Japan - A decade of lost glory!

Japan pioneered technology - be it cars, music or televisions and earned heavy royalty through exports. Also a strong tariff policy protected home market from imports which pumped up the yen and led to a massive buildup of new found wealth among consumers & government. Liquidity was high, which spawned an era of easy money, and that fueled a frenzy of stock-and-real estate speculation unrivaled since the U.S. Great Depression. Clearly the market manias were ignited by ridiculously loose credit policies.
Almost overnight, the newly wealthy Japanese were viewed with fear. Japanese cars filled American roadways and Japanese-owned companies started buying out US companies overnight – remember Universal, Columbia pictures…
At the peak of the frenzy, a piece of land at Imperial Palace in Tokyo was more than the value of the entire state of California - which defied all wisdom & senses, but which was mathematically correct as prime office space was going for $139,000 a square foot in Tokyo’s Ginza district, way back in 1989!

But “Irrational Exuberance” is “Irrational” after all. Japanese financial system, especially banks tumbled & Japan couldn’t even overcome 10 years of stagflation. 10 years of lost glory!
In Dec 1989, Nikkei 225 Index topped out at around 39,000. By September 1990, it had nearly been halved. Nikkei ultimately bottomed at 7,830 in April 2003. It hangs around 12,700, still down 67% from its trading high 19 years ago).
The fallout from that meltdown was incredible. By early 2004, houses were selling at 1/10th their peak value, and commercial real estate was selling for less than 1/100th of its peak-market value. All told, an estimated $20 trillion in stock market and real-estate wealth had been vanished!

Oil's Risk Premium

Oil is a difficult commodity. The position that oil commands, no other commodity can ever have.

The dual status of oil as an important commodity and proxy for global macroeconomic risk dates back to 1973-74 oil crisis, when OPEC waged an economic war against the West with crude as its weapon in support of the Arab attack on Israel. This elevated the commodity's profile to unprecedented heights on global stage. Since then, oil's price has reflected the forces of both supply and demand, and GLOBAL RISK PERCEPTIONS.

Nobody can determine how much risk premium does Oil command on any given day, but yes it does command increasingly more. Nearest to Oil as a significant global commodity was Gold. Yes, gold too is influenced by global risk, but gold has no strategic economic use. Jewelry and industrial demand are pricing factors for gold, but those applications are hardly critical in the global economy. Even if world sees Gold supply shortage, people simply can stop wearing & storing more gold. The only question is price, which is largely driven by sentiment and the vague memories that the metal was once used as legal tender.

At the moment, there's no shortage of risk fears. The challenge for the world is separating the Oil's risk-premium from the pure economic factors. This is inherently a speculative task and so no one can be confident that they understand how much of oil's price is affected by risk considerations vs. supply and demand analytics. Nonetheless, the biggest risk is underestimating, or ignoring the potential for an oil risk premium-which can and does fluctuate widely over time.

No lesson learnt from LTCM

Everyone remembers the high profile blowup of LTCM 10 years ago, but nobody learnt the lesson. The basic reasons of LTCM blowup was:

1. Very high levels of leveraged used to generate huge profits from minuscule arbitrage opportunities,
2. Expectation that liquidity will always remain high in the markets,
3. Financial models are the pennecia of all risk management needed.

Current scenario looks no different, other than the scale of this crisis. Its no more "one hedge-fund" problem now, it spans globe. Its the most biggest banks & financial institutions that are core to global financial system, are facing the heat. LTCM nearly single handedly brought the financial system to near collapse, but then a bailout package was available. Just no bailout is possible this time, the crisis is huge. Nearly $800 billions have been written down till now & few wall street veterans believe that another $400 billion is still to come. Can you imagine that the wealth worth a whole Hedge Fund industry size (of nearly $1.5 trillion) will be eroded by the time this subprime crisis ends.

Probably its the imperfections of global financial markets, assets were so much overvalued which were never worth that much. So they came down! But this reminds us of LTCM, and we have hardly learnt anything. Still Banks & Hedge Funds are highly levered (Carlyle disclosed 32x leverage, LTCM was 30x when it got bust). Risk mamagement measures is far from efficient. yes, trading/ financial models can churn numbers & predict well, but only when economic conditions & markets are stable. In case of "irrational exuberance", nothing works but greed and fear!

Where is the Oil top?

