The Forex Reserves Conundrum

Part of my job description demands me to teach, my fellow colleagues, about various types of securities including the US Treasury Securities. And, I try hard to justify my paycheck. Treasury Securities, be it a T-bill, T-note or a T-bond, are issued by a country’s central government to raise capital. The general perception is that Treasury securities issued by US Government are virtually free of credit risk, as they have the full faith and credit of the Government. At least, that is what I have been teaching in my class. The emerging American economic scenario, however, may soon force me to change the way I teach about them.

Capitol Hill’s balancing act
Every country needs capital for its growth. US is not an exception. To meet its expenditure, it levies taxes. If tax revenues exceed expenditure, the government has a budget surplus. On the other hand, if tax revenues trail expenditure, the government has a budget deficit. US Government’s budget has been in deficit every year since 1970, barring four years (1998-2001). The government raises debt (by issuing treasury securities, taking loans etc) to bridge this deficit. To put things in perspective, as of March 2009, America has managed to accumulate $10.9 trillion (Source: http://www.brillig.com/debt_clock/) worth of debt. When a country such as India invests its forex reserves in US Treasury Securities, it helps the US Government to cover the budget deficits. In other words, we indirectly fund America’s economic stimulus package, support Corporate bail-outs such as Bear Sterns, Fannie Mae, Freddie Mac, and AIG, and finance its war on terrorism.

Worried Chinese
Off late, the Chinese appear a worried lot and rightly so. After all, about half of China’s $2 trillion foreign exchange (forex) reserves are lent (invested in Treasury Securities and securities issued by Government Sponsored Enterprises such as Fannie Mae and Freddie Mac) to the US Government. Last week, Wen Jiabo, the Chinese Prime Minister, said that he was ‘worried’ about the investments concurrently criticizing US Government’s unsustainable model of development driven by high consumption and low savings.

China’s reliance on US dollar started coming down when it re-pegged its currency to a basket of currencies from the US dollar, a few years ago. The emergence of a strong Euro also supported this view. However, the mutual dependency between these two countries is forcing the Chinese to keep purchasing American bonds; China, in order to keep its factories running, should keep exporting to America, while a quintessential American is happy shopping a low-priced ‘Made in China’ product at Wal-Mart. The probability of US Government defaulting, though fairly limited, seems to be troubling China. The reassurances made by Secretary of State, Hillary Clinton, during her last month’s visit to China on the reliability of their Investments don’t seem to have allayed their concerns.

Should India be concerned too?
Perhaps yes, given that India is the fifth largest lender, behind China, Japan, Euro zone, and Russia. A sizeable portion of its $249.3 billion (for the week-ended March 6) forex reserves are invested in US Treasury securities. For years, several Indian economists were arguing that keeping money of such magnitude in forex reserves is highly risky and costly; a sharp decline in the value of dollar can result in losses. Also, they opine that these reserves can be reinvested in the domestic economy to drive growth. However, the Indian Government has learned its lesson the hard way; in 1991, it pledged its gold to Bank of England to tide over a ‘balance of payments’ crisis. Also, they know that large foreign currency can not only enable them to meet the debt obligations with ease, but also help them to play with exchange rates and in turn provide a favorable economic scenario. I am sure Indian economic experts will be closely watching to see how these turn of events play out.

My two cents
The stimulus package (we may also see another set of packages coming later this year) will require Obama’s administration to issue lot of sovereign paper. This may drive up the interest rates, concurrently lowering the prices of Treasury bonds held by countries like Japan and India and in turn reduce the value of their forex holdings.

Also, if these countries (particularly China) decide to alter their investment strategies (lets say, reinvesting in their own economy instead of lending it to US) it could spell disaster to the treasury securities market. In such a scenario, American consumers will face unprecedented increase in interest rates further delaying the economic recovery. The probability of this happening is though limited, America cannot ignore this risk; China is also going through a slowdown and has announced a stimulus package late last year, while India is not for behind in priming its economy. The need for capital has not abated in both these economies. After all, together they need to feed over two billion mouths.

Madhan Gopalan, the author, is a Consultant with Ness Technologies. The views expressed here are his own and not necessarily that of his Employer. He can be reached at gmadhan72@yahoo.com

Is it curtains for the Indian software Industry?

