Gold and Monetary Thoughts

The latest RBI working paper invites public comments on the topic “Gold Prices and Financial Stability in India“. The paper notes the recent sharp rise in international old prices; examines inter-linkages between desi and international gold prices and finally brings out the emperical observation that the implication of a correction in gold prices on the Indian financial markets is likely to be muted. I also picked up this interesting chart from the paper which compares the real and nominal prices of gold right from 1971. Interesting to note that the precious metal has never “really” breached the USD800/ounce mark, though it came very close to challenging that limit, during 1979/80 and 2011. The nominal price high has been ~$1,900 which came in Nov’11.

Shiploads worth of unaccounted wealth has always kept the demand for gold very high in India, making even someone like John Maynard Keynes liken our desi fixation for it as a ‘ruinous love of a barbaric relic‘. The paper notes this pre-historic Indian yearing for gold but then it makes a point which I don’t quite follow: the authors (of the paper) measure some important macro-economic parameters and restate them in gold terms; and observe that the value of these indicators has actually fallen in gold terms and therefore they conclude that gold must not be in ‘bubble territory’. Duh. Anyways, the paper also notes the fact that the really devastating asset bubbles are the ones that take the banking sector down with it – the dot-com bust has certainly caused lesser damage than the sub-prime crisis. I read up on some literature on the internet on this notion of complicity of the banking sector in global recessions and noted the events that have lead us to today’s line of monetary thinking:

By the 1830s, in England, it was generally believed that the mere legal requirement that the liabilities of the banking system (i.e. public deposits) be convertible to gold on demand was not sufficient to prevent various economic crises. So, in 1844 they introduced the Bank Charter Act which established a currency board – based on gold – to eliminate the banking system’s ability to create fluctuations in money supply. Between prices and money supply, it was firmly believed that prices were the effect and the supply of money was the cause. However, economic crises continued to persist in England in 1847, 1853 and 1865. The prime reason cited for these crises was that the framers of economic policy had not paid much attention to the role of bank deposits in the monetary system.

So, as a result of this, by the 1870s, monetary thinking brought in the concept of the Bank of England being the ‘lender of last resort’ . Gold convertibility was never in question and though financial crises did occur in England from time to time, none involved bank failures. The British experience was well known to observers in the US, where crises involving bank failures were a regular feature of the financial landscape until 1914 – this provided an important impetus for the founding of the Federal Reserve System and there onwards to the following 4 phases:

1. Classical Gold Standard (1880 – 1914): Governments accorded the highest priority to maintaining fixed prices of their currencies in terms of gold.

2. Interwar Gold Exchange Standard (1925 – 39): The techniques developed during the era of convertibility under the gold standard proved insufficient when the need of the hour was to ensure and provide domestic macro stability – ultimately resulting in the Great Depression. Countries cared little about their ‘neighbours’ and freely debased their currencies in order to make exports more attractive in order to grab a slice of the post war economy rebuilding opportunities.

3. The Bretton Woods International Monetary System (1944 – 71): Post WWII, ex Allied nations favoured a regulated system of fixed exchage rates, indirectly disciplined by the USD, which in turn was pegged to gold. All agreed on the need for tight controls. ‘Beggar thy neighbour’ no more. 

4. Managed Float (current): The great inflation of the 70s made policy makers re-emphasize the goal of low inflation and to commit themselves to convertibility-rule like behaviour. USA broke away from the Bretton Wood fetters and freed up the USD from the gold overhang. USD thus became a fully fiat currency.

So the cycle continues and gold (in real terms) has again risen to levels that it earlier saw during the runaway inflation levels of the 70s. Gold has always been central to monetary thinking – even in its divorce from monetary planning in recent times, the need for gold is as important as before – by proxy. When a currency becomes fiat – it derives its value from it’s issuer country’s regulations and policies. The modern economic policy of low inflation and mindless credit expansion has all but effectively debased these fiat currencies (USD and EURO). Therefore, the growing interest (and price increase) in gold under the hope that the current regime of managed float will end and we will move back to the era of tighter monetary regulations backed by gold. According to me, if that happens then fluctuations in the price of gold will most certainly impact prices and financial stability. The probability of occurrence of that happening anytime soon is incomprehensible to me. You need an expert to opine on that – but I’d just say that the world revolves around the USD – fiat or not.