Though nothing to conclude, but an interesting pattern to see-

Look at the chart below, it simply shows the relationship of the current oil bubble to the last 2 big bubbles - tech stocks and then the housing market. Now the rise in oil eclipsed the mammoth rise in tech stocks in the late 90s. Interesting - where is the top?

Cheap Chines Goods - End of an Era?

Why American consumers are about to start paying more for clothes, electronics, toys, and just about everything else.

For years, China fed the consumption hunger of Americans through its cheap exoprts. But it seems that $2 t-shirts era will soon end as china is witnessing an increase in cost of production across industries. Deceds ago when large Chinese population wanted jobs desperately, bulk manufacturing for cheap wages looked viable. As a result, labor & environmental laws were violated, people worked for 7 days a week, working environments were just pathetic & there were no respect for intellectual property rights. But economic evolution cycle goes on, wages increased. Also the effect of 1970's one-child-law led to a dwindling demographics in China. Those born then, now-workforce, demand better labor laws, medical insurance & a good working environment. These rising middle class in India & China will ensure that the cost of raw materials continue to increase throughout the world. Inflation grows more rapidly & chinese remibi appreciates against US. All this indicates one thing - era of cheap Chinese goods is coming to an end!

Now US is looking for alternatives - Vietnam, India, Indonesia, Mexico, or Malaysia?

Vietnam - American importers are now looking at Vietnam, for its lower wages. But Vietnam, how hard it tries, has only 85 million people—the size of one Chinese province. Moreover, prices are rising faster in Vietnam than anywhere else in Asia. Also the rising incidence of strikes and labor disputes, and Vietnam looks increasingly like a short-term alternative.

India - India has not yet managed to get its act together to take advantage of China's rising export prices. Importers say India is good at certain things—embroidery, for instance—but not at the volume production. India's road and port infrastructure, while improving, is nowhere near as efficient as China's.

So US importers are looking back to countries they once rejected in favor of China— Indonesia, Mexico, and Malaysia. But none can offers the one-stop shop appeal as China can, where factories make everything under the sun. For the time being, US consumers will still be buying a lot of "Made in China" products—and paying ever more for them - until......!

Mezzanine Debt - Balancing your Capital Structure

Capital Structures - While there are no hard and fast rules for optimizing a company’s capital structure, companies that areahead of the curve use an efficient combination of senior debt, mezzanine debt, and equity capital to minimize their true cost of capital.

Mezzanine debt capital generally refers to that layer of financing between a company's senior debt and equity - filling the gap between the two. It is subordinate in priority of payment to seniordebt, but senior in rank to equity. Thus using mezz capital has positive side: the owners face little dilution and maintain their control of the business; the companies total cost of capital is reduced; and the mezzanine debt has a flexible payment term that is structured as “self liquidating” and is paid off over time. On the negative side, this is a debt structure that requires interest payments over time.

India vs. other Asian Economies

There are few significant differences between Indian Economy and other major Asian economies, lets analyze few:

a). Current account deficit - India has a current account deficit. As oil and fertilizer prices go up, the deficit increases further. Other Asian economies (like China, Japan, Korea, Taiwan, Singapore, Vietnam etc) have a massive current account surplus which they can use to finance growth, India relies on capital flows - FDI and FII. During 1990s, the East Asian crisis emerged as those countries financed their growth through capital flows, not from any forex reserves (as they did not have much in their kitty then), they were devastrated as world pulled back their money out of Asia. India survived then and is not that worse even today - forex reserves are high and FDI flow remains strong. But still, its a concern.

Benefit of having current account surplus is that forex can be used to contain domestic inflation. So China can led yuan appreciate to control inflation because there is a massive current account surplus, India can't.

b). Fiscal deficit - With increasing wages of govt employees (6th pay commission) and subsidies on oil and fertilizer, the fiscal position of India can become very bad soon. If this continues longer, govt will need to cut down on its spending. Whether that will be subsidies or investments is anybody's guess. Most likely, it will be a mix of both.

Surviving a possible recission is important for an economy. But any recession requires multiple shocks. In 2001, there was tech meltdown, Corporate bankruptcies like Enron-Worldcom, junk bond blowup and Sept 11. This time, we had subprime blowup and the credit crunch. This time may be we are on the verge of an oil shock. Only time will tell how these mighty economies steer away from testing times.