The ban slapped by the World Bank on Wipro and Megasoft following the Satyam saga seems to have raised more than just eyebrows. And rightly so. After all, the Indian software industry – perennially in the media limelight for the right reasons – is the centre of our sterling economic growth. Several Indian software companies have been showcased in the international markets as benchmark companies. However, the string of events that have taken place since December 2008 seems to have created a blot on Indian software companies re-emphasizing the negative opinions that arose from certain quarters every now and then. These incidents also raise serious questions on the systems, regulatory norms and disclosure practices of India Inc. Not to mention that this gives an opportunity to staunch anti-offshorer’s to walk with ‘I-told-you-so’ smirk in their face.

Are these notions justified?

It appears that we are looking at these isolated incidents with a magnifying glass. In April 2001, The New York Times published a story, accusing New York-based Computer Associates (CA) for malpractices, and inflating profits and earnings by using `pro forma, pro rata’ method. How is the Satyam incident any different from the ‘aggressive earnings management’ performed by CA at the broad level?

Also, Frauds, scams and allegations are not quite uncommon for the Indian outsourcing Industry. For instance, in 2005, Australian media alleged illegal sale of customer data by a BPO based at Noida, India. I am not sure how successful National Association of Software and Service Companies (Nasscom) was in bringing in the alleged perpetrators, if any, to justice. In 2002, the Chief of the software company Polaris was arrested (and later released) by the Indonesian police, after the company’s Banking customer, Artha Graha, filed a complaint alleging deficient performance in the software deployed by the Polaris. During the same year, the Department of Company Affairs cracked the whip by prosecuting several companies including Cyberspace, DSQ Software, Pentamedia Graphics, Nakshatra Software and Goldfish Computers. Some of the charges that were levied on these companies included placing incorrect statements in the prospectus and fraudulently inducing individuals to invest money. A year priot to that, Silverline Technologies was charged with insider trading.

What it means to Indian software companies?

‘Pooh pooh’ing the sequence of events in the name of isolated incidents doesn’t seem right either. Considering the Global financial crisis, the recent set of events is a double whammy. The acts of Satyam, considering the size and the reputation it held in the past, and the Whiplash of World Bank certainly seem to have certainly dented the image of the Indian software Vendors. Several Industry players experts opine that these events are a blot on the Indian software industry.

Globally clients will be reluctant to move new engagement offshore. Indian offshore vendors should also expect accentuated levels of scrutiny from global clients prior to off-shoring. A greater emphasis on Governance at the Program/Project level will be expected by the Clients as well. The impact is likely to bigger on the European front, considering their level of risk-averseness. Indian software companies may lose the small advantage (of penetrating the European market) they got after years of long and hard fought battles.

What needs be done?

Software companies needs to first address the immediate concerns of the clients, by delivering the existing projects on time without cost and time over-run. This will enhance their confidence in the vendors. Also, India Inc. needs amended Acts that plug the holes, ensure better disclosures, and bring-in greater transparency. Else, scams such as these will keep popping every now and then over time.

Madhan Gopalan, the author, is a Consultant with Ness Technologies. The views expressed here are his own and not necessarily that of his Employer. He can be reached at gmadhan72@yahoo.com

Is it the tip of the ice-berg?

The Chapter 11 (Bankruptcy Protection) filed by the 158-year old Lehman Brothers, the $50-billion sale of Mother Merrill to Bank of America, and the ratings downgrade of AIG seems to have sent shiver down the spine of investors in both mature and emerging markets. A reflection of the same was seen in Wall Street, as it posed its worst losses since September 11, 2001. Fears that other big Investment Banks can belly-up also seems to be haunting the investors. It may be pertinent to note that Two weeks ago, U.S. Government bailed out two of its Mortgage agencies – the Fannie Mae and Freddie Mac. A few months ago, it also bailed out Bear Sterns. However, this time it was unwilling to commit tax payers money to bail out Lehman. Understandably, this is a cause for concern for several software and IT companies in India given their dependence on BFSI (Banking, Financial Services and Insurance) segment.

