improve the overall economic dynamics of the Euro Zone, and the signs are that it is in some way or the other heading in that direction. But a QE coupled with ultra low interest rate environment over a longer than desired period  isn’t all NET positive for the general well-being  of the economy. A sustained ultra low interest rate environment over a long period of time can cause misallocation of capital, mis-pricing of risks, and can also easily become addictive without really creating a big jump in the overall economic activity of the real economy. And here is an interesting data that I believe provides an interesting perspective. Based on various reliable estimates, Japanese savers have over US$ 7.1 trillion stashed in cash, and roughly around US $ 300 billion of cash is believed to be literally stashed under the carpet  across Japanese households creating a situation where excessive savings is not being utilised by the real economy as average household aren’t able to get the return they would expect from traditional channels of investments.

There are still a large number of savers who believe in the good old savings model, where a bank provides an attractive return to its clients on deposits. Also more than half of the population of the developed as well as developing world does not actively invests on a regular basis in stocks or bonds so therefore they are unable to reap the benefits of a record high stock market. And their savings get eroded over time through low to almost negligible return on their deposits while a small percentage of sophisticated institutional investors make good money from record high stock markets mostly driven by the easy QE money, which distorts the connection between the financial markets and the real economy.

And even in an economy where a large percentage of the savings comes from the higher valuation of the house prices, if through traditional channels, a saver is not getting decent enough return from the banks, the overall confidence in the economy suffers, and it is one of the reason why the economic data remains somewhat confusion creating volatility in the financial markets.

There are limitations to what a central bank and monetary policy can deliver or achieve on their own without a sound business and investment friendly economic environment. And this is where Europe continues to struggle. Euro zone economy is showing some signs of improvement  but it still has a long away to go.

A Europe where an entrepreneur as a value creator with credible ideas or project  is able to access right capital and start the journey without getting stuck in bureaucratic red tape is still a bit far from becoming a reality. In general, the market is turning optimistic on Europe’s prospect, but the EU leaders as well as the bureaucrats will need to be focused on delivering the essential reforms in order to make sure Euro Zone as an economic growth engine starts to fire, to ensure it stays relevant and competes better. So the European policy makers will need to keep their mind on the market while charting a better way forward for Europe.

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Taking measures to manage the future financial crises better – KNOWING the UNKNOWNS.

Posted on August 31, 2014. Filed under: Uncategorized | Tags: , , , , , , , , , , , , , , , , , |

A well thought out financial regulatory framework, economic system, and policy decisions that can stand the test of time needs to be evolutionary, and requires a certain level of debate, discussion of ideas and possibilities. A strategy and approach that has gone through an evolutionary process, and is proactive, tend to have a greater chance of success than a policy decision or measure that is more or less reactive. And that’s just common sense. But during the financial crisis of 07/08, and in its immediate aftermath, we were hit by a barrage of half baked ideas and measures that came out of a reactive decision making process, and although the aim of the exercise  were well intended, and in some case temporary in nature, they haven’t made the markets or the global economy any more safer than they were before.

Also the existing reactive measures put in place to deal with the financial crisis can only be defined as an experiment. And even in a post crisis world, we continue to operate in the experiment mode, be it, the ultra loose monetary policy experiment to support the markets and the economy or the hard core regulatory environment aimed at avoiding future financial crises. Making it a hot topic of debate, and the possible outcome or outcomes of this ongoing experiment are being discussed around various quarters.   But the end result still remains somewhat unknown because quite simply there are no precedent, so all we have is, best guess estimates, and theories to help us navigate through the unknown terrain.

Having said that, we are at a better place today than during the financial crisis of 07/08, but even after being 5/6 years on the road to recovery, the global economy is still not firing on all cylinders, and there are obviously a number of reasons for that. In my own view, we will only be able to get a better assessment of the strength of the economy after the unconventional monetary policies are taken offline (exit), as there are still many UNKNOWNS out there. The record high stock markets is not fully reflective of the real economy, and although the global economy is in a much better shape than during the financial crisis, parts of the economy are still not firing on all cylinders. A large percentage of the people on the main street are still stretched as evident from the lack of wage growth. And the ongoing geopolitical instability will most likely have an impact on the markets and the economy especially the EU states. The Euro area is still in a very precarious situation, and it is quite likely that the year 2014 will turn out to be a lost opportunity for Euro Zone nations especially if the leadership in the EU fail to get their priorities right. And going forward, we may see significant monetary policy divergence among developed nations especially between the EU, UK and the United States because the respective economies are already in different speed gears. Also major economies like China are going through a transition period, in other words, a gear shift which needs to be managed well through policy changes as we all know that running a car in a wrong gear for a long period of time can pretty much ruin the car’s engine. So the Central bank in China as well as major world economies including of the US and UK will need to manage the gear change efficiently. And this is why, it is important to  create a mechanism that allows greater policy coordination in the global financial system going forward.

