Vijay Kumar Gaba: commodities

Tuesday, October 27, 2020

Hyperinflation - Highly improbable

It was particularly gloomy winter evening of 2008 in South Mumbai. The global financial markets had their knees frozen. One of the top global financial institutions, Lehman Brothers had collapsed a couple of months back. Another global financial giant Merrill Lynch lost its identity to Bank of America. Some peripheral European countries were on the brink of defaulting on their sovereign obligations. The bankers in the financial hub of India (South Mumbai) were staring at massive job losses. Numerous businesses were on the brink. Many large investors had also suffered huge losses in their portfolios. For younger investors and bankers in their 20s and 30s, the conditions were totally unprecedented. The fear, uncertainty, scale of value destruction was overwhelming as they had not experienced anything like that before. Most of the then had seen 5yrs of strong bull market in credit and capacity building in infrastructure, energy and housing. Suddenly, all the credit started to look bad and all the capacities worthless.

The US Federal Reserve (Fed) had launched its Quantitative Easing Program (QE1) a week ago. Many other central bankers, including European Central Bank (ECB) was expected to follow the Fed soon. The commitment of central bankers to do “whatever it takes” had calmed the markets only slightly.

In this setting, I had the opportunity of hearing one of the most famous global commodity traders and fund manager in person. The gentleman was in Mumbai at the invite of a local fund house which had launched a Natural Resource Fund just a few months back. This gentleman, in his idiosyncratic style and attire made a passionate pitch for investment in global commodities. He strongly argued that the massive new money printed under the QE program of central bankers will inevitably result in hyperinflationary conditions in the global economy leading to sharp rise in prices of commodities. Quoting from the classical monetary theory books, he presented some hyperbolic charts and diagrams reflecting his projections of commodity prices.

I had many questions for the debonair looking trader cum fund manager, but I chose not to ask any, since I was fully convinced that inflation is certainly not one of the threats to the global economy in foreseeable future. Any question to the expert therefore would have been plain sophistry.

In hindsight, I feel it was a right decision to go with my conviction instead of arguing with the expert and weakening my conviction. As we all know that despite multiple rounds of QE and vigorous efforts to create some inflation, the global economy has continued to struggle with deflationary forces in past 12years. Many commodities are even yet to see their respective 2007-08 prices.

In past couple of months, the hyperinflation has again started appearing in headlines. Numerous reports and articles have been written on how the global economy is fast racing towards hyperinflation. Many strategists have suggested trades for this - gold and silver being the most common. Many traders have taken positions. The Natural Resources Fund launched in 2008 is being marketed again aggressively.

Some wise and smart traders and fund managers are calling it “reflation” instead of “hyperinflation”, indicating that the price rise may be short trading opportunity and not a global trend.

Regardless, my view continues to remain the same as it was in 2008. I strongly feel that hyperinflation, as we know it from classical monetary theory, is a highly improbable event in the modern economic conditions. The present day trade and commerce dynamics, technology, and demand-supply matrices do not support any extraordinary inflationary flare up. And if the hyperinflation premise based on imminent demise of US Dollar, it may also be unfounded.

Friday, April 24, 2020

Cheaper is not always better

The elementary principle of economics is that the price of a thing that has any economic value is determined by the forces of demand and supply. Often in the short term a state of inequilibrium may exist leading to higher volatility in prices. However, the equilibrium is usually restored by operation of a variety of factors.

There is no denial that economics is youngest amongst the scientific discipline and pure scientists hesitate in admitting it as a discipline of science. Nonetheless it is evolving fast and becoming popular. Not getting into this academic debate, what I have understood is that in popular economics theory is that:

(a) Price of currency is usually a function of demand and supply of that currency at any given point in time. Higher supply should normally lead to lower exchange value and vice versa. The demand of the currency is determined by the relative real rate of return (interest) and structure of economic activity (e.g., current account balance and inflation) in the parent jurisdiction.

(b) Price for a particular commodity is determined by the demand and supply conditions of that commodity at any given point in time. The demand of commodities fluctuates as per the level of economic activity in the consuming jurisdiction, export demand and outlook for the foreseeable future. The supply of commodities may fluctuate due to a variety of reason - local to the producing jurisdiction as well global. Cost of production, weather conditions, civil and geopolitical disruptions, inventory levels & cost of carrying inventory, etc are some of the key factors that may influence the supply of commodities in the short term.

