Stock markets the world over surged after the US Treasury announced its latest plan. The Dow jumped almost 500 points, its biggest one-day point gain since November 21. What makes this plan so different, and why are the markets so happy?
One of the key learning from the Japanese lost decade was that 'Zombie Banks' prolonged the crisis. Towards the end of the last century, the Japanese real-estate and stock market bubble burst. The country was faced with a situation which is similar to what the US economy is facing right now. It had a lot of banks had made huge loans, and the loans were going sour pretty fast (as customers and businesses failed to make monthly repayments). One of the biggest mistakes that Japan made was that it helped these banks survive.
The banks had so much bad loans on their book that their total liabilities exceeded their assets. Thus they were very reluctant to make more loans. As banks reduced making newer loans, other industries became starved of cash to run their business and people could not finance their big-ticket purchases. This caused massive problems within the economy.
In any economy, the only way governments can give money to the businesses and consumers is though banks. Hence the Japanese government reacted by giving more money to the banks (hoping that the banks would lend it to businesses and consumers). The banks, on their part, were very happy to take the money and keep it with themselves - to improve their reserves (i.e., make sure they have enough money - in case more loans go bad)!
These banks came to be known as 'Zombie Banks'. They were practically insolvent and the Japanese government fed them money to keep them 'alive'. However these banks just hoarded up the money and did not plough it into the economy. This ended up prolonging the crisis for many more years.
In the US, there were fears of banks like Citibank and Bank of America becoming 'Zombie Banks'. The fears were primarily because these banks have huge portfolio of bad loans. They are also hoarding up government money and not lending out as much as they should. The situation is very similar to that in Japan few years ago.
Hence, the announcement by the Treasury is very important. The announcement basically says that the bad loans that these banks have will be bought over by the Treasury. Once banks become free of their bad loans, they will again start lending out to businesses and consumers. This will help get the economy moving again. Consumers will be able to buy more goods, factories will increases production, and more people will get jobs.
But as with any other plan, implementation will be the key. If the Treasury is successful in implementing this plan, it will have effectively averted one of the biggest mistakes that led to the Japanese lost decade.
Tuesday, March 24, 2009
Saturday, March 14, 2009
The Indian Rupee (Part II: The Fall)
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Continuation of the previous post: The Indian Rupee (Part I: The Rise)
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The very same factors, that led to the rise of the Rupee, reversed rapidly in 2008. This led to a huge fall in the Rupee. However, there are a couple of more factors which accelerated this cycle:
Vicious cycle of stock market returns and currency depreciation: The returns for global financial institutions investing in India depend on the performance of the stock market and the currency exchange rate. Let us take the case of a firm that had invested 100$ in India in early 2008 (when the currency rate was 40Rs./$). Using the 100$ they got 4,000 Rs. and let us assume that the firm invested the money in stocks. Now in 2009, with the stock market down let us assume the value of the stocks that the company owned has come down by 50%. The value of the investment now is 2,000 Rs. However, it would be wrong to say that the loss of the firm is just 50%. If the firm wants its money back, it will have to convert the Rupees into Dollars. Now, if the exchange rate is at 50Rs./$ in 2009, then the company will get only 40$ (2,000/50). Thus the ‘true return’ for the firm will not be negative 50% but will now be negative 60%. Due to the double whammy of stock market decline and depreciating Rupee, global financial institutions are pulling money out in droves. To exit India, they sell Rupees - thus increasing the supply of Rupees. This drives down the Rupee further, which leads to even worse ‘true returns’ which further causes more financial institutions to exit India. India’s stock market dropped more than the US and other developed countries in 2008. Hence financial institutions that had invested in India, started to exit, leading to this vicious cycle - which has been one of the key factors driving the fall of the Rupee.
Uncertain future: We all know that the American consumer has taken on excessive debt. In India, this role has been taken over by the government. Of the major economies, India has one of the greatest debt burden. This essentially means that the government is borrowing a lot of money to finance its huge expenses (salary hike for government service employees, loan waiver for the farmers, stimulus packages, etc.). The debt levels have risen to alarming levels, leading to a downgrade by rating agencies. Elections are round the corner, and people are predicting a hung parliament. The lack of a single party government will ensure that strong polices will not be enacted to reduce the debt burden. The hung parliament will also be an impediment to reforms (which as desperately needed at such times). To top it all, if India has a bad monsoon this year, things could get really bad. Hence companies are shying away from investing in India, thus reducing demand, and driving down the Rupee further.
Looking ahead, all these factors are not expected to reverse in a hurry. The Rupee will likely go down further, as the year goes along.
***
This post presents a point of view which differs from conventional wisdom. Apart from being a good read (hopefully), it can also be a good starting point to help readers, preparing for CAT (IIM) or other MBA interviews, think differently. Since the data / facts for these posts are derived from a host of sources and websites, readers are advised to cross-check the authenticity before using them anywhere.
