Tuesday, September 1, 2015

Mr. Market emerges victorius, once again


"Time has been transformed, and we have changed"
-Khalil Gibran (Lebanese, 1883-1931)
Word for the day
Enceinte (adj)
pregnant
(Source: Dictionary.com)
Malice towards none
Governor Rajan says he continues to remain "accommodative". Whereas industry finds him unnecessarily hawkish.
Could you solve this conundrum?

Mr. Market emerges victorius, once again


The apparent failure of the largest equity for debt swap in the history holds important lesson for all of us.

The Chinese policy makers faced with mammoth debt of state of enterprises (SoE) and poor health of their financial sector hastily encouraged transfer of risk from SoEs to their unsuspecting population.

The process worked like this:

·         The state encouraged the household investors to take out their deposits from banks, bring in their money lying in overseas accounts, leverage their strong balance sheet and overseas assets to buy equity in SoEs, which had unmanageable debt on their books.

·         The SoEs would redeem their debt to the domestic lenders from the equity money collected from household investors.

·         Lenders would use the repayment received from SoEs to fund the margin money to fuel an unprecedented stock market boom to create wealth effect at massive scale.

This wealth effect was needed to propel domestic consumption needed to support (i) the economic growth that was sinking as the export demand slowed down and (ii) the overcapacities in infrastructure sector that had begun to look ridiculous.

The objective therefore was to kill many birds with one stone, e.g., - (a) convert the unmanageable debt of SoEs into equity, (b) restoring the health of lenders through repayments received from SoEs; (c) create a massive wealth effect to encourage domestic consumption to lower the reliance on exports for growth; (d) make the humongous investments made in infrastructure building in past one decade financially viable through higher utilization rate.

The gamble has obviously failed.

Mr. Market has once again emerged victorious in a battle with the state. It is proven once again that attempts to control free markets through state command are least likely to succeed.

The refusal of Chinese stock market to play the ball has actually increased the financial stress to ominous level - as a large part of the stress which was concentrated only at few SoEs and lenders has got spread out widely to households.

As we know from our experience from a similar episode, popularly known as Harshad Mehta period (1989-1991), the destruction of household wealth at this massive scale causes structural problems in the economy and the impact lasts for many years.

Even after so many years of that episode, the household investment in stock market has not reached even at half the level seen in early 1990s. Despite one of the highest household savings rate in emerging markets, the foreign money gets to play the controlling role in our stock market.

More on this later this week.

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