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What to make of this global crisis - Ajit Dayal
Yes,
Radha, the bust in USA will hit us in India.
In May 2006 when the BSE-30 Index declined by 17% in
eight sessions, we wrote about the bubble in the Middle East markets -
Markets Do Fall (PDF) and said, "Better economic and GDP growth is not an
assurance to a perpetually booming stock market".
The link between financial markets in the US and Indian
stock markets
Today, as the Indian markets get lashed by something
called sub-prime mortgage, we are being asked to remain calm and cool as
there is no linkage between what happens to the financial markets in the
US and to the Indian stock market.
Well, that is a partial truth and, in effect, a partial
lie.
Stock markets are influenced by 2 factors:
1) how much do companies earn, and
2) how much are people willing to pay for those earnings.
The earnings power of a company is a function of the
business of the company, its management, and the overall growth rate in
the economy in which it operates. There is little change here in our view
and we should safely assume that India's GDP will grow at a 6% to 6.5% per
annum rate for the next few years. (Many more optimistic people have a
higher GDP growth rate for India at 8% plus but we don't subscribe to that
view as yet.)
Understanding liquidity & sub-prime debt
How much people are willing to pay for those earnings
is a function of what economists call "liquidity" and though there is no
clear definition of what "liquidity" is, one can assume that it is how
much money is sloshing in the system. Imagine you are at a bar and
everyone is feeling a little good from the various other liquids that the
bar tender has to offer for a price, of course. Then the bar tender says,
"Hey, folks, how about I cut the price of the drinks by 50% - anyone want
some more?"
You bet! The crowds get bigger and people feel even
more elated. With all those drinks available on the cheap, they lose their
sense of judgment. Human nature is anyways tuned to drift into
flirtations. With a few more drinks, the drifting becomes a reality. The
poor bloke standing next to you in this bar - a total stranger - suddenly
feels like a friend. You begin chatting. By the end of the fifth glass,
the poor fellow who works as a waiter in some corner restaurant in some
obscure town in USA now looks like a promising young man who could one day
start his own restaurant, build his own mall, and maybe have a chain of
restaurants. So you lend him money to buy a house. He is actually what the
credit rating agencies would call a "sub-prime credit risk". But, because
that bar tender gave you all those free drinks, in your eyes he becomes a
good risk and better still, you turn to the other drunk next to you and
re-sell the loan you made to this sub-prime fellow for a profit. And why
do you sell the loan for a profit? Because the guy you sell it to (a
European, Japanese, Middle Eastern, whoever) is more drunk than you
because the bar tender in his country also gives him free drinks. And he
cannot assess the risk profile of that sub-prime American any better than
you can. So all the drunks are happy. And you use that profit to make
another loan to another poor sub-prime fellow and so on and so forth......
Since 2003 all the drunks are having a good time,
lending and buying and selling sub-prime loans to each other.
All the sub-prime folks who got this silly money in
2003, 2004, and 2005 from the folks at the bar thought they were rich and
started buying big houses and big cars and spent money which was not
earned, but borrowed.
The bar tender is serving the drinks because he needs
to make sure everyone feels good. There may be an election around the
corner. Or if he serves his drinks quick and fast, some big bank group may
come in and hire him as a consultant or make him a chairman of a global
financial conglomerate riding this tide of global liquidity.
So the central banks were the bar tenders, doling out
drinks and money as if their printing presses had to print, and print and
print. Rather than being the men in grey suits with grumpy faces worried
about the fate of the financial world, they became the stars on TV
channels and the toast of conventions: their suits were grey but they were
talking about this perfect world and this goldilocks, fairy tale.
And that fairy tale found its way to India and the rest
of the emerging markets. From being the poor countries with corrupt
governments and inept governments that have consistently failed to look
after the needs of their people, these countries got a new name: BRIC.
They became the darlings of the drunks. Yes, while there have been
significant improvements in many countries - including India - the
perception of the depth or the sustainability of these improvements were
exaggerated when the drunks at the bar came calling.
India has seen nearly US$ 50 billion of foreign inflows
- of which US$ 40 billion have come in since 2003. Yes, the Indian
companies and the Indian stock markets did deserve a lot of that but the
assessment of risk has been, in my opinion, absent.
The sub-prime fall out
The sub-prime blow has so far seen some US$ 2 billion
of losses from funds that have been closed down. There is maybe another
US$ 50 to 100 billion of losses that may yet be exposed, according to
people who track this industry. While US$ 100 billion is nothing in a
world where the market cap of stocks is US$ 30 trillion (300 times the
potential losses) and where bonds worth maybe US$ 100 trillion float
around, the bar tenders are now serving less of that booze. The drunks are
getting more sober. They now see that sub-prime person as someone who may
be lucky to keep his job in a restaurant as opposed to their previous
assumption (over the rim of their liquor glass) that they were lucky to
stumble on the founder of the next new big restaurant chain in USA. And
they will price that loan accordingly.
And they will see the investment opportunities in the
emerging markets with a little better understanding of risk. Don't get me
wrong: the fundamentals for India are fantastic, and money will flow in to
India over the next decade. Sensible, risk-assesses money. But for now,
the silly money will go out. The P-Note folks will vacate and that will
cause the Indian market to suffer.
India has, via its P-Note policy, linked itself to
silly money. We enjoyed the ride for the past 4 years, now we will feel a
bit of pain.
Keep your money ready to invest. Stay disciplined,
never be carried away, politely tell the bartenders to keep their extra,
free drinks. And you will profit: steadily but surely.
Ajit Dayal is Director,
Quantum Advisors Private
Limited. Ajit is the founder of
Quantum Asset
Management Company Pvt. Ltd. and also Quantum Information Services
Pvt. Ltd., which owns
Equitymaster &
Personalfn.
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