Continuation of the previous post: The Indian Rupee (Part I: The Rise)
***
The very same factors, that led to the rise of the Rupee, reversed rapidly in 2008. This led to a huge fall in the Rupee. However, there are a couple of more factors which accelerated this cycle:
Vicious cycle of stock market returns and currency depreciation: The returns for global financial institutions investing in India depend on the performance of the stock market and the currency exchange rate. Let us take the case of a firm that had invested 100$ in India in early 2008 (when the currency rate was 40Rs./$). Using the 100$ they got 4,000 Rs. and let us assume that the firm invested the money in stocks. Now in 2009, with the stock market down let us assume the value of the stocks that the company owned has come down by 50%. The value of the investment now is 2,000 Rs. However, it would be wrong to say that the loss of the firm is just 50%. If the firm wants its money back, it will have to convert the Rupees into Dollars. Now, if the exchange rate is at 50Rs./$ in 2009, then the company will get only 40$ (2,000/50). Thus the ‘true return’ for the firm will not be negative 50% but will now be negative 60%. Due to the double whammy of stock market decline and depreciating Rupee, global financial institutions are pulling money out in droves. To exit India, they sell Rupees - thus increasing the supply of Rupees. This drives down the Rupee further, which leads to even worse ‘true returns’ which further causes more financial institutions to exit India. India’s stock market dropped more than the US and other developed countries in 2008. Hence financial institutions that had invested in India, started to exit, leading to this vicious cycle - which has been one of the key factors driving the fall of the Rupee.
Uncertain future: We all know that the American consumer has taken on excessive debt. In India, this role has been taken over by the government. Of the major economies, India has one of the greatest debt burden. This essentially means that the government is borrowing a lot of money to finance its huge expenses (salary hike for government service employees, loan waiver for the farmers, stimulus packages, etc.). The debt levels have risen to alarming levels, leading to a downgrade by rating agencies. Elections are round the corner, and people are predicting a hung parliament. The lack of a single party government will ensure that strong polices will not be enacted to reduce the debt burden. The hung parliament will also be an impediment to reforms (which as desperately needed at such times). To top it all, if India has a bad monsoon this year, things could get really bad. Hence companies are shying away from investing in India, thus reducing demand, and driving down the Rupee further.
Looking ahead, all these factors are not expected to reverse in a hurry. The Rupee will likely go down further, as the year goes along.
***
This post presents a point of view which differs from conventional wisdom. Apart from being a good read (hopefully), it can also be a good starting point to help readers, preparing for CAT (IIM) or other MBA interviews, think differently. Since the data / facts for these posts are derived from a host of sources and websites, readers are advised to cross-check the authenticity before using them anywhere.
The Indian Rupee (Part I: The Rise)
The past few years have seen a monumental see-saw in the value of the Rupee. After hovering in the 44-46Rs./$ range for a long time, the Rupee gained in value and rose more than 15% in 2006-07. Then during 2008-09 it fell from around 39Rs./$ to nearly 52Rs./$ (a fall of more than 30%)!! What led to such wild swings in the value of the Rupee, and what does the future hold?
At the heart of the matter is the fundamental rule of economics at work: demand-supply. During 2006-07 the demand for the Rupee was rising, due to a host of interrelated factors:
Global companies come to India: The world suddenly discovered that the Indian economy was growing at 8-9% every year. The huge, and growing, middle class was a big potential market. Everybody and their dog wanted to part of the ‘India story’. Companies all over the world started coming to India. Now, when a company wants to set up shop in India, they need to buy land (by paying in Rupees) pay salaries to Indian workers (in Rupees), etc. Thus all these companies started buying Rupees to fund their operations (leading to a rise in demand for Rupees).
Rise of IT and BPO: After the Y2K success, India emerged as a premier destination for IT offshoring. The Indian BPO industry also picked up steam. IT and BPO companies from all over the world started expanding rapidly in India. Again, to pay their employees, they needed Rupees (thus increasing the demand for Rupees)
Stock Market: While all this was happening, the Indian stock market was breaking one record after the other. Global financial institutions started investing in the Indian stock market (again fueling the demand for Rupees).
The huge demand for the Rupee, led to its sharp rise. As more and more companies needed Rupees, India ended up with a huge foreign exchange surplus (which at its peak was close to 300 billion Dollars).
***
This post presents a point of view which differs from conventional wisdom. Apart from being a good read (hopefully), it can also be a good starting point to help readers, preparing for CAT (IIM) or other MBA interviews, think differently. Since the data / facts for these posts are derived from a host of sources and websites, readers are advised to cross-check the authenticity before using them anywhere.