 And though, there are still many unknowns, but what we do know, and have learnt so far especially in the immediate aftermath of the financial crisis of 07/08 is that, the financial markets and the economy are anything but efficient, and this may be contrary to what some may believe. The fear of the unknown will always trouble the market participants, and as a way to better understand the road ahead, people will make their own projections, which at times could raise more questions than answers.

So while taking a stock of the overall situation, may be its time, we look ahead , and find a way to revisit some of these experiments to help us better understand, and improve the existing structure of the economy and the markets going forward. And with this in mind, I thought, I will take the liberty, and share my own two cents worth on the subject.

To start with, I believe, we can all agree that the  financial crisis has revealed to us the vulnerabilities of our existing economic system and financial infrastructure. And, if we are to attempt to find a way to upgrade the system then we will need to explore ways to remodel, the whole financial infrastructure, in order to make sure it’s sustainable over a long run. So here is an outline of the broader idea, which is based around creating an ” emergency only use spare money supply capacity ” in the system, that could be tapped into during an exceptional situation ( a financial crisis type event ). This could be a possible solution to mitigate or address some of the underlying solvency related concern on a sovereign nation.

And here is how it could work, first and foremost, the utilisation of the newly added capacity will have to be approved by a country’s parliament, second the whole process could be monitored by a global financial stability board or a body under the IMF, and third the market should have a clarity about the rules. So the assumption is, if the markets know or knew that a country could tap into its inbuilt safety mechanism put in place or in other words utilise a back up facility under a defined set of rules in case of emergency then it is less likely to speculate about a potential bankruptcy of that country.

The overall premise is based on a common sense approach that an efficient and sustainable system should  have a back up or IN CASE OF EMERGENCY provision put in place to be  used under exceptional circumstances. So for example, in event of a tyre puncture, you would use the spare tyre that comes with your vehicle or in case of a power failure, you will switch on a back up generator, in same way the emergency money supply pool ( as a spare capacity )  could be tapped into or utilised during an exceptional financial crisis type event. So under the proposed framework, a country could be allowed to print emergency money equivalent to up to 10% of its GDP, and this new money supply will automatically cease to exist within a period of let’s say 5 years, and could be linked to the overall GDP growth. In others words, the money supply by design will be created with a limited shelf life, to be used under extreme and exceptional circumstances. And the assumption here is that a five year cycle should be a sufficient transition period to help the economy rehabilitate.

 Also linking the temporary additional money supply to the GDP growth creates a balance. So the overall idea works more or less like the rocket booster engine system that are used to take spacecraft into space, they do a job and then cut off  (burn out ). We are taking about, creating a provision that will allow a country to tap into its spare capacity, a builtin safety mechanism that could kick in, in case of emergency. And since the provision will have a defined set of rules, the debate around a possible exit, and its outcome will not have to factor in many UNKNOWNS, making the outcome somewhat certain. So we know what happens, and at what level.

And beside the concern over sovereign risk, the other big issue item are the large financial institutions considered too big to fail. Asking the institution to create a living WILL doesn’t really go far enough. So one of the idea worth exploring could be, creating a mechanism that will allow troubled large ( too big to fail ) financial institutions to temporarily come under the protection of the central bank. The limited protection will not be for a period longer than 2.5 years, and the restructuring and unwinding process could be monitored, supervised by a special committee reporting directly to the central bank.

The experimentation with unconventional monetary policies like QE  created uncertainty causing extreme volatility, and the problem was not the QE but the perception of QE, and what it will do or has done to the overall economy. Unconventional monetary policy tools like QE aren’t really a complete idea, and just like any human idea they need to reach a level of maturity through evolution. Also by design, the current structure of our economic system makes it prone to crises so if you are operating in a global financial system that has inherent builtin inefficiency then there is always a good chance that any policy measure even with best intention or design may not have the desired result.

So creating a defined safety mechanism in the overall infrastructure of the financial system should hopefully go a long way  in providing a level of certainty to the market. And here is an example, during the financial crisis, the uncertainty over whether a country would get bailed out or not, and on what terms sort of magnified the problem.

