Crude Shocks keep India in Smiles

“The economics of oil have changed. Some businesses will go bust, but the market will be healthier,” says the Economist (December 6, ’14). Is this the beginning of cheap oil regime or just an interlude between two big bumps?

2013, in retrospect, had turned out to be the strongest year of recovery, with growing US Economy and stabilizing Chinese economy. Commodity prices were projected to remain flat with an up-side risk due to unexpected supply-side shocks.

Enter December 2014 and all the projections seem little more than wishful thinking. IMF went on record recently: “the global economic growth may never return to pre-crisis levels” ! All the Quantitative Easing (QE) from the US (3 till now – totalling over $ 4 trillion or, twice that of the entire Indian economy) which was supposed to push cash to banks ended up just in increased valuations and stock indices accompanied by higher prices of gold and other commodities. Emerging economies like India had to contend with high inflation. Some even said: it is ‘US Fed exported inflation’!

Now we’re in a scenario where

The silver lining in Chinese Inflation

China has increased its Reserve Ratio Requirement (RRR, the amount required to be set aside by the banks, not to be used for lending) yet again...by 0.5% to mop up an additional USD 54 bn from the market with an intention to reduce liquidity and control inflation. Let's take a quick look at the different problems confronting China:

The Liquidity Problem:

Consider this, Chinese banks lent around USD 1.6 trillion (almost equal to India's GDP) in 2010, most of it for infrastructure, and lent almost around USD 160 bn in January alone (!), a figure that's almost twice that of December 2010.

The Inflation Problem:

Inflation in China is already quoting around 5%, according to official figures. I've covered Chinese Inflation issue in my earlier posts, consider reading Betting on China Crash and Understanding China and Japan. Also, while food prices are under control for now, the housing market continues to hog limelight. House prices rose in Jan 2011 in 68 out of 70 Chinese cities surveyed. This, despite the introduction of property tax (though a measly 0.6% to 0.8%) and frequent increases in RRR.

The Currency Problem:

China has been under pressure from various international organizations with sovereign members to let its currency appreciate. Currency appreciation will make its exports less competitive though it might play some part in checking inflation. Currency depreciation will boost its economy but increase the inflation problem. So China has constantly let its currency appreciate, and shows this as compliance to currency non-manipulation to better manage international relations. See the USD Yuan chart below which shows how yuan has appreciated against dollar:

Though the appreciation is there, but its too less, too slow...over the last 1 year, yuan has appreciated by about 4% against dollar.

Soft landing measures:

On the face of it, it looks like Chinese measures are failing to keep both inflation and real estate bubble in check. But just think about it, how difficult would it really be for the Chinese government to dictate terms and functioning to Chinese Banks if they really wanted to curb lending to infrastructure? And please bear in mind, Chinese Banking industry is considered by many investors as fairly opaque and government driven...(part of the reason why Chinese banks don't openly participate (except through proxies) during sale / purchases of various sovereign debt instruments). 

China cannot afford to have a real estate bubble crash now...and they know it pretty well. The introduction of property tax also reeks of a gesture to please foreign investors more than anything else. They're completely abstaining from increasing interest rates to avoid a "Yuan Carry trade" situation (read more about this here) which will further worsen the inflation problem. In essence, all efforts are being made to not shake-up the real estate bubble, which has long assumed the position of "too big to fail".

So liquidity control without raising interest rates is probably the best way they've got. And this they're doing not just by increasing the RRR, but even, to a smaller extent, by acquiring Gold mines outside and simultaneously promoting consumption / investment in Gold / Silver in China. So people are just converting their yuan into Gold / Silver, which eventually will go to the owner of these mines from where the metals are being procured...the Chinese government held companies. [This, by the way, is also helping them control inflation through currency appreciation - as yuan supply reduces, it appreciates against its basket of currencies.]