The banking sector has very much been in the eye of the storm during the current economic crisis and therefore no one would play blind on a bet that gold may not breach the $900 psychological mark…

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US Default?

China notes that the United States is “playing with fire” if it agrees to default on its debt. Quite unwittingly and a bit reluctantly this will most definitely force countries like China to try to prop up the USD by purchasing more and more of the defaulted treasuries as they get dumped (mostly by US domestic holders of such treasuries). What a debt trap! China seems to have invested as much as 70% of its $3 trillion foreign currency reserves in US Treasuries! The posture taken by the Chinese is all about their concern that the money that they have invested in US Treasuries is safe, the reality is that the US wouldn’t care as much even if a “technical default” causes a fall in the USD. But countries exporting to USA would get killed – therefore in order to protect their exports, countries such as China, Brazil, even India, might be prompted to buy more to help hold down their currencies from appreciating.

The picture on the right shows the distribution of the lenders to the US Government. The main worry of the US would be that such a technical default would likely cause a ratings downgrade which would in-turn increase funding costs; raise interest rates; depress house prices and slide the economy back into a recession. And of course crash stock markets and shoot up gold. US benchmark 10 year Treasury yields are already hovering near their historic lows of 3%. Now, just what trigger would these notes need to start yielding higher again? A massive sell-off?

Assorted articles on the internet (I’ve pulled most of the ideas for this post from Reuters) seem to be placing the chances of a US default at near zero and many people are obviously dismissing the idea as ludicrous – but stop and think about what would happen if this really plays out like this. We’d know by mid August when some chunk of treasuries are up for redemption and payments. The chart on the top (click to enlarge) shows the US debt levels and the corresponding increasing in its debt ceiling levels. Now, the US Government cannot borrow more than its debt ceiling level and since it breached that level in May 2011, the Senate needs to vote in an increase of the debt ceiling. The reason why people are calling for a “technical default” is that a delay in voting for raising the debt ceiling may give time for economic forces to play themselves out and things to settle and solutions to emerge. Like a cooling off period. Before upping the ceiling. Most certainly it sounds like the political opponents of President Obama trying to generate real bad press and image for him by making the US Government “default technically” and then coming in to the rescue by voting to support the resolution to up the ceiling. That may be why the Treasury Secretary and the Fed people are saying that the results to the world economy will be disastrous if the US defaults.

While the idea of the US defaulting does indeed appear crazy, nitpickers are therefore qualifying a “technical default” as being a different situation as compared to a real “failure to pay” kind of an event. The latter is catastrophic. The former is more like a pause that people do when enjoying a lavish luncheon buffet. They pause for breath, beam at their table-mates and reach out for their wine or water to catch their breath. Continuous eating, while supplying loads of calories, can be quite tiring. It also makes you a glutton. Take a look at this chart that I’ve sourced from Reuters (US online edition). How long can someone keep eating and eating and eating?

QE2′s Titanic Voyage

The QE2, now moored at Dubai is a magnificent ship. It is an awesome flotilla of human engineering with 5 restaurants, 2 cafes; 3 swimming pools; a pub, a nightclub and several bars; a casino; a 481 seater cinema; shops; health clubs; the largest floating library and a hospital – all comprising an ecosystem of 3000 people (incl full roster of passengers) that circumnavigates around the world in 80 days. Given the cacophony of the other QE2 (Quantitative Easing, proposed & hopefully stillborn Round 2) in the US, I try to compare this Cunard marvel to the US economy. I randomly switch between QE2, the ship and the Fed’s QE2 (the raising of a shipwreck)