Also an investment or a business model can only factor what is known, and what  can be seen so a decision making will always have an element of risk involved. But knowing that there are many UKNOWNs keeps us honest and wise.  So going forward,  what we need to admit, and fully understand is that ,the journey to creating an efficient financial system will come with failures, and we may not have all the answers so being open to all and any good ideas makes all the sense. A Market economy is nothing but a human idea, and it has to go through an evolutionary process, and one of the reasons why the financial markets go through boom and bust is simply because the undefined rules creates an environment for extreme uncertainty leading to speculation.

That said, striving to create a financial and economic system that is 100% efficient, is quite impractical ( at least for now) . Also it must be said that inefficiencies do create opportunities, which allows entrepreneurs to add value, and in the process profit from it. Money or capital has no NATIONALITY so people will chase opportunities where ever they can find, and I believe thats a fair game because it encourages economies and businesses to compete for capital.

However, as a part of the evolutionary process, and over time, we have learnt to make safer cars, planes, and made tremendous progress in making various manufacturing process safer, transformed the telecom industry. And we have also made significant progress in many other fields including of space exploration among others, but our innovation in financial markets hasn’t  really made the economy or the markets any safer.

So its about time that we focus our efforts on not only making the economy and the financial markets safer, but also on making it work better by improving the overall design of the existing system, and take measures to manage the future financial crises better, in order to minimise the financial hardship on people in the Main Street as well as on the nation states during the time of an exceptionally damaging financial crisis that leads to broken people, broken families as evident from the financial crisis of 07/08. This will be a journey of knowing the unknowns.

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So why didn’t the quantitative easing (QE) create the inflationary fire in the developed world?

Posted on April 11, 2014. Filed under: Uncategorized | Tags: , , , , , , , , , |

When answering the question, why the quantitative easing (QE) didn’t create an inflationary fire in the developed world as expected by many in the markets, we would probably need to go back to basic. And based on basic economics, we know that the real inflation is driven by an increase in spending from the consumer side. The worry was that easy money pumped through an unconventional monetary policy tool like quantitative easing (QE) will spill over, and the over supply of money will create runaway inflation. Now based on the evidence we have seen so far, it is probably safe to assume that while QE did in fact inflate the financial assets valuation, folks on the street didn’t real see a real term increase in their savings or disposable income. And here is why, quantitative easing (QE ) was designed more or less to keep funding the governments and the financial markets, and based on all the evidence, both the governments as well as the markets did make good money from QE. 

And with regards to the spill over worries related to QE. I would say, for discussion purposes, let’s just imagine a situation where the Atlantic Ocean dried up, and then in an effort to save the ocean, we try to fill it up with water, and while the filling process is ongoing there will always be those who will rightly be concerned about spilling over issue, in other words flooding related to overfilling of the Ocean but the problem is filling up an ocean isn’t as similar or as simple as filling up a swimming pool or a pond for that matter. Now let us imagine the global economy to be the Atlantic Ocean that dried up during the financial crisis, and the central bankers as various water pumping stations, and quantitative easing (QE) as the water supply ( money supply in case of the dried up global economy and markets) as a way to fill it up.

So what happens next?. You see folks on the street can only access the water ( QE in this case ) through a utility company ( intermediary or a financial intermediary in case of QE ), and these utilities ( intermediaries or financial intermediaries  ) who are and were able to directly tap the water or in other words the QE money pumped by various central bankers into the ocean ( the financial economy ), needed the water i.e. the QE money for themselves first in order to treat the side effects of extreme dehydration, they have all been suffering from caused by the acute shortage of water or in other words short of liquidity in case of financial economy during the financial crisis so since QE was not designed to be a Tsunami but to simply fill up the dried up Ocean i.e. the financial economy and the market, the flooding risk was extremely limited.

And because the average folks in the real economy didn’t really get to see or experience the benefits of QE directly in terms of an improvement in their own bank balance, their disposable income as well as overall living standard,  the direct impact of quantitative easing  (QE) on the real economy wasn’t strong enough to create consumer driven inflation in the real economy in the developed world.

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PERCEPTION and the Need For Greater Global Policy Coordination in a 2014 WORLD

Posted on February 4, 2014. Filed under: Uncategorized | Tags: , , , , , , , , , , , , , , , , , , |

Perception is a major factor driving volatility in the market and this is why I am of the firm opinion now that it’s the market psychology and the overall investors sentiment aka the “mood of the markets” that creates and drives the volatility. And when a perception starts getting entrenched then people generally tend to ignore the sense of reasoning and stop looking at the big picture and this is why at times markets tends to behave like headless chickens because the underlying perception creates uncertainty and CHOAS takes over. So it is important to arrest this momentum before it ends up damaging the economy, it’s like this…we create a perception and then use that perception to create a reality.