In fact, so strong has the demand been off late, that even China's appetite for Gold and Silver is making frequent headlines. Here's an article from Zero Hedge giving various news items (most of them recent). The result...take a look at the silver prices:

Now, if this is indeed the case, and encouraging gold and silver consumption domestically is indeed a strategy adopted by the Chinese government, it's only a matter of time before both break their all time high and surge further ahead...Now, that's a silver lining in a dark inflationary cloud...

Golden movements

Gold has been falling for quite some time now...giving rise to talks about whether it has seen its peak for some time to come...take a quick look at the 30-day Gold Price chart below:

This fall came in the backdrop of US showing signs of recovery, quoting better unemployment  numbers and good consumption increases. This led to people moving out of emerging markets plagued with unsustainable inflation and prospects of lower growth and overall shrinking corporate margins; just as investors moved out of gold as well. People were again backing  dollar denominated assets, US and European markets. Take a look at how US and European markets have performed over the last 1 month.

But still, its not that investors have started looking at dollar any more appreciatively...the US Dollar Index, which shows the strength of dollar against various currencies, continued its downward journey over the last 1 month.

All this points towards some sort of portfolio reallocation among some major funds of the world. As a part of their strategy, they are taking some profits off the table from Gold, liquidating their positions in emerging markets, and increasing the weight of US and European stocks in their overall portfolio.

However, to me, Gold still looks like a minor correction before the rally resumes...nothing more. Egypt is on the boil due to political unrest, creating tensions in almost whole of middle east...which is spooking the investors worldwide. Once that settles down, Europe will come right back on the radar. And then may be Japan, who knows; with 200% of GDP as debt, 1 in every 4 persons above the age of 65 and no longer contributing to the savings (which was being used by government to raise debt), Japanese government will sure have to look for other avenues to raise debt just to keep paying off its interest on the debt..leave alone retiring the debt. China's real estate bubble can now be seen from outer space (;)), and once that crashes, it'll take a whole lot of other asset classes with it, right from Copper and Soybeans to Equities and Bond prices. Asia, just because of these two big shaky giants...is a risky place to invest.

But fundamentals for Gold still look intact. Central banks are still buying Gold...and these are the biggest players in the market - please bear in mind, they don't get in into the market to make a quick buck and move out as soon as profit targets are achieved...they're in for long.

Take a look at this article here, that talks about how Russia added 135 tons of Gold in 2010...an increase of almost 21% from their 2009 end Gold holdings ! Saudi Arabia has disclosed a purchase of 180 tons which has come in due to "adjustment of gold accounts". Take a look at the latest Official Gold Holdings for countries:

World_Official_Gold_Holdings_January_2011

Getting back to brass tacks, it means that US has almost USD 350 bn of Gold with it. Germany has nearly USD 147 bn, Italy and France has USD 105 bn each, China has USD 45.5 bn worth of Gold, while Russia and Japan have 33 bn dollars worth of Gold each and India has around 24 bn dollars worth of Gold.

The Gold reserves of US, though the largest in the world, are still far away from its Debt levels of USD 9 trillion (not accounting for contingent liabilities - like medicaid and Social security). Germany, France and Italy will need these reserves to boost world confidence in their ability to come out of this crisis...any selling by these central bankers in time of crisis might trigger a sharp fall in Gold prices which will further depress the reserves status of almost all nations with substantial Gold holdings - and so is fairly unlikely to happen. 

China has a long way to go  as far as diversification in gold is concerned since its gold reserves are just 1.8% of its nearly USD 2.5 trillion reserves. This thought has also been propounded recently by Xia Bin - adviser to China's central bank (see here).

The world is still quite close the uncertainty in several aspects...China's hunger for Gold will not go down, central banks will not sell their gold in a mad rush...these, and many such aspects are bullish signs for Gold...so for me, its still a good buy on all dips.

Addendum: See this article from Financial Times that talks about some gold traders estimating that China has probably bought around 200 tonnes of Gold in the last 1 month ! That's nearly 36% of India's Total Gold reserves ! Let's wait for China to release data on Gold reserves again...and we'll know how true these estimates were...

Betting on China Crash

The rumblings of an imminent Chinese crash are getting louder by the day...giving an eerie feeling that something too big is so close that we're not able to see it!

