The most commonly used word in the past few weeks has been de-leveraging. So what does it mean and how will it affect economic growth and the asse t markets, including equities? In simple terms, it means that companies, especially investment banks and other financial institutions in North America and Europe, will have to reduce their debts to more manageable levels.
At the beginning of this year, most investment banks in the US were operating with a leverage ratio in excess of nearly 35:1. Simply put, every dollar of equity (or net worth) was supporting 35 dollars worth of assets. In contrast, Indian banks seldom operate at leverage ratios of more than 10. This leverage bubble made US banks sitting ducks when asset prices in which they had invested/traded - equity, real estate and commodities - began to fall. Besides cheap money, this credit bubble was fuelled by financial innovation or derivatives, which allowed investment banks and other financial institutions (FIs) to artificially raise their assets, and increase their purchasing power by spreading risks to other players. But what did this cheap credit do? Basically, it was used to bid up asset prices and as the mountain of dollar surpluses increased , the list of assets just kept rising. First it was real estate, then infrastructure assets (for example, in India BOT projects in highways, airports and ports), crude oil, commodities, bullion and even art featured in this list. The proponents of loose monetary policy had no such scheme in mind when they began to loosen money supply and lowered interest rates in '01 and '02. Their expectation was that cheap credit will aid corporate investment and consumption demand and thus, avert an economic recession. However, as Chinese factories kept reducing the relative price of their exports, it freed up the credit to finance an asset bubble across the globe. And as asset prices kept on rising, thanks to the flow of liquidity from Chinese export surpluses and followed by petro-dollars , it started a vicious cycle, with various asset markets feeding into each other. While Chinese export surpluses and petro-dollars aided asset prices, they in turn, aided the creation of more surpluses in the next cycle. This kept the cost of money low everywhere and triggered a global investment boom. While emerging economies used this opportunity to scale up investment in their infrastructure , it enabled investment banks and FIs in the West to scale up mortgage loans and proprietary trading in stocks and commodities . The financial derivatives market enabled them to do it at a never before scale - securitise the asset and sell it to other parties. The viability of the system was based on the prices of underlying assets - be it real estate , commodities or crude oil. This is because, even a small deflation in any of the assets will lead to losses, and the accounting rule of mark-to-market losses will trigger equity erosion, leading to distress sell. This is what happened when housing prices began to fall in the US and Europe. With one asset market broken, it choked off liquidity flows to other asset markets, leading to a general asset deflation the world over. The Indian asset market, especially real estate, equity and BOT projects, were one of biggest gainers of this liquidity glut. Global investors looking for superior returns found India to be an attractive destination, given its growth prospects. As foreign capital flowed in, it led to one of biggest bull runs in the stock market, coupled with a construction boom in real estate and ever-rising investment in low-return BOT projects. So, what will happen now? The deleveraging will surely lead to a contraction in credit availability in the global economy. It will reduce the demand for assets, including equity. At one level, it's a bad news for equity investors, but at another, the process is likely to make housing affordable and will bring down inflation and thus, the cost of living. The process is likely to reduce the rate of India's GDP growth from the current 9%. However, the contraction is not likely to be that swift and large. The economic expansion of the past few years has been fuelled by an ever-rising investment in fixed assets. The biggest chunk of that investment was accounted for by the private corporate sector. Between FY02 and FY07, the total fixed capital formation in India jumped by nearly three times to touched an all-time high of nearly 35% of the GDP. Nearly 55% of the incremental growth was attributed to the private corporate sector and it accounted for 40% of the investment in FY07, against around 20% in FY02. In the private corporate sector, machinery and equipment accounted for nearly three-fourths of the investment, while construction accounted for the rest. In contrast, the ratio was reversed for the household sector, i.e. individuals. So, as de-leveraging leads to a reduction in global appetite, the first hit will be taken by the construction sector, whose main customers are households , rather than corporates. This will moderate the fall in economic growth. The dramatic scale-up in corporate investment was accompanied by an equally strong growth in savings. In FY02, the private corporate sector accounted for less than 16% of domestic savings in India, By FY07, this share jumped to over 22%, reducing the sector's dependence on borrowing to finance investment. This means the private sector's growth plans are now less susceptible to a global liquidity crunch or higher interest rates. This is in complete contrast to the situation in the last slowdown when India Inc was battling high levels of debt. Besides, the past three years had witnessed a huge surge in investment in machinery and equipment. Now, many of those projects will come on stream and aid growth and thus, soften the blow. So, what is the downside in GDP growth from here onwards? Given the historical trend in India's capital-output ratio of around 4% and estimating a nearly 20% fall in corporate investment, India's GDP growth is likely to fall anywhere between 7.5% and 8% in FY10 and beyond. This kind of fall doesn't warrant the hue and cry that we are witnessing right now. The best way to gain from this shift in power from assets to productive assets is to start investing in strong manufacturing and services companies, which have used the boom to create world-class assets http://economictimes.indiatimes.com/Features/Investors_Guide/Start_investing_in_strong_manufacturing_and_services_cos/articleshow/3588030.cms He who puts up with insult invites injury --~--~---------~--~----~------------~-------~--~----~ You received this message because you are subscribed to the Google Groups "Kences1" group. To post to this group, send email to [email protected] To unsubscribe from this group, send email to [EMAIL PROTECTED] For more options, visit this group at http://groups.google.com/group/kences1?hl=en -~----------~----~----~----~------~----~------~--~---