In an interconnected global economy perception can create volatility and uncertainty and this is one of the reasons why a contagion risk remains a plausible scenario especially when people tend to get overwhelmed by the sound bites coming from various quarters of the financial markets. But it must be said that there is always value in looking at each market and economy individually. For instance, if we look at Turkey and Argentina, the fundamentals of these economies didn’t really deteriorate overnight. The Turkish central bank should have raised rates over a year ago but today the stretched fiscal situation combined with the political uncertainty is hurting the economy real bad but having said that a quick political resolution will likely calm the fears around Turkey and with regards to Argentina, the central bank of the country has been running a wacko monetary policy for sometime now so what the country is facing today is an outcome of such policies.

And assuming the worst case scenario, both Argentine and Turkish economies isn’t big enough to possess a systemic or a damaging contagion risk for all the emerging market economies, at least not based on the ground realities but yes in perception there might be. And to get some perspective, it is worth remembering that both Turkish as well as Argentine economies have gone through crises in the past without causing any significant problems for the world economy and also the rest of the EM didn’t really see any damaging contagion  come through and that’s the reality. Also, it is important to note that economies both in EM as well as developed markets tend to be at a different levels of maturity and they are different in many ways. For example, China and Brazil although a part of the same block of BRICS nations are in fact two different economies in many ways. The leadership in China for instance needs to implement the planned financial reform agenda whereas Brazil clearly needs a wholesale supply side reforms. So in short they aren’t dealing with the same issues.

We live in a very interconnected 24 x 7 world where perception drives the overall investors sentiment creating volatility and the global economy of 2014 reflects that reality. Perception can have a snowball effect and is no doubt contagious. So even though the IMF has revised up its global growth projection for the year 2014, there are a number of factors that could influence the real economic growth going forward. And one of them is a possible decline in positive sentiment and confidence in general around the global economy driven by a change in overall perception. And in most likelihood a potential sluggish growth and deteriorating fundamentals across emerging markets will have an impact on the overall growth dynamics of the developed world so it will be unwise to assume that the developed markets are going to be somehow immune. This is why it will be ill-advised to conclude that the developed markets have entered a self sustaining growth in 2014 so when I hear the sound bites coming from parts of the markets suggesting that the current volatility in the market is more or less an emerging market issue and thus the policy markers in the EM should get their house in order by adjusting to the market expectations, I can’t help but wonder, are they seriously suggesting or assuming that the developed world can grow in isolation especially in a post financial crisis world and also that the turbulent cloud over the emerging markets won’t enter the developed world? The markets clearly believe that a potential turmoil in the developing world could have an effect on the developed world. And there is probably a strong reason behind  that assumption.

When the western economies were on the verge of collapsing during 07/08 crisis, the politicians and the policy makers were busy calling anyone and everyone including their counterparts in emerging markets to help the global economy get out of the mess and most emerging markets did come together and a global policy coordination was worked out to keep the world economy going and from falling under. To help safe the financial sector and the economy, the central banks adopted an ultra loose monetary policy and there is very little doubt that part of the current volatility in the EM is driven by this ultra loose monetary policy adopted by the central banks in the developed world. So clearly, the EMs are dealing with the side effects of QE. The hot and easy money that flowed into various emerging markets chasing yields created asset price distortion. So the fundamentals of the emerging markets were known to the investors while they flocked into EM chasing high returns but now that the supply of hot money flow is being cut, the worry is that the real ground on which they were standing will get revealed.

Generally investors tend to invest in emerging markets attracted by the growth story but GDP numbers shouldn’t be the only indicator when considering an investment opportunity. In theory, we can measure GDP using three different approaches. 1 – overall production approach, 2- overall expenditure approach, 3- and the overall income approach but none of these 3 approaches can fully and comprehensively report or record the overall economic activities or output of a country let alone the world. High growth in a high inflationary environment creates distortion and isn’t really a sustainable growth model. And here is why, entrenched Inflation in the developing world tends to destroy disposable income and living standards and the idea that somehow high growth could fix everything in the long run doesn’t really hold water. In short, strong GDP growth numbers isn’t necessarily a one way ticket to prosperity because high growth creates various types of unforeseen problems and challenges so any growth model has to factor the exponential function rules, for example a 10% growth rate year-on-year means the economy will double in just 7 years and doubling of the economy isn’t just all positive. So any sustainable economic growth model will have to factor in a period of adjustment to allow for consolidation.