Consider this article in Telegraph a couple of weeks back, which says how many hedge funds are now betting that China would crash sometime soon. It says:

"One academic said: “Economists have contrarian views all the time. But these hedge funds have their shirts on the line and do their analysis carefully. The flurry of 'distress China’ funds is a sign to sit up.” ...A recent study by Fitch concluded that if China’s growth falls to 5pc this year rather than the expected 10pc, global commodity prices would plunge by as much as 20pc."

This is understandably so, given the huge amount of fears from Inflation, asset bubbles (especially real estate) and uncontrolled lending spree by the banks. Its not as if China is not aware of these issues...or not working on them. It has been tightening its bank's reserve ratios to absorb excess liquidity available with the banks. It has been buying European Union's debt to prop up Euro against the dollar and also yuan (Chinese currency). Keeping yuan lower with respect to Euro will help China in boosting their exports to Europe and give them some breathing space in terms of trade deficit (Exports - Imports).

The article further says:

"According to Corriente (Advisors), China has consumed just 65pc of the cement it has produced in five years, after exports. The country is outputting more steel than the world’s next seven largest producers combined. It has 200m tons of excess capacity. In property, Corriente said it had found an excess of 3.3bn square meters of floor space in China – yet 200m square meters of new space is being constructed each year."

Besides, Chinese real estate bubble is fairly well documented...an average apartment in Shanghai costs more than 22 times of disposable income there...making it beyond reach for most people. HK was recently reported as the costliest city in the world for housing. Despite several efforts to curb speculations on housing, China has been able to achieve little by way of increases in reserve ratios. However, recently it has put up a property tax for the first time...(read here). But with the rate at about 0.6%, it looks like a case of too little too late.

Take a look at another recent article in Telegraph that talks about how the real estate bubble could be growing bigger in China. The article mentions:

"The property tax would have "a big psychological effect on potential home buyers," said Ge Haifeng, head of research at China Real Estate Index System in Beijing. "China's housing market may get really quiet in coming months," he said. "

Big Impact !! A 0.6% property tax rate? In India, retail investors pay that much as brokerage (each leg) for all equity transactions ! Does that kind of rate stop them from trading? I don't think so...In India, property tax rates are fairly high and vary from state to state...and to me, a 10% + service tax (of 2%) is a normal rate for property taxes....that's how much people pay in India as their property tax...8-15% of property value...and it still does not stop people from speculating. And many Chinese, who are traditionally gamble-happy people, are expected to stop speculating the housing market because of a 0.6% property tax ! Let's just say, this is being made up to send a message to the markets that a lot is being done to keep bubbles in control...but obviously, the markets are not impressed.

I think this is more likely a warning signal to speculators to move out of the market and not get caught with their open positions when the rates are increased. The idea in such a case would probably be to remove the panic from the market when property rates are raised further, and thus ensure that a crash in real estate prices would not happen. But how it actually unfolds, only time will tell.

Chinese Automakers are also facing tough times with restrictions on selling cars being put up in most populous Chinese cities to reduce traffic jams. It'll again have a cascading effect as the automobile ancillary units are also an industry in themselves and will suffer major losses due to loss of revenue.

Also, with China talking of "no need for yuan to appreciate" since exports will slow down in 2011, it looks like even the pretense of letting yuan come up over a period of time is over now. This is not going to help the geo-political equations, look forward to comments from the US.

Even the credit default swaps (CDS) rates - the instruments through which people bet for a sovereign nation defaulting on payment of its debt, have been increasing for China...it means that more and more people are buying these instruments at ever higher prices, in the belief that when Chinese economy really looks weak, or even tumbles, they'll make a handsome gain on these investments. I have a rather dated article mentioning this, take a look at that here.