Likely outcome

Albeit a good year into sub-mortgage crisis, several Investment Bankers are still reeling under losses. Case in point is UBS, one of the largest Investment Banks based out of Switzerland, which has posted pre-tax losses to the tune of US$21 billion in the first six months of 2008. Arguably, this just appears as the tip of the iceberg, as the crisis is slowly moving towards the ‘prime mortgage’ segment. To a large extent, this is due to steady increase in job losses, which is forcing even genuine EMI payers to default. Adding to the woes is the steady increase in the mortgage rates, despite the rate cuts initiated by the Federal Reserve. This may further result in a drop in the home prices, as Job losses will deepen. Fed may opt for some more rate cuts, given the liquidity crunch the market is facing currently.

What it means to Software companies

Companies such as Wipro and Satyam claimed (in a Television Channel) that the Lehman’s bankruptcy may not impact them as their exposure to the company is low. Infosys, on the other hand, claimed that the acquisition of Merrill Lynch to add to their revenue, given BOA is their key customer. Taking a broader perspective the scenario does look gloomy, though there seem to some light at the end of the tunnel.

It is pertinent to note that Indian software companies get over 90% of their revenues from US and European Customers, even as $600 billion worth of Investments are made on IT budgets every year globally. But, only a miniscule of it is generally outsourced. However, given the looming crisis several fortune 500 companies may tighten their IT budgets. In other words, several projects on the anvil (on the verge of being outsourced) may get shelved. IT services providers may also be forced to cut their prices (and in turn their margins) while bidding for projects, as the market pie grows smaller. Software companies will be forced to part with their employees to survive this shakeout over the next one year. Companies such as Satyam have started paring its employee count, even as they put several employees under ‘performance improvement’ programs. This crisis, however, will also enable the software companies to source better candidates in the market, at modest price levels.

A closer introspection of results of Investment Banking companies, for the quarter-ended September, may reveal some more interesting insights. Till then, let us keep our fingers crossed.

Madhan Gopalan, the author, is a Consultant with Ness Technologies. The views expressed here are his own and not necessarily that of his Employer. He can be reached at gmadhan72@yahoo.com

Wealth creation for Dummies

Is it the economy that is behaving badly or is it us? Any article you read these days has references to the rising crude prices, Inflation problems, high interest rate regimes, mortgage problems and eventually some larger problems that with economy that a common man cannot understand. To not deviate from the trend, I have mentioned them here as well. Creating wealth may be easy when you follow some simple rules.

I am no analyst when it comes to an area like this, but my portfolio has consistently out-performed those of experts and for that reason, I feel obliged to share my wisdom and relieve the common folk of their miseries. Most message boards/ Q&A sessions that I participate, have very simple questions for which the analysts and experts give complex undecipherable answers with a lot ofjargon's that leave the questioner even more confused. The problem as I see with many investors, is that they are not sure why they went in for a particular investment be it stocks or Mutual Funds (MF) or other types.If you are blindly following a recommendation of your friend or a broker, then that could be your problem. If you need a washing machine that can wash and rinse on one touch, then would you buy a semi automatic one just because the sales man recommended that to be the best deal.

In many cases, If you have done your research, it wouldn't matter what kind of investment you make and what the cost price of your investment is. I am going to list a few cliches below that would stand in good stead for equity investors in the long run. Some of these can be generically applied to other kinds of investment.

• Patience is a virtue - Companies take time to grow and they evolve as they grow there by increasing value to share holders. At difficult times, they test your patience and question your judgement. At these times, review your decision and see if somethingfundamental has changed. Base your decisions on your review.

• Identify your investment style - Are you a aggressive investor looking for 50 % returns in a year or are you a passive investor looking for a moderate 15% return and so on. Place your bets based on what you are expectations are. Small companies may grow fasteras compared to the bigger ones and may suit an aggressive investor Traditionally Large caps give you a moderate return as compared to small and mid ones. The risks are always in directproportion to your returns, so choose wisely.

• Have a plan in place - When you invest in an asset, decide how long you may want to hold it, and review periodically. If you have decided to hold a stock for 5 years, then identify your return goals and review the same periodically. If you purchased a stock 'x' for 100 in 2005 and expect it to grow to 1000 by 2010, then do not look at it's share price everyday, but review it periodically to ensure that it will become 1000 by 2010. Reinvest if required and do not get stuck with the stock, for the sake of it. A wrong judgement when corrected early can prevent bigger losses.

