Euro Crisis: Where is the lender of last resort?

Sum constrasts the Euro Zone problems with countries who pursue an independent monetary policy and suggest a possible solution to the present Euro Sovereign Crisis. 

The Europe problem has been getting complex by the day. It started with Greece and inevitably everyone knew it is destined to spread to PIIGS (Portugal, Italy, Ireland, Greece and Spain) sooner than later. So here we are witnessing history in the making yet again. Europe, a union of nations formed to exploit synergies by forming a common understanding and policy framework on different subjects is falling like a pack of cards.

Complex and difficult situations demand serious path breaking efforts on the part of stakeholders to overcome the difficulty. The regulators and lawmakers in European Union are working their guts out to provide a temporary relief to the nations who found themselves underwater due to excessive spending and faulty policies. Once the bloodshed is controlled by temporary measures, efforts would then made to address the structural issues.

I have gone back and forth to the drawing board many a times trying to deconstruct the Europe Sovereign Crisis and start all over again in finding the missing link by studying the structural framework of Euro.

My recent efforts are aimed at contrasting the PIIGS with some other sovereign nations having independent currencies and monetary policies (i.e. having independent Central Banks). So I started with a comparison of Spain (Euro zone) with Britain (Independent currency and central bank). Both Spain and Spain have similar debts, deficits and inflation (in percentage terms). Spain, as a part of European Union has embraced the Euro and thus has given up its independent monetary policy in favour of a common European Central Bank. Britain, on the other hand Britain has an independent currency and has a central bank that pursues an independent monetary policy.

Let’s suppose that both Spain and Britain face a Sovereign Debt Crisis. The crisis is caused by excessive spending resulting in high fiscal deficit which is financed by foreign and domestic debt investments. As the debt repayment becomes due both the countries are overstretched with their finances and unless their debt is refinanced the creditors face a possible Sovereign Default. In the absence of any other source of refinance, the countries would only be able to refinance at steeply increased rates. Thus borrowing at high yields will increase the risk of a sovereign default by these countries in the future even higher.

If Britain is unable to roll over its debt at acceptable yield levels it will force its central bank to buy the bonds and in the process devalue its currency. Thus a liquidity crisis is averted by a devaluation of currency. In the case of Spain, refinance at acceptable rates is not possible because it does not have an independent central bank which can be forced to refinance the debt. Thus a liquidity crisis is highly likely in case of Spain if yield on refinancing of debt spikes higher.

One possible solution to this problem could be a consistent effort by the European Central Bank wherein it can give a guarantee to stand by its member countries in times of distress particularly when they face a liquidity crisis (or refinancing problems). For example if Spain needs to refinance its debt and it is unable to do so at reasonable rates, ECB should step in as a lender of last resort and buy the bonds. The value of Euro should thus be made up of weighted average of the respective members states economic parameters. Monte Carlo Simulations and Black Scholes Options Pricing Model can be reconfigured to accommodate financial parameters of member’s states. These parameters can be weighted in accordance with weights (which can be calculated using another set of economic parameters) to derive the targeted value of Euro. ECB should then balance inflation targeting with managing exchange rate expectations thorugh its monetary and fiscal policy.

At any stage the value of Euro should reflect the financial and economic strengths and weaknesses of its members. If PIIGS are refinanced by ECB, the relative devaluation of Euro in accordance with the weight PIIGS in Euro should be undertaken, so as to bring its value to a realistic level. It would not doubt be detrimental to the disciplined and hard working members who have instilled fiscal prudence and best practices in their respective states. A weaker currency would hurt the imports. A weaker currency however would be welcome across the board, especially by the exporters.

The downside to this solution is that bond purchases by central bank expand the money supply, potentially leading to inflation. A hyperinflationary economy may develop as a result of monetising budget deficits. Thus the reluctance of ECB to lend to governments is understandable. Germany is in particular still in the awe of hyperinflation in had to experience during 1920-24 due to monetizing its budget deficit. It’s opposition to such a plan is thus understandable, but as they say tough situations and circumstances demand tough solutions. So Germany pave way for a representative Euro, pay way for maintain order in the union your fondly formed.

Civil and criminal laws: Is obeying them our primary responsibility?

"The primary responsibility of citizens is to obey their nation’s civil and criminal laws"

The author’s statement that the primary responsibility of citizens is to obey their nation’s civil and criminal laws forms the fulcrum of modern society’s premise of fundamental rights and duties for its citizens. The modern society and representative form of governance confers upon its citizens certain fundamental rights and list the duties its citizens must perform as a part of a society.  The obedience of nation’s laws and regulations is one such duty the society expects from its citizens. But in my view the author’s statement is biased and invalid if seen in isolation and without giving due consideration to changing socio economic environment. 