Will China really go bust? Its difficult to predict, given the fact that we don't even know that the numbers that we're talking about are true or not (these are, and can be massaged by government agencies). China's public debt is reportedly just about 20% of its GDP compared with 40% for India, 60% of US and nearly 200% for Japan. It can no doubt continue to build bridges to nowhere for some more time, and hoard gold to protect itself from a dollar bust scenario, but eventually, all this lending spree and housing bubbles have gotta give...and they will. But when? Now, that's a trillion dollar question!

Strong China Growth - Bullish / Bearish ?

Like I said in the last post - these are interesting times indeed...Please consider the two news articles given below.

The first one is dated 14th of December 2010, and talks about the day when Asian stocks rose due to China reporting strong growth numbers. It says:

"Asian stocks advanced on Tuesday, supported by optimism that China would avoid aggressive moves to curb inflation that could inhibit its strong economic growth and blunt its voracious demand for raw materials."

Compare this to the second one which is dated today, 20th of Jan 2010, and talks about how Asian markets tumbled when China said it grew by a robust 10.3% in 2010. It further says:

"China said its economy grew 10.3pc in 2010, marking the fastest annual pace since the onset of the global crisis but concerns about persistent inflation sent Asian markets tumbling."

What a difference 28 - 29 trading days can make ! Inflation was high then, is high now. Interest rates haven't been raised during this period, although liquidity has been sucked in through increases in RRR - the reserve ratio requirement which mandates banks to keep a certain percentage with themselves as cash and not give it off as loans.

It doesn't end here though. The first article goes on to say:

"A Reuters poll released on Monday showed economists still see a rate rise in China in coming months, but expect policymakers to rely more on lending controls in 2011 as its weapon of choice in the fight against inflation."

...while the second goes:

"Analysts said the pick-up in growth in the fourth quarter - partly driven by stronger exports - and the still-high inflation in December supported the case for further interest rate hikes and bank lending curbs."

Apparently now the markets are really sceptical about interest rate hikes coming up...quite a bit of change of view from the previous one !

Like I said before...interesting !

Indian Markets - down but not out, Trading Strategy

Its amazing to see a strong unidirectional trend in the markets...this time its down ! Consider this, from the start of this year, Nifty has gone down by nearly 7% while some others like Bank Nifty and CNX Realty have shed over 10% and 12% respectively !

Here's the chart for Nifty:

(click for a sharper image)

And for Bank Nifty:

(click for a sharper image)

The reasons for such drastic fall are apparently the flight of hot-money from India in the backdrop of strong consumption / demand and reduced unemployment numbers being reported from US and rising default risks in EU region again reminding investors further about the relative sustainability of the US.

The flight of money from India is also reflected in the USD INR Chart of the last 5 days (see chart below). Notice how INR has moved from 44.4 to nearly 45.4 in just 5 days...in currency markets, that's a HUGE movement.

(click for a sharper image)

China's inflation worries and its continuing stress on further rate hikes is keeping the entire Asia Pacific region on tenterhooks for an impending crash. Besides, China has been coming under increasingly higher pressure to let its currency appreciate in order to help US and Europe cope with their crisis better, which if it happens, would be disastrous for most markets as it will lead to China crashing.

However, I think given the strong 200DMA supports coming up for both Nifty and Bank Nifty, the fall should take a breather here. Moreover, with China reporting a trade surplus (net of Exports - Imports) of nearly USD 13 bn for Dec 2010, (which happens to be much lower than what it was last year in the same quarter), it is in a better position to bargain for slower / no increases in yuan (CNY) during meeting with Barack Obama on Jan 19 this year. [Keeping its currency weak will help China in boosting its export value, and thereby increasing its trade surplus. Ditto for US, which is going to be one of the points of discussion during the meet] Such a bargain (though US is unlikely to give it) will help China immensely in keeping itself from a crash, which will be a good boost to Asian markets.