At the heart of the matter is the fundamental rule of economics at work: demand-supply. During 2006-07 the demand for the Rupee was rising, due to a host of interrelated factors:
Global companies come to India: The world suddenly discovered that the Indian economy was growing at 8-9% every year. The huge, and growing, middle class was a big potential market. Everybody and their dog wanted to part of the ‘India story’. Companies all over the world started coming to India. Now, when a company wants to set up shop in India, they need to buy land (by paying in Rupees) pay salaries to Indian workers (in Rupees), etc. Thus all these companies started buying Rupees to fund their operations (leading to a rise in demand for Rupees).
Rise of IT and BPO: After the Y2K success, India emerged as a premier destination for IT offshoring. The Indian BPO industry also picked up steam. IT and BPO companies from all over the world started expanding rapidly in India. Again, to pay their employees, they needed Rupees (thus increasing the demand for Rupees)
Stock Market: While all this was happening, the Indian stock market was breaking one record after the other. Global financial institutions started investing in the Indian stock market (again fueling the demand for Rupees).
The huge demand for the Rupee, led to its sharp rise. As more and more companies needed Rupees, India ended up with a huge foreign exchange surplus (which at its peak was close to 300 billion Dollars).
***
This post presents a point of view which differs from conventional wisdom. Apart from being a good read (hopefully), it can also be a good starting point to help readers, preparing for CAT (IIM) or other MBA interviews, think differently. Since the data / facts for these posts are derived from a host of sources and websites, readers are advised to cross-check the authenticity before using them anywhere.
Friday, March 13, 2009
Mortgage Foreclosures: To help or not to help?
As the subprime crisis deepens in the US, more and more people are finding it difficult to make payments for their home loans (mortgages). As a result, banks are re-possessing their houses to sell them off and recover the loan amount. As many people are being forced out of their houses (foreclosure), there is increasing pressure on the US government to help these people. However, there are some side-effects to this which need to be considered.
Economic cycles are inevitable and booms are followed by bursts and vice-versa. During a burst, demand goes down. Hence prices decrease rapidly. Thus demand picks up again and this sows the seed for future growth. There is always a danger in stopping or slowing down the price decrease - as this can prolong the burst.
The US government has put pressure on banks and lending institutions to help mortgage borrowers avoid foreclosure. When this happens, banks come up with arrangements that help borrowers retain their houses for some more months. However, finally once the arrangement ends, people end up foreclosing anyway.
What the temporary arrangement ends up doing, though, is that it delays the whole process of price reduction. As people stay in houses longer than they should, they reduce supply and price reduction is hampered. For a good recovery to begin, markets have to adjust to natural equilibrium level. The US government’s efforts to keep prices artificially elevated will delay this process, prolonging the pain for the rest of the economy. When a person can buy a house and rent it out and generate a positive cash flow, houses will be reasonably priced. Till then buyers will shy away from buying.
Another side effect is future borrowers are faced with a restricted supply of houses and hence higher prices. On top of that interest rates on loans are sky-high, because banks needed to compensate for the fact that they will not be able to re-posses and sell houses for bad loans. Thus new buyers are penalized.
Given the state of the US economy there is every need to help the people impacted by the crisis. However, the US government needs to weigh the benefit of helping people who took on loans they did not deserve, versus prolonging the crisis and affecting people who had nothing to do with this in the first place.
***
This post presents a point of view which differs from conventional wisdom. Apart from being a good read (hopefully), it can also be a good starting point to help readers, preparing for CAT (IIM) or other MBA interviews, think differently. Since the data / facts for these posts are derived from a host of sources and websites, readers are advised to cross-check the authenticity before using them anywhere.
Economic cycles are inevitable and booms are followed by bursts and vice-versa. During a burst, demand goes down. Hence prices decrease rapidly. Thus demand picks up again and this sows the seed for future growth. There is always a danger in stopping or slowing down the price decrease - as this can prolong the burst.
The US government has put pressure on banks and lending institutions to help mortgage borrowers avoid foreclosure. When this happens, banks come up with arrangements that help borrowers retain their houses for some more months. However, finally once the arrangement ends, people end up foreclosing anyway.
What the temporary arrangement ends up doing, though, is that it delays the whole process of price reduction. As people stay in houses longer than they should, they reduce supply and price reduction is hampered. For a good recovery to begin, markets have to adjust to natural equilibrium level. The US government’s efforts to keep prices artificially elevated will delay this process, prolonging the pain for the rest of the economy. When a person can buy a house and rent it out and generate a positive cash flow, houses will be reasonably priced. Till then buyers will shy away from buying.
Another side effect is future borrowers are faced with a restricted supply of houses and hence higher prices. On top of that interest rates on loans are sky-high, because banks needed to compensate for the fact that they will not be able to re-posses and sell houses for bad loans. Thus new buyers are penalized.
Given the state of the US economy there is every need to help the people impacted by the crisis. However, the US government needs to weigh the benefit of helping people who took on loans they did not deserve, versus prolonging the crisis and affecting people who had nothing to do with this in the first place.