I have been absorbing and echoing popular thoughts that the recent Indian market rally has been fuelled by Foreign Institutional Investment (FII) related flows and that once this spigot runs dry, we’ll have a nice juicy correction. A big enough gash to seriously bleed the short term traders. But I never counted on the Fed docks building and launching another armada of liquidity into the markets! The US docks, from this perspective just never seem to run dry. And now I am big time confused. The QE2 rush of dollars will only add fuel to the fire, right? So, will we be seeing a near parabolic rise in Indian equity? Will the Diwali rockets fire up real high this year? You may have noted my aversion to seeing parabolas in stock charts from some of my past posts and the accompanying note that parabolas are not self-sustaining. Good for the Indian Government really – considering the slew of paper that is about to be thrown into the ring.

Like QE2, the American economy moves slowly and consumes a lot. The QE2 reportedly moves a cool 40 – 50 feet per gallon of fuel. That implies a mileage of 3.7 meters per litre of fuel. A snail (if blown up proportionately) will be supersonic in comparision, I guess. Like the ship, the American economy is moribund and is crawling towards what many are calling a recession? The QE2 has been navigated by 23 Captains till date, the Fed on the other hand has seen only 14 Chairmen at its helm. The QE2 was introduced in 1967, the Fed came about in 1913. The Fed Chairmen are quite sticky: like barnacles I guess. The QE2, when it was floating around used to consume 430 tons of fuels per day. My back of the envelope suggests that the US drinks 2.3 million tonnes of gasoline a day. I guess India’s figure is at 100 million tonnes of petrol a year.

The other important point is that the Royal Navy recruited the QE2 in 1982 to serve the original Queen in the Falklands War. Similarily, the Fed Captain is pushing QE2 to prepare for war. Only this time it will be a war that will be played out on the currency screens of traders across the world. We seem to be bracing for a full scale global currency war as the QE2 sets float. The difference being that this new artifact from the Fed is being pressed into service on an already raging sea of liquidity. The voyage around Tierra del Fuego has always been notorious – imagine creating a tsunami on a particularly nasty day aross this southern tip of South America as a solution to taking ships over and around the bend! Davy Jones Locker, surely. That too a man-made artificial tsunami. That’s what the Fed is doing, I think. Raising the waves in the hope that domestic (read US) yatchs, boats, dinghies and sundry canoes will start ‘consuming’ the momentum by hoisting up their sails, revving up their motors, rigging up the tow lines and picking up their sculls. Really? What many think is that nature will always choose the path of least resistance and this extra liquidity will quit the Atlantic and flow down towards more Pacific waters. Whither QE2? What will it achieve if that happens?

And finally one last lesson to pick up from QE2. It’s new owner is the Nakheel Group – an Asian real estate group with diversified interests in asset management, liesure and real estate whose website, just like the QE2 seems to be quite slow. The lesson is that developing nations one day will get tired of having to bear the responsibility of mopping up all of this money that the QE2 is spilling out. Unfortunately, it’s not a cornucopia – it’s really a runny nose. And the virus is catching on fast. Emerging economies will one day realise that they’d be better off buying US assets and directly injecting equity into the US system as opposed to buying the rapidly falling US Dollar. If the US domestic investment does not get kickstarted by this QE2, can foreigners buy mines, companies, set up offices in the US and provide employment directly? Can they, is the other question. Arnold Schwarzenegger is touring Asia to see who can build a high speed train system for California.

 The war is on. We saw two wars around the time the gold standard was abolished and the major countries of that age took it upon themselves to support local inflation by printing currency to fund war. After the dust had settled down,  the US dollar was to be much more than just the national currency of the US. After the gold standard was abolished, the US was at its zenith, unscathed by the World Wars and it took it upon itself to make the USD a truly global medium of exchange. The people managing the USD (the Fed Captains) therefore, theoretically at least had a global responsibility. They still have. The point is that when the Fed does things like QE2, the pain is equally felt everywhere. That is why this unilateral stewardship of the world economy will make the recalcitrant new kids on the block itching to pick up a fight. The rednecks will stolidly hang on to their artifical currency pegs while the boys in blue will stoke up local inflation. Common man will get crushed under the weight of rising prices and a Government might fall.