• Invest systematically - Very self explanatory, make sure you set aside some part of your money every month for investments,Do not delay investments for the sake of expenses. Discipline with investment is what will create wealth.
  

• Start early - The power of compounding is something that will astonish you. Invest regularly, and over time your investments will grow in multiples. A one year delay on your start could push you behind the race for wealth.In fact have a retirement plan in place so you know when you need to start investing and how much you need to invest every month.

There are quite a few others, but i don't want to dwell into all of them. Whether you invest by yourself (in stocks) or want to leave things with a portfolio manager, make sure you set your expectations clearly. The principles of wealth creation are simple enough but as you see with Kya Aap Panchavati Pass Se Tez Hai? (Are You Smarter Than a 5th Grader?), not many are as smart as they think they are and King khan's show proves that very well.
- Suresh
The author works for a Global IT consulting organisation as a IT consultant. He is currently based out of London. The views expressed in this article are his own. All copyrights and Trade Marks are duly acknowledged. He can be reached via the link on the right tab on this page.

Sensex and Nifty: What Next? - Part 2

My two cents

Predicting the direction of market is like driving a car blindfolded taking directions from a man who is looking out of the rear window. Nevertheless, I am willing to stick my neck out and say that the chances of Sensex touching 20,000 again in 2008 is limited. I also expect the markets to remain volatile through the remaining part of the year, even as crude wreaks havoc on the earnings card of index stocks. The rationale:

Earnings may remain under pressure

Investors value a stock (and in turn the index) based on future earning expectations and not the trailing earnings growth. An analysis of Sensex companies indicate that the top-line and bottom-line growth of these stocks may decelerate over the next few quarters:

• Revenue of software firms, Infosys, Satyam, TCS and Wipro, are likely to take a hit as US economy is struggling with a slew of things including a housing slump, a mortgage crisis, job losses and a possible downturn. The recent change in the rupee-dollar parity (Rupee has lost about 7-8% against the dollar in the last few weeks and is currently trading at Rs 42.8 per dollar) may offset this a bit
• The possibility of an increase in interest rate and Cash Reserve Ratio, on the back of higher inflation that is set to touch 9%, also don’t augur well for banks; credit disbursements, and in turn the revenue, of SBI, ICICI Bank and HDFC Bank may get impacted. Higher interest rates also don’t bode well for realty companies such as DLF, as homebuyers in India predominantly buy through housing loans. It is worth noting that interest rate on housing loans has climbed 4 to 5 percentage points in four years
• Higher input costs will also be a cause for concern for several corporates. With crude marching its way towards $150 a barrel (it is currently trading at $135 a barrel), the margins and in turn the earnings may come under pressure. The demand for crude and the subsequent price surge may not abate in the near term, as China may consume more to rebuild itself from its worst natural disaster in the recent times. The recent hike in gasoline price is likely to act as a dampener on the sales of automobile manufacturers, Tata Motors, Mahindra & Mahindra and Maruti Suzuki.
• The price of coal, the key input for cement, steel and power companies, also has more than doubled in the last one-year. Jaiprakash Associates, ACC, Ambuja Cement and Tata Steel, may find it difficult to pass on these increase costs to the customers as the Government has requested not to hike the price of key commodities such as Cement and Steel

FII flows may diminish

WL Ross, a FII, recently told a television channel that they are net buyers in the Indian equity market. Exceptions such as these are very rare, as FII’s remain net sellers in 2008. According to SEBI, FIIs have sold (net) $4.5 billion worth of securities as of 9^th June. Ben Bernanke, the chairman of the Federal Reserve, recently said that the risk of a substantial economic downturn has diminished. This perhaps is an indication that further rate cuts are limited. In turn, this may also lower purchases by FIIs in the Indian markets.

Conclusion

As negative global cues continue to depress investors’ sentiment, markets are likely to remain volatile. It would be interesting to see the next two quarters earnings card as they would determine the course of the market. If Sensex touches 20,000 again in 2008 without a clear visibility or a strong earnings support, it would be another case of irrational exuberance.

Madhan Gopalan

The author, who is currently based at Chennai, India, is an independent Investment Management consultant. The views expressed here are his own. He can be reached at gmadhan72@yahoo.com