***
This post presents a point of view which differs from conventional wisdom. Apart from being a good read (hopefully), it can also be a good starting point to help readers, preparing for CAT (IIM) or other MBA interviews, think differently. Since the data / facts for these posts are derived from a host of sources and websites, readers are advised to cross-check the authenticity before using them anywhere.
Sunday, March 8, 2009
The curious case of VolksWagen
The global financial crisis is having strange implications across the globe. Courtesy of the crisis, VolksWagen (a car manufacturer) suddenly found itself as the most valuable company on the planet! VolksWagen (VW) is normally less than third the size of market cap leaders like ExxonMobil . However, a string of strange events shaped up to make it the most valuable company for a short time.
Since the subprime crisis erupted, the fortunes of car companies worldwide have been in decline, due to lack of consumer demand, shortage of credit, etc. Most stock traders and hedge funds were 'shorting' auto stocks. Short selling or shorting is the practice of selling a share that the seller does not own at the time of the sale. Short selling is done with the intent of later purchasing the share at a lower price. Short-sellers attempt to profit from an expected decline in the price of the share. In essence, you borrow a share and sell it now, and then buy it later (to return the borrowed share) when the share price has gone down.
Hedge funds and traders had shorted the VW stock to the extent of 13%, which means they had effectively sold off 13% of the total shares (and were expecting to buy them in the future at a cheaper price).
VW was owned 43% by Porsche and 20% by Lower Saxony. One fine day Porsche announced that they had increased their stake in VW by 31% to 74%. Now this meant that only 6% (100 - 74 - 20) of the VW shares were out in the market! Hedge funds and traders were left scrambling - they had to buy 13% shares, but now only 6% were available! As demand outstripped supply, the share price went through the roof. VW’s market cap went up from $100B prior to Porsche’s announcement to $376B (easily surpassing ExxonMobil which was at $343B).
There were other effects of this phenomenal rise. VW is a component of the German share index – DAX. Now at a time when global markets were falling, DAX rose 11.3%, thanks to the ‘VW effect’. People who were shorting the DAX or fund managers who benchmarked their fund performance to the DAX were left hopping mad. There were widespread calls to boot VW out of the DAX index.
Finally Porsche managed to ‘help’ the hedge funds and traders by selling some of its shares (and making a huge profit in the bargain). Just goes to show that the global financial crisis is leading to some strange events, and some companies are making a ton of money from it!
***
This post presents a point of view which differs from conventional wisdom. Apart from being a good read (hopefully), it can also be a good starting point to help readers, preparing for CAT (IIM) or other MBA interviews, think differently. Since the data / facts for these posts are derived from a host of sources and websites, readers are advised to cross-check the authenticity before using them anywhere.
Since the subprime crisis erupted, the fortunes of car companies worldwide have been in decline, due to lack of consumer demand, shortage of credit, etc. Most stock traders and hedge funds were 'shorting' auto stocks. Short selling or shorting is the practice of selling a share that the seller does not own at the time of the sale. Short selling is done with the intent of later purchasing the share at a lower price. Short-sellers attempt to profit from an expected decline in the price of the share. In essence, you borrow a share and sell it now, and then buy it later (to return the borrowed share) when the share price has gone down.
Hedge funds and traders had shorted the VW stock to the extent of 13%, which means they had effectively sold off 13% of the total shares (and were expecting to buy them in the future at a cheaper price).
VW was owned 43% by Porsche and 20% by Lower Saxony. One fine day Porsche announced that they had increased their stake in VW by 31% to 74%. Now this meant that only 6% (100 - 74 - 20) of the VW shares were out in the market! Hedge funds and traders were left scrambling - they had to buy 13% shares, but now only 6% were available! As demand outstripped supply, the share price went through the roof. VW’s market cap went up from $100B prior to Porsche’s announcement to $376B (easily surpassing ExxonMobil which was at $343B).
There were other effects of this phenomenal rise. VW is a component of the German share index – DAX. Now at a time when global markets were falling, DAX rose 11.3%, thanks to the ‘VW effect’. People who were shorting the DAX or fund managers who benchmarked their fund performance to the DAX were left hopping mad. There were widespread calls to boot VW out of the DAX index.
Finally Porsche managed to ‘help’ the hedge funds and traders by selling some of its shares (and making a huge profit in the bargain). Just goes to show that the global financial crisis is leading to some strange events, and some companies are making a ton of money from it!
***
This post presents a point of view which differs from conventional wisdom. Apart from being a good read (hopefully), it can also be a good starting point to help readers, preparing for CAT (IIM) or other MBA interviews, think differently. Since the data / facts for these posts are derived from a host of sources and websites, readers are advised to cross-check the authenticity before using them anywhere.
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