Additional reading:

  1. A view from Infosys’ Think Flat blog: Will QE2 sail or sink?
  2. A caption that I do not agree with: QE2 to speed triumph of emerging markets

The Bond Bubble

The bubbling stories going around this week in the financial blogosphere have mostly centered on the heady climb of US treasuries. In fact the topic has been quite hot the past month but the din is getting louder now. Comparisions with the dot com bubble and the housing bubble have started doing the rounds. The yield on the 10 year US paper is currently around 1% now. Which means that if you freeze the frame today, it will take a hundred years for the interest component to add up and match the price you pay for such bonds today. The P/Es (inverse of yield) of the no-brick and no-mortar tech companies were also in the heady hundreds during 1999-00. I don’t have too much of a view since it’s all happening outside of our shores. The Small Investor writes about it here as also the links I’ve listed below: it’s important enough for us to pay attention since we have NOT decoupled ourselves from the west. It’s actually the FII money that’s driving up our local markets here. Hot money.

  • FT Alphaville on the conundrum that equity prices and bond price are now moving in step. i.e. UP!

Logically, I’d guess that the bond market is bigger, more liquid and less amenable to manipulation. So, if the bonds and the stocks are sending out conflicting messages, should one not trust the former?

However, are bond markets better predictors of the economy? I think not: since nominal GDP growth and interest rates are both driven by inflation. Correlation is NOT causality. It’s a mistake many make – if two lines A & B move in tandem, that does not necessarily mean that A and B have a causal relationship. There could be a third factor C which is driving both A & B. So, bond prices are ↑; equity markets are ↑; economic data (US) is ↔. Thats the confusion. 

  • A website called bond-bubble (what else!) has come up and the graph on it’s homepage is quite telling.

It shows the super steep rise of US public debt – almost a parabolic rise. To me this looks similar to the rise of the Chinese stock market. That looked parabolic as well ( y = 4 * A * x↑2) and it could not defy gravity. But can US debt come crashing down? Maybe – if the currency crashes.

  • That seems to be awesome news for the gold bugs! It makes the case that the bursting of the bond bubble will pave the way for a massive upsurge in gold prices. The article notes that the yellow metal shines brightest in three situations – “heightened economical/financial risk; outright inflation and/or deflation”. And therein makes the case for a coming Gold bubble! Marc Faber,  (who keeps telling people to buy gold) has been bearish on treasuries right through the start of April but no one seems to be listening.

 TULIP SOUTH SEA RAILROAD ROARING TWENTIES → POSEIDON → JAPAN → DOT COM → HOUSING → BOND → IS IT GOLD NOW? 

This is making people like me (the “half informed”) even more nervous now. Ignorance is bliss – part knowledge is most painful. Anyways, the local markets are frothing on all the money that’s coming in from the US. The Fed there is busy buying up treasuries and sloshing money in their system (to buy the bonds, the Fed has to release money by paying whoever is holding bonds). They’re doing it by working their printing presses overtime spooking inflation. But I guess the game with inflation is that if you whack it too much too fast, the thing just snaps and the party careens towards deflation. I wish I had paid more attention during my economics classes. But to me it sounds logical that what comes in, goes out. So, this money will go back from where it came (at least in the interim). And all will fall down.

Though there is some more ground for the NIFTY to cover. That’s what the “experts” here are saying. The market isn’t fully stoned yet. It’s just started rolling the weed, maybe a few drags….let’s stop hallucinating. In 2008 so many of our local “experts” were shouting out that India is decoupled and that the housing bubble will not effect us. Even politicians had joined the chorous. De-coupled my moon. We are as joined to the US hip as our big bro in the vicinity.