(c) Interest rates are usually function of demand and supply of the money in the monetary system. Demand for money is again impacted by the level of economic activity and outlook in foreseeable future; whereas supply of money is mostly a function of risk perception and relative returns.

The traits of human behavior like "greed", "fear", "complacence", "renunciation", and "aspirations" are usually accounted for as the balancing factors for demand and supply and not considered as determinates of price as such. This in my view is the cause of most problems facing global economy in the present times. Consequently, the business of forecasting and trading in currencies, money and commodities has become extremely difficult and fraught with risk. The huge volatility and irrationality in crude oil market in past 6 months is just an example of this.

In past three months I have seen hundreds of reports forecasting prices of commodities, currencies, and interest rates. Most of these forecasts appear mere extrapolation of the current price trend and hence do not inspire any confidence.

In Indian context, exchange value of INR, 10yr benchmark yield and crude oil prices evoke much interest. Interestingly most economic growth forecasts appear predicated on these, whereas logically it should be the other way round.

INR depreciation is beyond economics

In the summer of 2007, I had just moved to the financial capital Mumbai from the political capital Delhi. The mood was as buoyant as it could be. Everyday plane loads of foreign investors and NRIs would alight at Mumbai airport with bagful of Dollars. They would spend two hours in sweltering heat to reach the then CBD Nariman point (Worli Sea link was not there and BKC was still underdeveloped), and virtually stand in queue to get a deal where they can burn those greenbacks.

Mumbai properties were selling like hot cakes. Every day one used to hear some mega property deal. NRIs from middle east, Europe and US were buying properties without even bothering to have a look at them.

Bank were hiring jokers for USD 100 to 500k salary for doing nothing. I was of course one of these jokers!

That was the time, when sub-prime crisis has just started to grab headlines. Indian economic cycle started turning down in spring of 2007, with inflation raising its head. RBI had already started tightening. Bubble was already blown and waiting for the pin that would burst it.

INR appreciated more than 10% vs. USD in first six months of 2007.

Then INR depreciated over 75% during period from January 2008 to August 2013. This was the time when Fed was printing USD at an unprecedented rate. There was no shortage of EUR, GBP and JPY either.

The point I am making is that in the present times when most globally relevant central bankers are using unconventional policy measures with impunity to stabilize their respective economies, the value of currency is seldom a function of demand and supply alone.

Regardless of the economic theory, it is the faith of people in a particular currency that is primary determinate of its relative exchange value.

2005-2007 was the time when the Indians had developed good faith in their currency. Local people were happy retaining their wealth in INR assets, despite liberal remittance regulations and NRIs were eager to convert a part of their USD holding in INR assets. The situation changed 2010 onwards. There is no sign of reversal yet. Despite huge popularity of Narendra Modi amongst overseas Indians, we have not seen any material change in remittance pattern in past six years. Despite tighter regulations, local people appear keen to diversify their INR assets. Most of the USD inflows have come from "professional investors" who invest others' money to earn their salaries and bonuses. These flows are bound to chase the flavor of the day, not necessarily the best investment. Whereas the outflows are mostly personal, or by corporates with material promoters' stakes.

In my view, no amount of FII/FDI money can strengthen INR if Indians do not have faith in their own currency. Yield and inflation have become secondary considerations.

...so are interest rates

Yesterday, RBI auctioned 91 days and 182 days treasuries bills at far below the policy repo rate and lower than the recently reduced reverse repo rate. Even at ~3.6%, it accepted only one fifth of the bids received. SBI has reduced the rates on whole sale fixed deposits to 2.5%.

Obviously, the supply of money at this point in time is overwhelming higher than the demand. Like crude, banks have no place to park their deposits.

However, interpreting these lower rates as supportive for growth would be a huge mistake; just as it was with lower crude prices (see here). In fact in the present circumstances, low interest rates are likely to do more harm to the economy than help it. In next 12months, there is going to be hardly nay growth in investment demand irrespective of the interest rates. However, lower interest rates may damage the consumption demand as it may lead to lower interest and rental income for consumers, negative real return for savers, worsening income inequality.

Remember, lower interest rates because demand for money is less is as bad a thing as in case of anything else.