Besides, with US pumping in more money into the system through its currently on QE II, China is going to find it tough to increase interest rates. This is because if it does, it'll boost what is known as the "Yuan carry trade". The term Carry trade was earlier associated with Yen, wherein, given the near zero interest rates in Japan, investors used to borrow in Yen and invest in foreign markets where interest rates were higher, thereby making a neat sum in this simple arbitrage. For China however, increasing interest rates will bring in even more from the US where the rates are currently near zero. This will further pump up the money supply in China boosting inflation further - which is the last thing China wants at this stage. This will, among other factors, keep China from increasing the rates too much, too often...and it is more likely to contain inflation by sucking liquidity out of the financial system (by increasing reserve ratio for banks, making loans to real estate more difficult, etc.).

Given this scenario, I'd suggest another trading strategy for this month...to sell a Strangle. Sell Nifty Jan 5700 put for 87 and sell Nifty Jan 6100 call for 15.4. This will result in a net inflow of (87+15.4) = 102.4 * 50 units = 5120. If Nifty ends up between 6100 and 5700, before 27th of Jan (another 12 trading days) the entire money is yours.  The break-even points would be 5598 and 6202. Beyond these points, you'll end up losing 50 bucks for every point. Keep your stop-losses in place and trade.

See my earlier trading strategy and its follow-up here.

Disclaimer: No positions as of now. But be aware of the risks...I'm not a trader by profession and don't claim to have any expertise in either trading or recommending trading strategies.

Global Oulook for 2011

Here are a few questions that I posed in my post earlier. These are a part of the Global Outlook for 2011, some of the most important questions staring us in the face right now....from Euro to Gold, Currency wars to US recovery. Enjoy the ride...

• Is Euro zone going to fall apart? Will Euro cease to exist as a currency?

Tough one to start with....the troubles in EU seem never-ending...its like the "Hydra of Lerna" (from Greek mythology)...a deadly serpent which had nine heads, and each time one head was cut-off, two more came up. Only this time, it all first started with Iceland instead of Greece. [Remember the good 'ol joke about Iceland's capital? It was arguably around 4 Euros !]

The troubles have since passed through Greece and Ireland, and looks set to suck-in Portugal, Italy and Spain sometime soon. And don't forget, its not that Iceland, Greece and Ireland are out of troubled waters just because they got handed over some nice bail-outs.

Unlike the US, since EU is woven with the same currency with different political leaderships, the more Euros that are printed and given out, the more the purchasing power of the other EU nations reduces (as it devalues their currency as well). People in countries that are better off, like Germany and France, don't like this Robin-hood story being played on them...(I think rightly so). But what choice do they have? If they don't bail-out these guys, their banks are going to take a big hit on the Iceland / Greek / Ireland bonds they hold...which is going to put them into trouble...creating a contagion effect.

Moreover, as per recent reports, German leadership, under pressure from the vote-bank, is getting tougher on such bail-outs. Reduced bail-outs with severe austerity-imposing conditions will not make things any better for the troubled countries.
So from the looks of it, EU has tough choices, and it'll have to do a tight-rope walk between keeping its vote-bank happy and letting the Euro go down. My guess is, it'll continue making and imposing tough choices on near-default nations, who'll have to abide by the rules, and manage their civil unrest internally. May be, just may be, to teach others a lesson, one of the countries just might be let out of the EU, possibly the worst & smallest one, which will also help shoring up Euro value and giving a moral boost to the general EU public.

Accordingly, Euro should continue to do badly, but abandoning Euro altogether is probably not an option. Euro should sustain for some more time.

• Which countries in Euro-zone are getting into trouble next? Will anyone default?

Taking over from the previous question, Portugal, Italy and Spain should be next in line, possibly in that order. But to default either the country has to choose it or or they have to be made to default. My guess is, and its really just a guess, that probably Portugal should default, although i cant say due to which of the 2 reasons above...and probably Germany and France may even force Portugal out of the EU.

Again, like I said above, not doing it with Portugal will further emphasize the fact that individual country's leaderships are willing to sacrifice their people's financial health for the overall health of the EU...which not many people will like. Also, while Portugal is big, its not as big a problem as Italy / Spain...so letting it default will probably just cause tropical storms in the financial sectors and not a Default Tsunami. Such an action will also prove to people that their leadership cares first about them and then the general good of people who've spent & speculated mindlessly in the boom times.

