Vijay Kumar Gaba

In July 2007, investment bank Bear Stern announced that couple of its hedge funds have gone bust. These funds were primarily investing in derivative securities with home mortgages as their underlying. It was later unfolded that the underlying for these derivatives were actually a web of complex financially engineered instruments where actual underlying security was of very poor credit quality. This was the first time when “sub-prime” entered the popular market jargon; which essentially meant that though a derivative financial instrument is rated of investment grade, the actual security underlying that derivative is of sub-standard quality.

The market briefly took note of this event correcting sharply. However, the event was soon forgotten as a standalone instance that could not have impacted the overall markets. Subsequent months witnessed one of the sharpest global markets rallies.

In January of 2008 it was realized that Bear Stern was just a tip of the iceberg. The malaise of sub-prime was all pervasive and had impacted trillions of dollars in derivative instruments. What started with Bear Stern, soon engulfed the entire world. Many large banks and hedge funds were found to be infested with this termite. Not only banks, it has hollowed finances of many sovereign governments like Portugal, Iceland, Italy, Greece, and Spain (PIGS) etc.

What followed was total chaos. The global market froze. Trade and commerce was hit as banking channels were shut and credit frozen. The giants like AIG, CITI Bank, The Federal National Mortgage Association (commonly known as Fannie Mae) and Federal Home Loan Mortgage Corp (commonly known as Freddie Mac) etc came to the brink of disaster. Some of the top US investment banks like Lehman Bros, Countrywide and Merrill Lynch etc. could not survive.

To mitigate the disaster, the central banks and governments devised some innovative monetary policies (commonly known as Modern Monetary Theory or MMT). Under these large central bankers started an unprecedented quantitative easing (QE) program, which is nothing but an euphemism for printing new money and buying stressed assets with that money to support the market from collapsing. US Treasury also unveiled a US$800bn Troubled Asset Relief Program (TARP), under which it financed the stressed lenders by infusing equity or extending liberal credit. TARP was unwound in 2014 with US Treasury actually earning some money out of this.

The QE program has been extremely successful in at least one of its stated objective, viz, ensuring financial stability. The sovereign default crisis in peripheral Europe was totally averted. Global markets reopened immediately and credit flow restored. The asset prices were not only normalized but exceeded their fair value in couple of years. The other objective of faster sustainable growth is however yet to be achieved.

The Central Banks, primarily US Federal Reserve (Fed), European Central Bank (ECB), Bank of England (BoE) and Bank of Japan (BoJ), however continued their QE program, though the extent of printing money has been tapered. To mitigate the impact of pandemic, central bankers have again started to expand their balance sheets (printing money).

Back at home, RBI had resisted any QE in the wake of global financial crisis. The stimulus given by the government of India was also very limited, as Indian economy was not directly impacted by the crisis. None of our institutions were meaningfully involved in global Ponzy schemes of sub-prime mortgages and credit default swaps (CDS). Overseas branches of few banks lost some money in forward forex contracts and underwriting sub-prime papers, but nothing to threaten their existence or impact the domestic financial system meaningfully.

The economic crisis due to pandemic is however very different. It has directly impacted our economy and financial system. Besides, the financial system was also struggling with the lingering impact of the large credit defaults of IL&FS etc. RBI therefore has to step in along with the central government. While the central government has done multiple tranches of fiscal stimulus, RBI on its part has started its own version of QE program, with the hindsight gained from the global experience of past one decade.

Through this program, it has successfully managed to keep bonds and currency market stable; supporting the government’s expanded borrowing program, improving the current account and comforting the foreign investors who could be panicked if INR exchange rates fluctuated wildly.

The collateral benefit of RBI’s QE program to the government has been huge interim dividend of Rs911bn for FY21. The RBI would have made huge profit in trading of (a) government bonds (LTRO, Twister etc.) in which it buys bonds of shorter maturities and sells bonds of longer maturities and (b) trading of INRUSD by selling spot USD (to keep INR stable) and buying longer term swaps, or the other way round.

Given that RBI usually buys the asset under some stress (bond or currency), has the ability to print money, and need not bother about the MTM losses on its positions, the chances of it losing money on its trades are remote. It is therefore reasonable to assume that RBI shall continue (and even increase) its trading activities in years to come. It is too easy and lucrative source of income and managing markets to give up easily.

