Vijay Kumar Gaba: July 2020

Friday, July 31, 2020

New Education Policy - Encouraging proposals

The government finally released the broad contours of New Education Policy. The last such policy was formulated 34years ago in 1986. Since then the socio-economic and technology context have completely changed. We are perhaps 25years late in effecting the necessary changes in our education, training and skill development system. Nonetheless, the new policy proposal is a strong positive move and needs to be welcome. In fact, it is arguably the best thing that has happened to India since MNREGA and RTE were implemented more than a decade ago.

The new policy is a "reform" in true sense, as it aims to change the status quo materially. The new proposals mark significant departures from the extant methods & practices of teaching, curricula, learning objectives, assessment procedures, regulatory framework, and other related aspects of the education system. The strong emphasis on accessibility & affordability, vocational training, value system, ethical orientation, nationalism etc. is a great initiative. Incorporation of modern technology in the curriculum is most desirable. The focus on development of creative thinking and solution based approach of young students is also much needed.

The goals of the policy are obviously ambitious, when assessed in the present context of fragmented political establishment, resource constraints and dominance of the vested interest groups who control the present education eco-system in the country. The implementation (particularly within the given timeframe) therefore is certainly going to be challenging. I wish the administration and political establishment will show strong commitment to come over all challenges.

Having said this, I would also like to share the following observations:

(a)

(b)

The influence of the American education system is too conspicuous on the policy proposal. This is a good thing as that system has been extremely successful in delivering the desired objective, and admired world over. However, ignoring the basic qualities of that system - uniform education to all desiring students and high quality education in government schools - raises some doubts.

(c)

Thursday, July 30, 2020

I am happy not owning Gold

Lately, I have received a lot of queries from readers about Gold. Everyone seems to have woken up to the idea of investing in yellow metal. Many readers have read a lot about the latest trends in the global financial markets, and appear to be in full concurrence with the idea of structural decline in the relevance of USD as global reserve currency; however the views about the rise of EUR or CNY as alternative reserve currencies do not seem to be sanguine. This uncertainty about the future of the global financial system is probably driving the interest of investors towards gold, which has traditionally been a popular reserve currency and preferred store of value during crisis period particularly.

Many readers have highlighted that it was perhaps a mistake on my part to cut allocation to gold in my portfolio. I would like to answer the queries and concerns of the readers herein below.

First of all, I would like to remind the inquisitors that it has been my consistent stand in past three decades of my investing life that in my view gold being mostly an unproductive asset, having little industrial use, does not qualify to be an "investment" grade product. Given its popularity and general acceptance in global financial system, it does qualify to be a decent alternative to the paper currency. It therefore does well with the rising inflationary expectations and negative real rate environment. I therefore use it more as a tactical shift from cash & bonds; and sometime as an opportunistic trade. I never use it as a permanent asset class in my asset allocation. (read more on this here Gold is glittering; but is it the endgame?) Incidentally, my wife and daughters are also not fond of gold; so there is no conflict on this issue at least!

In my investment strategy update for 2020 in December (see here), I had stated- "In view of the adverse risk reward ratio and growing divergence between bond and equity yields, I shall scale back my strategic equity allocation to 50% from 60% presently. The strategic asset allocation now stands at 50% Equity; 25% Gold and 25% Debt."

However, as the news of COVID-19 outbreak from China spread and global markets started to take note of the crisis in February I revised my asset allocation to sell the tactical allocation to gold and upgrade equities to overweight (see here). Incidentally, markets tanked in March affording me an opportunity to make the shift at favorable prices.

In April after the global economy went into a lockdown, I made a big call, increasing the equity allocation further (see "Time to Take Big Call") I maintained my equity overweight stance on asset allocation and increased equity allocation further to 70% from the previous 65%, cutting the debt allocation from 30% to 25%. The overweight stance on IT, Pharma and chemical (including agro chemical) was adequately emphasized.

I am pleased to note that the strategy has worked out well so far. Since the recent bottom of the market recorded on 24 March, IT sector has returned 61%; Pharma sector has returned 57%; Nifty is up 48%, S&P500 is up 41% and gold is higher by 29%. The chemical sector has also outperformed the benchmark Nifty and gold comfortably. Average IT sector mutual fund return has been 35% (absolute) in past 3 months.

I therefore do not see much point in this brouhaha over gold, and would prefer to continue with my strategy for some more time, till I see indications of an imminent and material correction in the equity prices.

Wednesday, July 29, 2020

SEBI need to learn the art of adding salt to the dish

The new margining norms proposed to be implemented from 1 August 2020, in respect of the equity market trades done on stock exchanges are a cause for worry for one simple reason, i.e., this highlights for the n^th time that the securities market regulation in India lacks a robust conceptual framework.