• How will the currency war be played out between US and China?

Include Euro here and what we get is a thriller of a race... to the bottom ! Let's try and understand what's happening here...as global demand for almost everything goes down, countries increasingly prefer a weaker domestic currency (e.g. 54 INR / USD is weaker than 45 INR / USD; 8 CNY / USD is weaker than 6.6 CNY / USD...and so on). This helps the countries compensate the lack of demand / growth with increased export value. Therefore, with say, 15% weaker currency, even a drop of 10% in exports will result in net realizations of +5% for the country.

So, to prop up their fledgling economies, all countries are trying hard to push their currencies down. China, under pressure from various groups and markets, has let their currency appreciate from nearly 8.3 CNY / USD to current levels of 6.62 CNY / USD...a strengthening of almost 25% ! And the US is still crying hoarse about Chinese currency's undervaluation...! Now, this is not to say whether Chinese currency is fairly valued or not, the point is, the amount of strength Chinese currency shows from here, that much growth is required in Chinese exports just to keep the value of exports same...and where is that growth going to come from? US, UK, EU, India, SE Asia, Australia? All have the same problem and are trying hard to keep their currencies weaker and fulfill all their domestic demand internally by putting more import restrictions in place.

My take on this is, its going to end up in favor of China ! Despite all its problems of unemployment, housing starts, foreclosures, states approaching bankruptcies and what have you, US is still the safest bet amongst the likes of Euro, Renminbi and Yen, can keep pumping in money to keep a semblance of sanity longer than most believe, and still amounts for a massive pie in the global consumption.Many states are nearing bankruptcies, but can pull along from an year's perspective.

China, on the other hand, is already struggling with inflation and poor domestic consumption growth at the same time...(consider reading my earlier post on Inflation in China and India). It has massive infrastructure just lying around waiting to be used, strengthening currency is further eroding wafer-thin margins from export oriented manufacturing units - further limiting the worker's pay rises. Although China is making amends to avoid a crash, in terms of diversifying into Gold, asking its trading partners to use CNY as base currency for trading, buying out debt from EU zone to help stabilize Euro, and investing big-time in agriculture to address the supply side issues in agriculture, my feeling is, its too small an effort too late in the day.

Also, given the expectations that demand from Japan is not going to be very encouraging, (consider my earlier post on Understanding China and Japan), commodities and manufacturing dependent China is far less likely to be able to avoid a crash...which might help it in at  least one way - it'll weaken its currency quite a bit. Such currency crisis at global levels have occurred before but this time around the difference is restrained geo-political efforts in containing it. Almost everyone is so deep in crap, that fending for themselves is top priority now.  There is no consensus on who to trust and which side to stand on. In times of global crisis, like these,  USD will appear a fairly decent haven, especially when compared to CNY, Eur and Yen.

• Will the US Economy recover?

Fairly unlikely but considering the uncertain scenarios elsewhere in Japan, China, EU, Australia and SE Asia, I think it should do just OK this year...or rather "muddle through". US states will continue to have problems clearing their pension bills, the unemployment is really difficult to come down, the foreclosures are likely to maintain pace, and Fed is likely to give-in to a QE III if need be, to keep the rotting machinery lubricated for some more time. So its not that the problems in US are going to get solved any time soon, but I look at this as a Titanic sinking, due to its massive size, it'll take time sinking.

• Are Gold and Silver the new proxies for currencies? Will countries start dealing in Gold and shun dollar completely?

While gold is widely accepted as a good alternative to any currency, world is not likely to move freely (stealthily, maybe) to a gold standard. This is primarily because large economies like Japan, China, EU countries, hold humongous amounts of US bonds...so if they show clear interest towards dealing in Gold, US Bond prices are going to crash...and so will the M2M value of all central banks' holdings. So right now, countries are stealthily diversifying their holdings into gold and other currencies (e.g. China, instead of buying gold from markets, which will be widely known and reported, is quietly buying gold mines worldwide, and marking down their potential reserves). 