Recently the world has seen uprising in West Asian countries particularly those which were under the rule of oligarchs and dictators. The uprising in these countries was primarily against the regime and autocratic laws and regulations which made the oligarchs and dictators strong while undermining the basic human rights of the common man. People revolted against a change in leadership in these countries and demanded for a representative form of government. The author’s statement of obedience of nation’s civil and criminal laws does not hold in the scenario when the common man is affected and he revolts for a change, sometimes even by undermining the nation’s. civil and criminal laws. 

Another situation where the above statement does not hold is when the present civil and criminal laws are unjust and formed by people who do not hold the mandate to do so. An example of this is the freedom movement of India led by Mahatama Gandhi. Under the leadership of Gandhi, India fought for its freedom from British Rule by practicing non obedience and non violence. 

In a democratic set up where laws and regulations are formed by a representative form of government and duties conferred upon the citizens; the primary responsibility of citizens no doubt is to obey the nation’s civil and criminal laws. Without such obedience, a rule of law will not prevail and a system of justice and fair society will be unthinkable.

In the end I would like to reiterate I do not agree with the author’s statement if seen in isolation. If we make provisions for civil disobedience and non cooperation by citizens if their common interests at large are affected by such laws and regulation, the statement can be accepted as a generalist opinion. The statement also holds for mature societies with a fair system of justice and legislature. 

What's more important in an enterprise; the process or the result?

“In any enterprise, the process of making or doing something is ultimately more important than the final product.”

An enterprise has a perpetual existence. It involves an ongoing process that involves many processes and procedures to produce or manufacture products or services for marketing, selling or consumption purposes. The final product goes through a rigorous process of transformation with varied degrees of time and effort.  A process of value addition takes place at each step to produce the final product right from the inception of idea to transformation of raw material and semi finished goods into a final product. Thus the author’s statement that the process of making or doing something in an enterprise is ultimately more important than the final product holds good in my opinion.

The primary reason why I believe process is more important than the final product is because the opportunity to gain a cost advantage or design leadership can be exploited during the various processed and procedures involved in the production process. Innovation if any can be introduced and core competencies developed during the process of making or doing something. The result of such efforts and competencies will reflect in the final result which the final product we are talking about. An example of this process preference can be found in the development of the cheapest car in the world – the Tata Nano; manufactured by Tata Motors. The company gave more importance to the process of designing and production of the car and obtained patents for the processes and production procedures used to manufacture the car. The end product, the world’s cheapest was not only possible through a product centric approach alone. A system led approach made the dream of producing the cheapest car in the world possible.

Another reason why I give more weight to the process than final product is because a systematic approach and streamlined procedures is required for the successful production, marketing and sales of a product. In the systems approach to management the focus of attention is on the processes of doing or making something. Two companies making identical products can be differentiated by the process and procedures each company is following. A well thought out and professionally structured process reflects in the DNA of the final product. One of the biggest examples of a systems led approach is the Apple. The company has introduced blockbuster consumer electronic goods which had caught the fancy of people. Although the company focused on making a cutting edge final product, it obtained its objective by prioritizing the processed and procedures for the same.

However it needs to be acknowledged that the final product is the ultimate destination an enterprises is aiming to reach. All efforts and resources of the company are thus directed towards achieving the objective of a superior final product. But the efforts and resources thus used are channelized through systems and procedures which if used otherwise will prove counterproductive in giving an edge to the company.

Thus I agree with the author’s statement that in any enterprise, the process of making or doing something is ultimately more important than the final product. This is especially true if we take a system led approach to management. An interplay of final product and strong systems and procedures in a coordinated fashion will ensure overall success of an enterprise.

Greece Crisis: Any opportunity for Hedge Funds?

-->

My take on how Hedge funds can benefit by investing in distressed assets amid the ongoing Greece Crisis

The crocodile’s eyes are not shedding tears this time. Rather they are lit up with the prospect of a Greek Sovereign default. Most Hedge funds (stakeholder love calling them crocodiles) are under invested in European banks and financial institutions so they are likely to take a relatively light hit as compared to post Lehman crisis. They are also well placed with respect to cash positions primarily because of low investment opportunities in the developed world particularly in the US.