An economic journey isn’t about just about speed at which a country can reach from point A to Z quite simply because there is no Z or in other words there is no final destination but targets  to help deliver overall progress. A sustainable economy will have to keep evolving every 5 years or so to remain relevant and this is where the challenge lies for the global economy. By design, the global economic model along with the existing structure of the financial markets are less than efficient and this is why every now and then we find ourselves in a CRISIS. For example, today while the developing world is struggling with inflation, the developed world would love to have some of that inflation in the system.

And the ultra loose monetary policy has so far failed to deliver inflation in the developed world. Also though the tapering of quantitative easing (QE) by FED which I must say is inline with my own expectations ( not that is matters ) is being perceived as a start of an early tightening measure than ideally preferred by some in the market. But this perception does not accurately reflect the reality and here is why. So based on the latest (Jan 2014) data, FED’s balance sheet is now around US$ 4.1 trillion and even with tapering the balance sheet will continue to expand and also by committing to keep the rates near zero the FED continues to be in expansive mode. So by reducing the QE level ,the FED is basically trying to slowly dial down the booster engine put in place during the crisis to support the economy and switch over to traditional and conventional monetary policy tools to manage the economy going forward. And the reality is, it will be unwise to expect the FED to keep operating in crisis emergency mode so a gradual switching over makes good sense. Also it is important to note that if the FED gets its QE exit wrong then it could have substantial losses so it will have to be mindful of the market condition. A continued improvement in the economy along with the housing market will enable the central bank to book a substantial profit on the purchased securities and obviously a big chunk of the overall profit will end up at the US treasury and could very well be used to pay down the debt.

Whatever may be the perception of the market today, there is very little evidence to suggest that Quantitative Easing has in fact financed the global growth however, it has been extremely useful in supporting the financial markets and to a large extent helped create a distortion in the asset pricing across the world so a curb in QE will most likely help the global economy remove all the speculations and fear around the nature of the overall growth going forward because quite clearly the markets today aren’t sure if the world economy has entered a self sustaining growth cycle hence the extreme volatility.

And when looking at the bigger picture, in the medium to long term investment perspective, the Emerging Markets ( with the exception of some ) will most likely grow at a better rate than their counterparts in the developed world. Having said that, today when the markets are dealing with extreme volatility that is clearly creating CHAOS then talking about medium to long term investment horizon may not make much sense to most in the market. Also, a wait and watch approach and hoping that markets will look at the big picture and by applying some common sense figure things out is an extremely risky strategy because the markets are all about perception, momentum and confidence so an announcement on a global policy coordination by major central banks from around the world going forward should go a long way in providing a degree of certainty and should help arrest the current CHOAS from spreading into every corner of the market. And the thing about perception is, if you could keep a perception going for a period time irrespective of it being right or wrong then there is a good chance that perception will most likely be perceived by some as the REALITY.

And this is why the global economy of today requires a greater degree of policy coordination from major economies and is essential to addressing both immediate and long term challenges facing the world economy. Also this has to be by far the biggest lesson learnt from the 07/08 financial crisis.

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The BIG Hoo-Ha on FED’s planned Tapering of Quantitative Easing

Posted on September 1, 2013. Filed under: Uncategorized | Tags: , , , , , , , , , , , , , , , , , , |

 

The US Federal Reserve Open Market Committee’s announcement on lowering the amount of monthly bond purchases or in other words tapering of the existing level of quantitative easing (QE) has got the financial markets animated in a big hoo-ha causing volatility. And the financial media has been inundated with commentaries on various plausible scenarios. To understand possible outcome and where the economy could be heading, we will need to start with where it is today. And here is something interesting, in over last 10 months US treasury’s overall tax revenues collection was around $ 4.3 trillion, a jump of nearly 15% from the same period last year. According to the Congressional Budget office ( CBO ) projection the US government budget deficit for the Fiscal Year (FY) 13 is estimated to be around $ 642 billion, a decline of over 35% from last year and because of the sequester related spending cuts the deficit is projected to be around 4% level for FY 13 and may fall further to around 2.1% in 2015. Also the recently revised data suggests that US economy grew at an annualise rate of 2.5% for the period April – June 2013. So clearly the US economy is getting healthy and probably entering an expansionary phase but having said that going forward we may still see mixed data and the reason being, the existing high level of external support from the FED to boost  growth.