It is important to understand that regulation of securities market is like salt in a dish - any excess or less magnitude of regulation could make the dish unpalatable.

Any market participant would vouch for the fact that the regulators understanding of the risk management needs in the securities market is inadequate, as it relies more on adhoc methods rather than a strong conceptual framework. In the event of a crisis, comes out like a brave fire fighter and douses the fire with whatever tools it has. Unfortunately, there is little empirical evidence to highlight that SEBI has taken enough preventive measures to stop frequent occurrences of crisis in the market. We frequently witness the cases of blatant price manipulation, malpractices, and unethical conduct by corporates, intermediaries and large traders (called "operators" in the common market parlance). In past 28yrs of SEBI existence as statutory market regulator, there has been little diminution in the frequency or intensity of these instances.

The market participants will also vouch how much detrimental has been the SEBI's intervention in the matter of securities' classification for the purposes of categorization of mutual fund schemes. Ideally, the regulator should have flagged its concerns to the industry and self regulatory organization governing the industry, and let them evolve the optimum solution. Not relying upon the industry and imposing rules which made little sense caused tremendous pain to the industry and investors, and benefitted almost none.

One primary reason for this in my view is the lack of a robust conceptual framework for securities'' market regulation. For example, let us consider the instant case of revision in margining norms.

Minimizing the systemic risk is one of the paramount concerns of the securities' market regulation. Imposing prudent margining requirement for traders is one of most popular and effective method of managing the systemic risk. However, it defeats its purpose if margins become excessive or impractical. It is important to understand that margins are used to mitigate systemic risk of default on settlement obligation and not for the purposes like managing the trading volume etc.

There are two types of margins imposed in cash market, viz., (i) Value at Risk Margin (VaR) and (ii) Extreme Loss Margin (ELM). VaR is calculated based on historical volatility and trading pattern. This covers the normal expected adverse movement in the stock price in one day. ELM is used to cover exceptional volatility due to some extreme event. These margins should be adequate to cover 99.999% of cases of payment defaults.

When, an investor sells shares in the market, the default counterparty is the clearing corporation (e.g., NSCCL). Thus, the clearing corporation guarantees the settlement of all the trades executed on a recognized stock exchange. The moment trade is executed and securities are delivered to the clearing corporation as pre pay-in, the VaR for the seller defaulting on its obligation becomes Nil. Since the counterparty is clearing corporation, the risk of counter party default for the seller is also Nil. Not allowing seller to use the sale proceeds for buying other securities is certainly no prudent risk management. This in fact creates doubts about the infallibility of clearing corporation itself, which in turn makes the whole argument of trade guarantee and secure settlement system suspicious.

There are also chances that some of the traders may move to grey market (dabba market in common market parlance) for trading, thus exposing themselves to larger risk of default.

Tuesday, July 28, 2020

Consequences of runaway debt accumulation

Continuing from Friday (see Slipping back into deep abyss)

Two of the key questions that are begging answer from the central bankers infusing trillions of dollars in fresh liquidity in the global financial system and the governments borrowing incessantly to further their populist agenda, is what will be the impact of this debt burden on the potential economic growth? and How the perpetually slow growth will impact the demography, i.e., whether the world will follow the demographic trends of Japan and grow old? (see How will this tiger ride end?)

As per the World Bank report titled Global Waves of Debt - Causes and Consequences, "Amid record high global debt, low interest rates and subpar growth have led to an intense debate on whether the recent rapid increase in debt is reason for concern. Some argue that countries, especially those that issue reserve currencies, should take advantage of low interest rates to borrow more to finance priority expenditures. Others caution that high debt weighs on long-term growth, by increasing the risk of crises, limiting the scope for countercyclical fiscal stimulus, and dampening private investment."

The report further highlights that, "Although the focus of this debate has been mainly on advanced economies, similar issues are also faced by EMDEs. Many of these economies have also borrowed heavily and, in many cases, hard-won reductions in public debt ratios prior to the global financial crisis have largely been reversed over the past decade. The tradeoffs EMDEs face are actually even starker, in light of their histories of severe debt crises even at lower levels of debt than in advanced economies and their more pressing spending needs to achieve development goals and improve living standards."

The importance of public debt in growth economics can hardly be overemphasized. Government investment in physical and human capital provides an important foundation for stronger economic growth over the long term. It helps in attaining the ideal goal of full employment and optimum capacity utilization on sustainable terms.

It is important to note that despite substantial progress over the past two decades in many areas, several Sustainable Development Goals (SDGs) remain well out of reach. As per the World Bank estimates, to meet the SDGs, EMDEs have large investment needs: low- and middle-income countries face aggregate investment needs of $1.5–$2.7 trillion per year—equivalent to 4.5–8.2 percent of annual GDP— between 2015 and 2030 to meet infrastructure-related SDGs, depending on the effectiveness of this investment, accompanying policy reforms, and the degree of ambition in meeting the SDGs. Higher debt level for emerging and underdeveloped economies is necessary in most cases.