So even the slightest prospect of a Greek Default and a resultant exit from Euro is making the Hedge Fund managers sit up and take notice. An exit from Euro will stretch the Greece economy beyond its means and a bank run will render many businesses bankrupt; particularly the one’s with exposure to other parts of Europe. A business which has Euro debt to pay to financial institutions and banks outside Greece would risk default. The Greece will have a weaker currency post the default and the Euro will strengthen.

A weak currency will make Greece attractive, particularly to Euro zone. Holidaying in Greece will be cheaper for Europeans as Euro will buy more Greece currency. Similarly investing or buying a business in Greece with real assets (say a luxury beach resort) will make economic sense. Hedge funds look for opportunities to buy cheap and sell high by adding value. They may buy businesses in Greece, bargain with creditors for a haircut and keep the business solvent. They may then add value and sell it for a huge profit a couple of years down the line. Buying such claims would be like investing in distressed assets so the risk /return payoff would not be linear. Rather the risk/ return would resemble that of a call option. 

Investors and fund managers who are ready to take the extra pain of searching value in the abyss by careful and well structured valuation would find this crisis a blessing in disguise.

My take: Look for a 40-50 room beach hotel in Thessaloniki or Mykonos with debt on its balance sheet. You may be able to pick it up lower than its real asset value. 

Coming Soon to a market near you – Lehman II

 An alternate view on Greece currency crisis and how Greece should think differently.

 

Greece should be saying “Screw Eurozone, It’s all over” akin to what Lady Gaga tweeted after her concert in Delhi (Screw Hollywood, its all Bollywood). Greece is at the threshold of a major economic disaster. Not that a sovereign default will happen for the first time in the world, but it’s the complexity of a single currency union and the resultant lack of consensus that is making the markets and investors nervous. Greece is caught between a rock and a hard place. It needs help from Eurozone partners to evade sovereign default and keep its credit lines open. At the same time the conditions set forth by Eurozone are pushing its economy further downhill in terms of competitiveness and long term growth and stability.

Greece at the moment looks like any other common person who has incurred more debt than he or she can repay considering his or her current income and assets. A default is thus very likely. Greece is looking towards its partners to bail it out of this situation by lending money; much like any other common man would do in such a situation. However, the problem is that its partners are enforcing stiff conditions on Greece, in terms of controlled spending, cut in jobs and continuous monitoring on measurable basis of austerity measures to help it out of this mess. Once Greece accepts the austerity measures and cut spending and jobs, its growth will further fall and its ability to repay the debt will diminish. A bailout from partners would no doubt avoid a global economic catastrophe and give Greece relief in the short and medium term. But it would be stressed again when the loans from its partners become due. 

An alternate, which Greece should be considering at this stage is a full blown sovereign default. It sound outrageous and unethically in the first place, but if I am Greece this sound like a long term solution to my problems of low growth, unemployment and balance of payment situation. Lets consider what will happen if Greece goes into a full blown sovereign default. If Greece defaults, outside the preview of what is being proposed by Eurozone, it would be forced to exit Euro and there may be a bank run on its banks and financial institutions. Its currency will devalue and local businesses will face bankruptcy. It will also import high inflation as currently Greece is a net importer.

But on the other side because of a devalued currency its competitiveness will increase and it will slowly start to be an attractive market for cheap manufacturing in the Eurozone. Its long term prospects, if seen from a 10-15 years perspective, may be healthier than if it sticks to the austerity conditions as a precondition to staying inside the Eurozone. It can also consider setting up preferential zones for emerging market companies to set up businesses and provide easy and cheap access to labor and infrastructure. Since the emerging market currency would buy more of Greece devalued currency, it would indeed be attractive to set up business in Greece. 

Greece needs to evaluate the pros of cons of being in the Euro currency versus an exit from Euro and having its own currency. At this stage the long term prospects needs to be balanced with the immediate and medium term prospects and consequences. A short sighted vision at this stage might lead to a permanent defect which would be difficult to correct later.

No doubt a sovereign default would wreck havoc on a global scale. But then some other countries (particularly Thailand and Argentina) have been in similar circumstances and they have only come out stronger thanks to their independent currency and fiscal/ monetary policy. Greece should take a cue from India too. In 1991 India was at the verge of a sovereign default. But devaluation of its currency coupled with structural reforms turned the table and today India is one of the more stable and better managed countries embarking on a high growth trajectory.

As Lady Gaga says, Screw Hollywood, it’s all Bollywood; Greece too should be saying Screw Eurozone, it’s all over.

Understanding the psychology of investors

Sum analyzes how investor's portfolios are affected by their emotions and biases. 