There will be no surprises to see (a) the finance ministers providing higher dividend from RBI in years to come; and (b) senior bankers with rich experience in managing treasuries being at the helm of RBI.

 A Newsweek story couple of weeks ago (see here) highlighted that Americans may not be splurging the $1400 stimulus checks given by the Biden administration. As per the story, a survey has found that “Americans are generally saving about 42.6% of the third federal stimulus payments, up from 37.2% and 36.4% of the second and first stimulus checks respectively”. It is pertinent to note that the latest stimulus payment of $1400 is larger than the first two, which were $1,200 and $600 respectively. The Survey also finds out that little over one third of the latest payment has been used to repay debt, as compared to 37.4% and 34.5% respectively for the previous two stimulus checks.

This data could be interpreted in different ways. The most common interpretation is that the recipients may be saving the money to get some more clarity on the Covid-19 conditions and come out in hoards to spend in next couple of years (2022-2023). Few are interpreting it as harbinger of a structural change in the US consumer behavior. It is suggested that the shock of global financial crisis (GFC, 2008-09) and Covid-19 may result in curtailment of overspending habits of average American.

(The following is with inputs from www.zerohedge.com)

In its latest earnings report, JP Morgan drew attention towards another dimension of this phenomenon. The bank highlighted that “in Q1 its total deposits rose by a whopping 24% yoy and up 6% qoq to $2.278 trillion, while the total amount of loans issued by the bank was virtually flat sequentially at $1.011trnn (down 4% yoy). This implies that for the first time in history, loans to deposit (LTD) ratio of largest bank in USA is below 50% for the third consecutive quarter. Similarly, at Bank of America, the second largest American Bank after JPM, the amount of total outstanding loans is below GFC levels, implying NIL loan growth for 12years. In fact, the aggregates at the top four US Banks indicate, no loan growth for past 12years while deposits have doubled in this period.

Prima facie, this divergence is unprecedented. Traditionally, loans and deposits have not diverged to this large extent. However, if we juxtapose this divergence to the unprecedented amount of money printed by US Federal Reserve (QE) in post Lehman era (2008), this divergence may not appear too blatant; for the amount of excess deposits accumulated over past 12years is approximately equal to the amount of excess reserves injected by the Federal Reserve in that period.

This obviously has changed the traditional paradigm that banks create money through extending loans and in the process fractional banking builds the reserves at Federal Reserve. This time Federal Reserve has created money and that money is lying in banks as deposits. The velocity of money has crashed to lowest levels. This is the primary reason why trillions of dollars in new money printing have not resulted in any inflationary pressure so far; even though the equity markets have been factoring in bouts of hyperinflation for more than a year now.

The question now is “how this situation shall get corrected?”

Many analysts expect the situation to revert to the traditional paradigm as Fed begins to taper in 2022. It is estimated that tightening of liquidity from Fed would force banks to lend aggressively, at a time when the deposits may be shrinking. A couple of years of aggressive lending and withdrawal of deposits will restore the balance in financial markets. The collateral would be higher interest rates and higher inflation.

I am neither an economist nor a research analyst. I am therefore not eligible to make an intelligent comment on this situation. Nonetheless, my naïve view is that this saving glut has only allowed QE to persist for so long; which means, QE has been nothing but a book entry to sooth the nerves of markets. The collateral of QE has been massive reverse transfer of wealth, from poor to the rich by way of wealth erosion for poor (joblessness, negative rates, asset price erosion) and disproportionate rise in wealth of top 10%.

In my view, this tiger ride (QE) will end only when the rider (excess saving deposits) perish. I am however not yet inclined to believe that this will happen the way it is popularly believed, i.e., Fed tapering, higher rates, inflation, aggressive lending and higher investment & consumption demand. I have a feeling it will happen through currency redundancy. The USD and EUR deposits may just become irrelevant over years, as new independent currencies become popular establishing a parallel global monetary system. The small savers will carry this cross, as has been the case always.

Just when everything appeared to be settling nicely, the volatility in Indian equity markets has increased materially. The sharp corrections at any hint of adverse event highlights the jitteriness (and to some extent lack of conviction) of market participants. Considering that household investors (and traders) have increased their participation in the market significantly in past 6-8 weeks, the pain quotient of any sharp correction from here could be significantly higher.