Besides, temporary debt accumulation can also play an important role in helping to minimize and reverse short-term economic downturns. During recessions, borrowing financed government spending or tax cuts can provide stimulus to support demand and activity.

However, it is important to do an intensive cost benefit analysis of every dollar in new debt. The cost of debt is not only the interest payable on such debt; but also the impact of the debt on the future growth potential and changes in socio-economic structures.

During the post-crisis period, the cost of government borrowing in terms of rate of interest has been historically low, for both advanced economies and EMDEs. Further, demographic shifts and slowing productivity growth are expected to contribute to a further secular decline in real interest rates in advanced economies, continuing a multi-year trend. However, if a sudden increase in global borrowing costs occurs; the sustainability of high debt in some countries will be tested. A failure in this test could bring disastrous consequences.

As per the World Bank, "Debt sustainability has deteriorated since the global financial crisis both in advanced economies and in EMDEs. In advanced economies, debt-reducing fiscal positions (i.e., positive sustainability gaps) in 2007 turned into debt-increasing fiscal positions (i.e., negative sustainability gaps) from 2008. Subsequently, sustainability gaps narrowed and, in 2017, returned to debt-reducing positions. In EMDEs, debt-reducing positions in 2007 turned into debt-increasing positions in 2015.

In commodity-exporting EMDEs, this deterioration partly reflected the sharp growth slowdown that came in the wake of the steep slide in commodity prices. Subsequent recoveries in commodity prices and economic activity helped improve debt sustainability in these economies and, by 2018, fiscal positions in commodity exporters had become debt reducing. In commodity-importing EMDEs, fiscal positions have remained weak as a result of fiscal stimulus implemented during the global financial crisis, chronic primary deficits, and, in some cases, anemic post-crisis growth, leading to debt-increasing fiscal positions in 2018.

High debt constrains governments’ ability to respond to downturns with countercyclical fiscal policy. This was the case during the global financial crisis: fiscal stimulus during 2008-09 was considerably smaller in countries with high government debt than in those with low debt. This is one of the reasons why weak fiscal positions tend to be associated with deeper and longer recessions, a situation that worsens if the private sector also falls into distress and its debt migrates to government balance sheets as the government attempts to rescue private enterprises. Reducing the effectiveness of fiscal policy. High government debt tends to render expansionary fiscal policy less effective. Specifically, high government debt can reduce the size of fiscal multipliers through two channels

With higher debt typically comes higher debt service. Spending on higher debt service needs to be financed through some combination of increased borrowing, increased taxes, and reduced government spending. Spending cuts may even include spending on critical government functions such as social safety nets or growth-enhancing public investment. Separately, high and rising government debt may raise long-term interest rates and yield spreads. High debt could also create uncertainty about macroeconomic and policy prospects, including risks that the government may need to resort to distortionary taxation to rein in debt and deficits (IMF 2018a; Kumar and Woo 2010). Higher interest rates and uncertainty would tend to crowd out productivity-enhancing private investment and weigh on output growth.

As per the available empirical evidence, a return to monetary policy normalization in advanced economies could raise borrowing costs (Ruch 2019). If there was a rapid increase in policy interest rates, as happened in the first global wave of debt accumulation, it could be accompanied by large currency depreciations in EMDEs that would sharply increase debt service burdens for foreign currency-denominated debt (Arteta et al. 2016). It would also be likely to trigger a turn in investor sentiment that would especially affect those EMDEs with large foreign participation in local bond markets, which in some economies now exceeds 30 percent of government bonds. Although the normalization of monetary policy in USA and EU is not visible on horizon, occurrence of this even could spell disaster for many emerging economies.

It is pertinent to note that during crisis it does not take much for the private debt to become public debt. Large private sector losses, including losses threatening bank solvency, and the materialization of contingent liabilities, including those of state-owned enterprises, can lead governments to provide substantial financial support. We have seen glimpses of this phenomenon in India in past 10 years.

During the current wave of debt, potential growth in EMDEs has also declined, because of slower productivity growth as well as demographic change. Productivity growth has declined as investment growth has slowed, gains from factor reallocation have faded (including the migration of labor from agriculture to manufacturing and services), and growth in global value chains has moderated. Slower investment growth has tempered capital accumulation. Demographic trends have become less favorable to growth, since the share of working age populations in EMDEs peaked around 2010. In case of India it is expected to peak in this decade. Burgeoning debt could therefore a major issue for these economies.

(Most of this write up is reproduced from the Word Bank Report titled Global Waves of Debt - Causes and Consequence. The copyrights are acknowledged.)