Emotions determine tolerance for risk and tolerance and risk plays a key role in portfolio selection. Investors experience a variety of emotions as they, ponder their alternatives, make decisions about how much risk to bear, ride the financial roller coaster while watching their decisions play out, assess whether to keep to the initial strategy or alter it, ultimately learn the degree to which they have achieved their financial goals. According to folklore, greed and fear drive financial markets, but this is partly true, while fear does play a role, most investors react less to greed and more to hope.

There is another way to consider this phenomenon on an emotional time line in which time advances from left to right. Let’s assume Investment decisions are at the left and goals at the right. Investors experience a lot of emotions as they move on an emotional time line from left to right and wait in the middle. Hope and fear are polar opposites on the time line, one positive, and one negative. Positive emotion is above the time line and negative below. As we move from left to right, hope becomes anticipation and then turns to pride. Fear become anxiety and turns to regret.

Investors form portfolios using a layered pyramid. Pyramid is structured to address the needs associated with security, potential and aspiration. At the bottom of the pyramid are securities designed to provide investors with security. As we move up the pyramid securities designed to address the needs for potential growth and fulfillment of aspirations are added. Investors think in term of layers, bottom layer for security and top layer for potential. They are willing to take fair amount of risk on the upside, once they have adequate protection on the downside. Most investors do not choose securities by ascertaining where the risk return profiles place the securities on the mean variance frontier, rather investor choices stem from their emotional reaction to the features promised by the securities. Those that promise safety appeal to investors who primary reaction is fear. Securities that promise safety appeal to investors whose primary emotion is hope. Many investors are driven by both emotions – we can categorize them as cautiously hopeful (I fall in this category).

Having a financial advisor enables the investor to carry a psychological call option. If an investment decision turns out well, the investor can take the credit attributing the favorable outcome to his or her own skill; however if the decision turns out badly, the investor can protect his or her ego and lower the regret by blaming the advisor. The phenomenon involves self attribution bias. 

While forming pyramids and using layered investing, anticipation adds a lot of value to investing decisions. Anticipation is the manifestation of hope and anxiety of fear. Tolerance of risk is thus a function of hope, fear and aspirations. When a major financial goals is within reach, fear and aspiration combine to favor a conservative approach. Individual investors are especially prone to heuristic driven bias. Investors are excessively optimistic about the performance of shares they own but not the market index. They are overconfident and they are often surprised by the prices changes to their stock more frequently than they had anticipated. Their stock price forecasts are anchored on past performance ad they underestimate the degree to which their stocks move in tandem with the market. 

Attribution: Key inputs for this blogpost taken from CFA Readings.

Dear little one......

Dear Little One

I eagerly await your arrival. You are the most precious God is going to give me and I am looking forward to receive you with humility in my heart and a prayer on my lips. You are the forbearer of hope and energy that I am eagerly looking forward to. Come to this world and bless your family with the most precious gift of all, a continuation of generations.

Indeed it is a long journey you have had to take in coming to this world. Your chariot, your mother has been ever strong and caring in providing you all the love and care to ensure that this journey remains comfortable and relaxing for you. Even before your birth you share a very strong bonding with your mother; your chemistry tells me you both are so fond of each other.

My little angel, I want to share some things with you, which as a father I want to tell you before you come to this world and bless our family. You are coming to a family where each one is looking forward to your arrival. We are all so happy in making little preparations that we could for your arrival. But also little one, each one of us has our own personality and traits while we live together as a family. We share our joys and sorrows but we also have our shortcomings and weaknesses that make us all vulnerable to odd behaviour. We love each other fondly but we also have difference of opinions and thoughts. Indeed it is an evolving family like any other family in the world. Your arrival will bring a smile of everyone’s face, which at the moment lacks sometimes. I also hope and pray that you bring strong bonding, understanding and lots of patience in the family for you are the hope, and you are the energy that will carry this family forward.

Your mother, is one of the most beautiful and loving wife of this world. Her love for me, and now for you is selfless and truthful while at the same time possessive and full of passion. I am blessed to have her by my side always and you are fortunate to have her as your mother. I also pray for your strong bonding with me and your mother. May God bless us with inner strength, courage and wisdom to provide you with a good, happy and healthy life and fulfil all your wishes.

I, as your father remains a person with a lot of shortcoming and weaknesses, but hey little one I will try my best to be a good father. I will learn from you, little angel. Your being in this world will make me motivation and courage to me more responsible, caring and provide me wisdom. I believe, little one, success isn’t always a lion’s roar, It’s also the silence of an ant working patiently, persistently and never giving up.

So welcome my little angel, to his world, we as a family eagerly await your arrival.

With lots of love and blessings

Your fortunate father