Maybe I’ll be able to call the top.

Obama Speak

The US President is going around asking his fellow countrymen to produce more graduates and compete with the likes of India and China. These are good points to raise but then when this is accompanied by curbs on granting visas it begins to sound like rhetoric. All under the guise of protecting US borders! The border security bill will hike visa fees to $2,000 per applicant for companies that have fewer than 50% of its workforce as US citizens. Thats a cool $200 million bill for Indian software companies that rely heavily on “body shopping”. The standard line of the Indian industry has been a lament on the lack of the totalisation pact between the two countries. India has to contribute towards social security for the workers that it sends to the US – and if they return back to India, there is no possibility of a refund. I would welcome to hear something from Dr. Manmohan Singh on the issue. He is his usual quiet self.

While India remains preoccupied with flash floods, Kashmir, honour killings and the Commonwealth Games tamasha, China picked up the gauntlet and responded well by making outsourcing completely tax free if delivered from 21 cities. The Chinese have made no bones about the fact that they want to end India’s dominance in the sector. Should India not make a counter move to steal some foundries away from China?

India’s earlier responses sound quite pathetic to me. If the US politicians are ushering their wards back to school and hoping and helping their middle class to retain their sources of income, whats wrong with it? Cribbing about it and making it sound as if some grave injustice is being done against it is mooching. How would India feel if people across its eastern border arrived in hordes and stole away jobs? Some factions cannot even tolerate intra country movement of labour.

The rhetoric in the US however is also missing its mark. Senator Charles Schumer has called Infosys a chop shop. Its easy for the sound bytes to morph into an India/China hate undercurrent (if one does not exist already). Lou Dobbs, a popular media anchor, for instance has written a book on outsourcing and devotes much of his website to the phenomenon and how the American middle class is being killed. Is it? Don’t think so. Maybe going through a very tough phase. An important counterpoint to note is the indirect benefit that this can yield to the US.

It would be good for the US to note that the Indian middle class is gravitating towards more and more consumerism. People are seeing their incomes rise and are swiping their credit cards, buying second houses, ipods, etc. gleefully. This is allowing banks like BoA, Citibank etc to set up their shops in India. While such benefits selectively accrue to the Dells, Microsofts and BoAs of the world, the American middle class can certainly benefit. President Obama should also consider exhorting his masses to match imports (of services from China and India) with American exports to these countries. The oriental appetite for consuming intelligently designed goods and services in the occident will only grow. Americans would do well to understand one basic trait of most Indian middle classes – they are afraid to take risks. Innovation is rarely seen. While hordes of software junkies pound away at maintenance and basic software jobs, there is hardly any technological breakthroughs that emerge from this populous nation. The US has always thrived by managing risk and employing innovation which have set up a very strong financial acceptance to see capital freely flowing to fund ventures that are risky. Indians generally take the easy way out – outsourcing is one of them.

But these shifts and changes, as significant as they can be, happen slowly and the threat of the current American middle class losing its plot somewhere is indeed very real. And such Obama speak will found many takers and therefore votes. Whether the White House politicians actually act in earnest to plug the leak (which in my opinion they should not blindly do) is a different matter. Donations from many top industry groups may be funding the election expenses of these law makers.

In my opinion, its futile for the US (as a nation and culture) to fight outsourcing. Its perfectly logical and sane for the US society to agitate and therefore equally logical for the politicians to flog this sentiment for election victories. The US should focus on earning export dollars (USD should depreciate as years roll by) by tapping into the growing prosperity in China and India. India and China, on the other hand, should open up their economies further, slicing and selling off non-strategic assets to the highest bidders and generating more wealth in the process. Its a great lifetime to spend in the Indian and Chinese capital markets of today.