The Federal Reserve has been acting as the BOOSTER engine supporting the economy and only after the withdrawal of this anchoring support we will get a clearer picture of the health of the economy. Various policy measures or tools have acted as a cocktail of drugs loaded with steroids to help the patient ( the economy ) fight the fatal infection and by all accounts it is quite evident that the world economy ( the patient ) today is not in intensive care and the recovery is gathering pace hence lowering of the HIGH dosage should be considered as a natural course of action. But this proposal of lowering of the high dosage of  drugs by a way of tapering  the current level of quantitative easing ( QE) has caused panic in the market and created volatility hitting the emerging markets the hardest. And since the announcement of QE tapering in June of 2013 a whopping US 1.4 trillion in value has been erased from emerging market equities. The markets have recovered somewhat in the last few days of August but given the uncertainty over the monetary policy exit and geopolitical risk to a certain extent the volatility isn’t going to go away tomorrow. And this is why the global economy needs a smooth transition and not an abrupt or sudden change of gears.

By announcing the planned proposal to start tapering of quantitative easing (QE) from the existing level by a way of lowering the amount of monthly bond purchases, the FED is more or less lowering the current high dosage of antibiotics and cocktail of drugs (steroids) that it thought was essential to fighting the fatal infection during the financial crisis. The temporary policy measures or in other words the current prescribed course of medication has to end sooner rather then later as there is a serious risk of overdose so like a good doctor, the FED has to trust the immune system of the Patient ( the economy ) and allow it to slowly take over the recovery process.

And with regards to the exact timing though Mr Ben Shalom Bernanke as a part of his forward guidance strategy has linked the start of the QE tapering process to Key economic data and the overall US economy reaching certain milestone, the announcement has created a level of uncertainty in the market and there are already a number of projections on the time line, amount or level of tapering as well as possible outcome for the global economy. The debate will most likely continue going forward but it is safe to conclude that Bernanke & Co won’t be rushing into the process without being sure about the health of the economy and the strength of the overall economic data including of employment numbers among others. Also the central bank ( the Federal Reserve System ) does risk losing serious money on its overall assets holding in the existing volatile market environment related to concern over tapering as well as the ongoing geopolitical situation.

The other interesting event which may influence FED’s decision is the treasury secretary Jack Lew’s recent announcement regarding US government borrowings reaching the congressionally imposed limit on federal debt ( debt ceiling) of $ 16.7 trillion around mid October of this year. This will have an impact on treasuries considering the fact that August was a tough month for US treasuries and other fixed income assets. In the month of August bonds funds have lost over $ 30 billion. Also foreign holders of US treasuries are  becoming increasingly concerned, China recently sold around $ 20 billion worth of US treasuries and others may follow suit driven mainly by concern over Fed lowering the amount of monthly bond purchases under its planned QE tapering, pushing the yields higher. A sudden rise in borrowing cost may be damaging for the economy especially when the economy has just started to gather pace.

The uncertainty is obviously not helpful for the market but a forward guiding strategy deployed by the FED primarily aimed at giving some level of certainty to the market especially on policy measures has clearly created more questions than answers in this case as evident from the existing volatility. However, there has to be a clear understanding that the existing policy measures were designed to be temporary and a tapering of the current level of QE isn’t going to kill the global economy or emerging markets for that matter. What quantitative easing (QE) did is provided cheap and easy money and this HOT money flow drove the asset valuation in most emerging markets to a bubble territory level.

During the crisis, the policy makers across emerging markets were happy talking about the shifting of the paradigm and how well placed their respective economies were but the easy money caught them napping as most of them got complacent and are now paying the price for not being proactive and failing to prepare for a post crisis world. This should serve as a wake up call for the politicians and policy makers in the emerging market. Only last year the financial media was full of sound bites on how US is starting a currency war by doing more QE and today when most EM currencies have depreciated heavily and the economies have started to struggle somewhat, the sound bites have changed. The concern over tapering is understandable but it is highly unlikely that emerging market ( EM ) economies will start to fall like dominoes cause of QE tapering. And the reason being, there is no solid evidence to suggest that hot money directly financed the economic growth across emerging markets, quantitative easing has had a significant impact on the overall valuation of the financial assets but not on the real economy. In fact, the outflow of hot money will most likely diffuse the built up asset bubble making the EM assets look more attractive to value investors. Also the investors will need to realise that the global economy is more interconnected then ever before so at some point before getting into a panic mode or jumping ships they should have a sit down and think their strategy through with a clear mind without getting bogged down in non stop sound bites.