 

However, this is a shift that will continue to take place, albeit slowly - like IMF has started accepting payments in Gold. So instead of seeing a massive move towards Gold as a reserve currency, we're fairly likely to see subtle shifts, which will also help in keeping the Gold prices up and rising for the year to come.

Understanding China and Japan

I usually don't put a post that's just a review of a post on some other blog...but I'll make an exception for this one...Here's a conversation posted in John Mauldin's Outside the Box section, with Vitaliy Katsenelson (VK), the Chief Investment Officer of Investment Management Associates Inc., and the author of Active Value Investing.

Long but amazingly well-done interview...real perspectives on China and Japan, put in a simple way, with applicability to the rest of the world, more specifically, the US.

I'll summarize VK's point of view on China, but this summary will be as much a substitute to the interview as a trailer is for a classic movie...so do watch the trailer, but don't miss the movie...!

China is a bubble which will burst eventually, due to the following reasons:

Uncertainity is the new trend

I spent quite some time thinking up the title for this post, 'coz the points I'm about to cover in this post are neither bullish nor bearish...and it all rolls-up so differently for different countries, despite being ever more interconnected with each other. Its' like playing a game of chess, but with 10 boards kept beside each other, with the possibility of moving pieces of one board to the other...imagine the possibilities...the inter-connections...the complexity of the game...

Something similar is at play here, and like I've said in my earlier posts as well, the players are central bankers and governments more than the usual market players...who'll decide which way the game goes.

Musings - II

Finally, as expected, China has raised bank's reserve ratio by 0.5%, which means that the Chinese banks will have to deposit an additional 0.5% of their total deposits with the Chinese central bank. This is expected to suck out nearly USD 50 bn from the Chinese financial system, which will help in keeping inflation in control / even reducing inflation. 

Now, this move is mostly to account for excess cash flowing in from the US, courtesy US Fed (QEII - in which US is printing over USD 600 bn of paper currency). But US is going to release this money in phases till April next year...so expect China to keep an upward pressure on interest rates and RRR (Reserve Requirement Ratio) to keep absorbing this money.

As yet, RBI has kept quiet regarding reaction to QE II funds flowing in into the Indian economy. However, if RBI feels "compelled" to do something about it, they will also likely hike the reserve ratio to suck out liquidity from the system, just like China, and not  tinker with the interest rates as it will directly hit the growth rate.


[Also, regarding such opinions given in Economic Times "...Realty Stocks are showing signs of life"...if I were you, I would not believe it much, 'coz if RBI takes any liquidity tightening measures, realty stocks will be the first to go down.]

Besides, Europe's problems are far from over...once the Ireland insolvency issue is sorted out, Poland / Spain will crop up...probably in that order ! And once again the world will be looking at Euro as an unsustainable currency and the ensuing chaos.

These factors, in my view, are going to be some of the biggest factors in keeping upward moves in markets in check...As I've pointed out in my previous posts here and here, the markets are expected to move down some more before pointing up. RBI still shows no signs of doing anything about curbing the inflow of QE II money, which will probably be the stance till the IPO  / FPO calendar is mostly done (MOIL, SCI, SAIL, ONGC, EIL, OIL, and some more) coming up between now and March 2011. So expect some see-sawing in the markets for the next months...with markets going up with QE II money pouring in and coming down as China increases its interest rates  giving markets jitters about the demand. I don't know (or think) if the markets are going to go majorly in any direction in the near term (now - 6 months), but I think the volatility is going to increase from here.

Margin Requirements hiked - Effect on Global Markets

There was one other point that I did not cover in my last post (Rumblings of Markets...), due primarily to 2 reasons - one, the post was getting too long for audience's perceived comfort (in my view) and two, this is a lesser known, less talked about, but an extremely important point nevertheless, which needed a separate coverage.

And the point is about exchanges increasing margin requirements on various contracts.  Margin requirement is the minimum amount that a trader needs to deposit with her broker / exchange in order to take a futures contract. This is apparently being done to remove some of the speculative money from the markets. We'll jump in into the dense world of commodities, but first, some news for those of you who have skipped this important piece.