Rupee’s “stable” symbol

It was good to see our currency getting a formal symbol in the midst of all talk and nervousness about inflation. While D. Udaya Kumar scrawls himself into history’s books for designing the symbol, I have my own take on the symbol and what is symbolises. Some people felt that using Devanagiri script is anti-non Devanagiri India and I feel that they are loco. My problem is that Ms. Ambika Soni used the design to explain the underlying stability of the Indian currency. What stability? I am not able to understand. Inflation is running so very high and controlling the currency is like riding (and trying to tame) a wild horse. I am a bit slow in these things.

But what I do know is that some of the factors that determine currency stability are : A) enough liquidity and cushioning in the local banking systems, B) the accompanying political landscape is stable, C) inflation is under control, D) legal systems are strong. If these ingredients are not in synch, the currency may topple over. Since symbols represent the inherent qualities of a currency and since the currency is a barometer of the strength of an economy, let’s use reverse logic to check if the chosen symbol for the INR does indicate stability. Let’s at least check if the symbol chosen for the INR is stable in the first place. We’ll might also take a look at the stability factors of the major world currencies while we are at it.

The concept of center of mass, borrowed from physics indicates the center of any shape, however weird it may be. If you make a 3 dimensional solid out of any basic shape, such a shape should be able to spin around it’s axis – and keep spinning if friction were absent. In the real world, friction and restraining forces constantly act on physical bodies. Let’s examine each major currency symbol (click on symbol to magnify), as if it’s 3 dimensional figure were standing on the world platform and see how it respondes to forces of inter-country friction, asset bubbles, financial profligacy, etc – all being represented by the testing forces of friction (cost of being a world currency on the world platform) and gravity.

JPY GBP INR USD EUR
Stable. But one nudge and it’ll topple over left or right – i.e. to China or the U.S.A Very stable!! Stodgy and just may not budge. Won’t be able to withstand it’s own weight. Will topple over Stable. But one nudge and it’ll topple over. Already fighting it’s 200DMA Will fall down right. If only the horizontal railroads began from further left.

I recommend that you do not take such advise when initiating positions on currency movements! BTW, you don’t have to be a financial whiz kid or a professional trader to initiate positions in world currencies. Just your decision to take up a job in India’s software industry makes you terribly short on the INR. 

Anyway, I like the symbol – whether it is stable or not. I like it since the Big B has requested that it be featured in the logo of the next edition of his show – KBC. I like it despite the fact that it looks like a bastard child borne out of the union of the Devanagiri Ra and the Latin R. I like it despite the fact that it gave me a kink in the neck. I wanted to see if there is some Dan Brownish hidden symbolism in it’s meaning. I craned my neck up and down, held up my laptop at weird angles for that aha! moment but all I got was a sprain in my neck. See, there is massive hidden meaning in the symbol of the EUR. What happens when you tilt the EUR by 90 degrees? You get something similar to this! Hinting at the intrigue and various games that the continent has always been a stage for. Then there was that story of the WTC attack being foretold in a USD 20 dollar bill.

Actually, if you are lean that way and incline yourself physically that way as well, you might just spot this in our currency symbol. Hardly something to associate free capitalism with! 🙂

But considering the fact that cigarettes, tulips, spices, cows, et al have all served as good currencies in the past, I do not think we should have any problem with this tilted masterpiece.

Symbolism apart, the real concern that should play on the minds of our policymakers is the runaway inflation that’s on us at the moment. I was in Mumbai over the weekend and just could not believe the amount I had to pay for just 250 grams of okra, a kilo of tomatoes, a suspicious looking floret of cauliflower. Around a 100 INR! Prices of food and related stuff are increasing @ 20% per annum. So are costs of education and medicine. Eating out has become crazily expensive. So, what I am saying is that the INR is not fiat currency. Far from it. Just that inflation is making things difficult. Very difficult. And the people in charge need to change many more things than just the symbol of the INR.

Did you know that the Vietnamese currency is known as the Dong? And that frugal Vietnamese women really know how to stretch one to the hilt? 😐 The symbol for their currency looks a bit sexual as well.

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