Many in the market projected that a break up of the European Union was more or less imminent but it didn’t happen then there were projections about China falling but again it hasn’t fallen and now some are projecting of an imminent crisis brewing in the emerging markets. The projections and the sound bites are part and parcel of the financial market and navigating through them will always remain a challenging task. But investing isn’t a quick 100 metre sprint or about winning one lap, it’s a long marathon and thats what people fail to realise.

The economy and financial markets are human ideas and not an exact science so the human element will always be a key influential factor. The inherent human nature and desire to make a quick BUCK by using any means has lead to downfall of the financial market on many occasions. And the lesson is in history.

Based on the available historical data, the first recorded financial market crash happened over 300 years ago. The modern financial system as we know it today saw its first stock market crash around 1901. Then the panic of 1907 triggered the creation of the Federal Reserve System and after a relative boom period, the markets crashed again in 1929 causing the Great Depression. But the markets recovered from the Great Depression crashing again in 62 then peaking and crashing back again around 1974. After going through a down time the recovery gathered pace from 1975 onwards but then the markets crashed again in 87. So the story of Boom & Bust goes on. The volatility and periods of BOOM followed by a BUST aka ” Boom-Bust Cycle ” is inherent to the financial market and not a new phenomena and almost all the BOOM and BUST cycles were predictable and caused by the human elements influencing the market. So in the case of financial market history does keep repeating itself and in all likelihood the financial crisis of 2007-08 isn’t going to be the last recorded and reported crisis in this history of humanity.

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The SMEs Bank project – An Idea that could energize the SME sector in a gloomy outlook

Posted on September 22, 2011. Filed under: Uncategorized | Tags: , , , , , , , , , , , , , , , , , , , , , , |

In the past few weeks the markets have come to a realization that the developed world is struggling to generate growth and going forward the global growth projections put out by multilateral institutions including of the International Monetary Fund ( IMF ) and the World Bank paints gloomy picture. The growth outlook has been downgraded to a lower level from previous estimates. To counter the downturn in the economy the policy makers and the central bankers have been trying out various ideas to keep the economy growing. One of the widely used though unconventional monetary policy tool to stimulate growth has been to print more money through quantitative easing (QE) program by the central bankers. Although through their quantitative easing (QE) program the central bankers were able to provide critical support to the market it has had a limited affect on generating growth so far. And one could also argue that monetary policy tools on their own are not going to be enough to create growth.

Going forward the policy makers in the government will have to take the baton from the tiring hands of the monetary policy makers and have the courage to take bold decisions that goes beyond party politics and is right for the economy.  The people on the streets especially those in the U.S. and Europe as well as the markets are increasingly losing faith in their political leaders’ ability to fix the CRISIS.  And it is probably the right time for the politicians to stand up and deliver. In a recent speech delivered by the president of United States to joint session of the congress Mr. Obama proposed tax credit to the SMEs under Obama’s American Jobs act plan as one of his own initiatives to encourage SMEs to hire more and create jobs. He also proposed common sense based regulations to remove the regulatory burden on the SMEs. Although these are steps in the right direction but the tax credits and the removal of unnecessary regulatory burden on the companies won’t do much on their own to create the level of jobs growth that US economy needs. Besides the tax credits and regulatory reforms the SMEs also need to have an easy access to capital at very reasonable and flexible terms. The government will also need to energise the supply and demand side. Consumers’ confidence is going to be one of the key factors in turning the economy around and the government will need to work closely and tirelessly with all the parties to bring the confidence and positivity back in the system.

It is important to point out that a CRISIS born in a globalised world will need a global effort to fully overcome it. Although it is unwise to expect the developing world especially the BRIC nations to bailout European states it is in the best interest of both the developing and the developed world to work together closely on finding a long term sustainable solution.

In the aftermath of the CRISIS high street banks especially those in Europe and the United States have so far failed to support the SMEs and in fact most banks have reduced their lending to the sector significantly while increasing the cost of capital at which they will lend to the SME sector companies. Banks as one of the beneficiary of the quantitative easing program have not passed on the cash to the real economy and they are still struggling with their risk management strategy so to expect them to do more to support the economy and the SMEs sector is probably unrealistic at least for now.

The small and medium size enterprises ( SMEs ) are an important integral part  and the supporting pillar of any economy. Generally the sector tends to lead a country’s new and fast growing industries.  Some of the success stories of developing world today including of Korea, Taiwan among others has been built on the dynamism of the SME sector. Also due to its inherent structure the labour intensity is generally higher in the SME sector companies hence the sector is usually the largest employer in a country. For example over the last two decades the SMEs sector has accounted for around 65% of new jobs created in the U.S. and overall it accounts for about half of non-farm U.S. employment and within Europe the SMEs sector employs around 68 million people which in percentage terms translate to around 72% of the workforce in the non-primary private sector.