Evidently, while the benchmark indices are now mostly flat for past 8-9 weeks, the sectoral shifts have been meaningful. Investors have adopted inflation (commodities) and cyclical recovery (mid and small cap) as a primary investment theme. Financials, discretionary consumption and realty sectors have witnessed a major “move out”.

The investors positioning seems to be, inter alia, based upon the following premise:

(a)        The earnings recovery witnessed in 4QFY21 shall continue for most of the FY22 and FY23.

(b)   The inflation which has been mostly a “supply shock” phenomenon in past three quarters will become a “demand shock” as cyclical recovery continues to gather pace and supply response lags the demand surge.

(c)    End of forbearance period for loans may lead to accelerated delinquencies, especially from MSME sector.

(d)   RBI shall continue to pursue accommodative monetary policy, regardless of the fiscal conditions, inflationary pressures and pace of cyclical recovery.

(e)    The companies may further improve on the multiyear high margins achieved in 2HFY21 and justify PE rerating of mid and small cap stocks.

The investors’ positioning is mostly based on promise of higher fiscal spending and incentives for setting up new manufacturing capacities. Obviously the assumptions suffer from a certain degree of dissonance.

Stress in MSME sector that is driving financials down is not reflected in sharp outperformance of mid and small cap stocks. Fears of lockdown, poor income growth etc. are reflecting in underperformance of discretionary spending (auto, media, realty etc.) but the “demand shock” expectations in metals etc. contradict this positioning. Service sector underperformance also mostly belies the cyclical recovery thesis.

The participants’ positioning also does not fully factors, in my view, the recently added high risk dimension to the RBI’s monetary policy. So far the quantitative easing (money printing) has been the domain of the jurisdiction having a universally acceptable currencies (US, EU, Japan, UK). RBI has ventured into this with a partially convertible currency. This could be a two edged sword. Could make INR highly volatile and impact the CAD.

The following excerpts from some recent global research are worth noting:

“US producer price inflation has jumped to a 10-year high. Business surveys suggest pipeline price pressures continue to build with some surveys suggesting a greater ability to pass higher costs onto consumers. This will add to the upside risks for CPI in coming months and increasingly points to earlier Federal Reserve policy action.” (ING Bank NV)

“China’s renewed focus on de-carbonisation leading to steel capacity cuts, strong domestic demand and muted global coking coal costs are likely to sustain high steel margins globally over FY22-23E. Lower Chinese export rebate as suggested (for months now) in media articles can discourage Chinese steel exports further. India domestic HRC price ex- Mumbai stands at c. INR 60k/t , significantly higher than JM/street assumption of INR 48k/t, while the landed China price at c. INR 68.7k/t leaves significant room for further price hikes in the domestic steel circuit.” (JM Financial Research)

“After two consecutive quarters of solid earnings beats and upgrades, we expect another strong quarter, aided by a deflated base of 4QFY20 and healthy demand recovery for the large part of 4QFY21 – as attested by high-frequency indicators. Performance is expected to be healthy despite headwinds of commodity cost inflation in various sectors. The key drivers of the 4QFY21 performance include: a) Metals – on the back of a strong pricing environment and higher volumes; b) Private Banks and NBFCs – on moderation in slippages and improved disbursements / collection efficiency; c) a continued strong performance from IT – as deal wins translate into higher revenues; d) Autos – as operating leverage benefits offset commodity cost pressures; and e) Consumer Staples and Durables – on strong demand recovery despite commodity price inflation. MOFSL and the Nifty are expected to post a healthy two-year profit CAGR of 16% and 14%, respectively, over 4QFY19–4QFY21” (Motilal Oswal Securities)

“If our growth projections were to come to fruition, India’s economy would pass the US$6.4 trillion mark by 2030, with per capita income at US$4,279 – reaching the upper middle income country threshold. This implies a real GDP growth of 6% and nominal growth of 10-10.5%. A key ingredient to our forecast is our estimate that manufacturing as a share of GDP will rise from approximately 15% of GDP currently to 20% by F2030, implying that its goes from US$400bn to US$1175bn. We believe that the thrust toward a manufacturing-led growth will set in motion the virtuous cycle of productive growth of higher investment - job creation - income growth – higher saving - higher investment and India would be one of the few large economies offering high nominal productive growth.” (Morgan Stanley)