As per Bloomberg, "Ice Raises Margins on Sugar Futures by 9.9% as of Close Nov. 12" which lead to a sell-off in raw sugar prices that was so sharp, that it beat all records set in the last 22 years ! Simultaneously, ICE also increased margins on cotton, leading to a 2.7% sell-off. CME raised margins on soybeans, while Chicago exchange did so for Silver (which tanked 7.1% later). If you would like to, read this good piece from WSJ Online here.

Back in 2006-08, when authorities in India accused commodity futures for pushing and keeping prices of physical commodities higher, the ones who did not support this view said that futures prices are in fact determined by the physical prices. So if sugar demand goes up / supply goes down, the mandis / local markets will push the physical prices of sugar up, and thereby the futures prices will also go up since physical prices are an input to calculating futures prices. If this does not happen, there is an arbitrage opportunity which allows prices to come back in sync. This is another way of saying that the tail (futures market prices) cannot wag the dog (physical market prices).

But going by the events listed above, it seems like the futures prices were actually being held up to some extent by speculators and it wasn't entirely tied to physical prices. Such a sharp sell-off in various commodities underlines the fact the speculative money can in fact, keep the prices artificially high. The margin money is the life-line of traders, its what they calculate ROI on, its what is churned n times a day to make money. E.g. if we assume that the margin required for  1 futures contract is around Rs. 25000, a trader with Rs. 50000 will be able to take only 2 contracts in either 1 or 2 different assets. On the other hand, a trader with Rs. 10,00,000 (ten lakhs) will be able to take 40 such contracts. Assuming both are normal, disciplined traders, its an easy guess who will make more money. Thus, margin money determines your churn, which affects your profitability directly. Any increase in margin money requirements slows the churn cycle so if 0.5% daily returns were good earlier with X margin money, nothing less than 0.75% daily return is good with 1.5X margin money.

Besides, the margin money requirement also has a contagion effect: You need more margin money, you decide to pull out some money from some other trade, ----> that asset prices goes down, ----> traders holding that asset get margin calls ----> they sell something else -----> that asset prices goes down...and so on. Besides, stop losses start getting triggered, which leads to further sell-off, leading to further downslide...and so on...not just in the same market / asset class, but in others as well.

This is probably one of the major reasons (apart from the ones given in my last post), which has lead to a sharp sell-off in various asset classes across the globe. It looks likely that this sell-off will continue for some part of next week as well, till traders re-align their portfolios again.

But notice how all these margin requirement hikes are happening across exchanges across geographies simultaneously...giving an eerie feeling of an implicit dictum from the big daddy of commodities...(but its just my guess, I could be entirely wrong here). Also, notice how these requirements have been upped in commodities which China imports heavily...(sugar, cotton, soybeans). [Co-incidence anyone?] 

They have good reasons to do so - one, they are faced with inflation issues just like in India (any they're hoping that this move will cool down prices which will be reflected in lower inflation figures), and two, with their currency appreciating against dollar, their exports will take a hit and so they might have wanted to make some downward adjustments to their import bill as well (to keep trade deficit in check). If these are indeed the reasons, expect margin tightening in more commodities, in more markets.

There is just one thing which can derail the above tactic - the producers / sellers of these commodities, who will not be very happy with the falling prices (some of these players are really really big in the market). Besides, typically, their sale contracts are not based on end-of-day prices, but more on monthly average / quarterly average prices, which will come down drastically with the effect of such falls. Also, with falling prices, the chances of defaults by the buyers increases drastically (not very uncommon) further putting in question the actual sales figure done by these producers / sellers for this month / quarter.

Expect these players to come back big time to push the prices back up again. If they need to borrow money to put in the markets, they will. Expect banks to increase their lending to these guys and to usual trading companies to make good their increased Working Capital Requirements (due to payment of higher margin money). Whether and how soon the prices come back up will really depend largely on such players in the market. 

But till then, it'll be the case of the tail wagging the dog.