Even though the SMEs are seen as an important part of an economy and play a very crucial role in jobs creation in general the sector is not serviced well by banks today. The banks who mostly play the role of an underwriter of loans or suppliers of credit to an enterprise are limited in their abilities to offer a flexible funding solution to the sector and provide the right support  to the SMEs due to a number of reasons, including banks being very cautious in their lending approach, uncertainty about the future and the changing market conditions, a changing mandate from their shareholders and the board, lack of commitment to the sector as well as the lack of the supporting secondary market infrastructure that will encourage and allow the banks to make good PRIMARY loans to the SME sector and be able to refinance in the secondary market if and when required. Financing SMEs do pose real challenges for the banks especially in the current environment where they are continuously feeling the pressure on their balance sheet and struggling to keep their heads above water. Also it is important to point out that while there is an immediate need to address the lack of capital availability to the SMEs it is important that the solution is sustainable and will add value in the long term.

The idea behind the new SME bank or the SME financing vehicle will be to work closely and directly with the sector as well as other banks, credit guarantee agencies, regional development agencies, usiness associations among others to provide direct and right funding solutions to the SMEs and also help in developing the secondary market infrastructure that will allow existing banks and lenders extending loans to SME sector companies to refinance their loan books.

Most Small and Medium Size enterprises require a flexible funding solution that is right for their business and will support them fully and won’t be called back or withdrawn living their business in limbo like an overdraft facility or credit line due to changes in the market conditions or a change in the strategy of the bank. SMEs like any other sector of the economy will prefer certainty and also a ring fencing of their funding commitments from the banks so they can make business decisions.

The inception & operational strategy of the proposed SME Bank

  • The Central banks and the governments could create a SME Bank or SME Financing Vehicle in partnership with financial institutions including of development banks, private investors and other investors with focus on SMEs or similar investment asset class.
  • The investment strategy and the role to be played by the SME Bank should be multifaceted and flexible to allow it to meet a range of capital requirements coming out of the SMEs. A single funding solution or investment strategy may not provide the right support to the sector.
  • The SME bank should also be able to work with traditional and nontraditional lenders to SMEs including of high street banks.
  • The SME bank should also provide a third party service to others and help other banks manage and monitor their existing SME loan books better and get paid a fee for its services.
  • Buy off the existing loans from the balance sheet of the banks enabling them to refinance their loan book and use the new money to extend more loans.
  • Also act as a guarantor to the SME sector companies that are looking to secure funding or provide performance bonds to their counterparties/clients if and when required.
  • Be able to securitise SME loans under special tax free investment provisions for a limited period to attract investors into the asset class.
  •  Provide advisory and consultancy services to SMEs and work intimately with the sector.

 Proposed Shareholders/Participants of the SME Bank (or the SME financing Vehicle) 

The government or the central banks, development agencies, multilateral institutions, local banks, credit guarantee agencies, private investors and financial institutions among others

Proposed Capitalisation and Guarantees

A part of the capital commitment to the SMEs bank could come from the Central banks using the government bonds purchased through their QE program and the remaining from its prospective shareholders. The capitalization of the bank should be based on the real funding requirement of the sector and should be sufficient to service good SMEs.

Benefits of the SMEs Bank

The SMEs bank will play a very important role with huge benefits to the SMEs sector companies, high street banks, lenders focused on SMEs, credit guarantee agencies as well as development banks and other market players. It will also act as an additional pillar supporting the market in the long run and will be a good value ADD going forward.

The local banks, credit guarantee agencies and other lenders or service providers to the SMEs by working closely with the SMEs Bank will be able to take a preemptive action on any loans or services extended to the SMEs that has a possibility of becoming a non performing loan. Also banks could easily offload good and performing loans to the SMEs Bank (or the SME financing Vehicle). While the SME Bank will do direct primary loans and investments to the SMEs sector companies it also will also help develop the secondary market for SMEs loans underwritten by the local banks and other lenders. It could also play the role of the credit guarantee agency to the SMEs sector.

Exit strategy for the shareholders

The shareholders could EXIT if and when required through an IPO in few years time when the markets are going to be much calmer.

The SMEs bank will energize the sector by providing a critical support to the SMEs with a range of financing solutions and will also add significant value to the existing system on a long term basis. It is an idea that needs to be seriously explored by the policy makers.

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