Corporate Governance in India: Is There Any?

As individuals, we learn certain values, morals and ethics as we grow up. These influence our behavior throughout life. We act as parents, children, taxpayers, employees, employers, borrowers, lenders, shareholders, business owners, neighbors, within the rules of this broad framework which is our individual value system; this is how we interact as part of a larger society. This broad framework is governed by our individual conscience and by law.

A company is a legal person. Its behavior reflects the collective value systems of its constituents. Because a company is distinct from its constituents, it has certain rules and regulations, including but not limited to corporate charter, bylaws, formal policy, and internal controls, which guide corporate behavior. This comprises the broad framework that is the corporate value system and it too is governed by a corporate conscience and by law. Corporate conscience is the collective conscience of the constituents of the company; and it gains coherence through the board, including most importantly, independent members of the board.

Corporate governance is all about the value systems, the laws which set a minimum standard, and most importantly the conscience, which is expected to differentiate between right and wrong at the very highest level.

First we look at the values, morals and ethics of society in general.

Transparency International publishes a Corruptions Perceptions Index which seeks to measure the degree to which corruption is perceived to exist among public officials and politicians. Corruption is defined as the abuse of entrusted power for private gain. The index scores on a scale to 10, where 10 is good, and 0 is bad. India scores 3.4 during 2008, which is a significant improvement on 2.7 during 2002. Of 180 countries surveyed, India comes in at 85^th. Overall this is a negative; I would feel comfortable only on reaching neutrality with a score of 5 or over. Yet, all is not lost; a "moderate" rating on the Global Integrity Index, which assesses the existence, effectiveness, and citizen access to key anti-corruption mechanisms at the national level in a country, is comforting. The Global Integrity Index is an entry point for understanding the anti-corruption and good governance safeguards in place in a country that should ideally prevent, deter, or punish corruption. I would say that corruption is limited to a very small segment of society; society in the broadest sense of the word has values, morals and ethics which are above reproach. Overall I would rate India at "below Median" levels; say fortieth percentile.

Then we look at corporate charter, bylaws, formal policy, internal controls, which guide corporate behavior.

There is a sufficiently large body of legal and accounting professionals which ensure that knowledge is widely available to corporate houses in India. The Corporate houses are steered towards best practice and in my view these best practices are fairly rigorously applied. In this area I would rate India at "Mid Second Quartile" levels; say sixty fifth percentile.

Then we look at the laws.

There are a number of positives including the vast body of legislation including enabling legislation such as the Right to Information Act, together with various Acts, Bills and Rules which can be viewed here. In order to catch up with the rapid pace of development, several laws have been updated; more continue to be updated. The Ministry of Corporate Affairs is in my view doing a reasonably good job. There is strong access to the Ministry of Corporate Affairs to lodge complaints. The Securities and Exchange Board of India also acts strongly to protect investor interests through regulation. The accounting rules are well defined and the Institute of Chartered Accountants in India is a very well regulated body of financial professionals. The judiciary at the higher levels is experienced and knowledgeable; laws are correctly applied and the judiciary is in my view not corrupt.

But for justice to be dispensed, delays are widespread, and some say that justice delayed is justice denied. For this reason, overall, I would rate India at "Low Second Quartile" level; say fifty fifth percentile.

Finally, we look at the conscience.

Ultimately protection of the various interests of customers, shareholders, employees, government and society at large, is what good governance seeks to achieve for a Company. Conscience is in my view the single most important aspect of governance; for a conscience can prevent both intended and unintended failures in governance.

In this area, India is weak; I would rate it at "Mid Third Quartile"; say fortieth percentile. In order to strengthen it, I believe we need legislative reform in certain areas including:

• Non executive directors within the board (chairman excluded);
  
• Separation of the roles of Chairman and Chief Executive
  
• Clear rules on independence
  
• Formal procedures for appointment of new directors
  
• Provision of more and relevant management information to directors, including, non executive directors
  
• Training and performance evaluation of Boards, Committees and Directors from cradle to grave
  
• Role of audit committee and auditors widened and clarified
  
• Disclosure of directors external roles and financial interests together with transactions with entities where a director has a significant role or financial interest
  
• Well defined rules on compensation of the board, including non executive directors
  

All things considered, I would rate corporate governance in India is at "Top Quartile" amongst emerging markets and at "Median"; say fiftieth percentiles for emerging and developed markets together.

Do keep in mind that this note is written in the context of corporate governance as it applies to companies in India which are of interest to me. The universe of companies of interest to me, are mainly those which are considered large and mid capitalization stocks in India. These include the non public sector undertakings that are or were included in the Dow Jones India Titans Index; they also include other mid cap stocks which have grabbed my attention because of outstanding product quality which came to my attention or actions of management which impressed me.

Below I provide some examples of possible governance failures.

Satyam

No discussion on corporate governance in India can exclude Satyam. Satyam's story is a tale of deceit and mal-intent right at the top of the company. Mr. Ramalinga Raju successfully defrauded the company and its shareholders. It was a failure because of the pathetic values, morals and ethics of Mr. Ramalinga Raju, the founder and ex Chairman of Satyam. It was also a failure of the governance in that the companies charter, bylaws, formal policy, internal controls, failed to protect the interests of shareholders and employees. There was a complete failure of corporate conscience; the decay was at the mind of the corporation, which blurred the vision of the board, including independent members.

But there was also great success in corporate governance too. Laws were in place which allowed the regulatory authorities to quickly intervene and take corrective action to limit the damage to stakeholder interests to the maximum extent possible.

Before the fraud was revealed, there were hints to guide investors as to the existence of bad governance, despite all the awards Satyam won for good governance! The Upaid dispute was always a key risk for Satyam. A Satyam subsidiary had worked on developing software for mobile prepaid technology for Upaid. To obtain the patent, Upaid required the signature of 20 Satyam employees and Upaid received the signatures from Satyam and the patent in due course. Upaid then sued Verizon and Qualcom for using patented technology; and Upaid got a rude shock. An ex-Satyam employee, who had worked on the prepaid mobile technology, now a Verizon employee, pointed out that his signature which was on the patent application, was forged. Upaid then sued Satyam for $1 billion. That Satyam provided a client a forged signature for something as important as a patent application had been in the news a long, long time. And it is a clear example of how good governance failed; this was a clear example of blatant disregard of the wellbeing of employees, customers and shareholders of Satyam.

Now the majority Satyam shareholder is Tech Mahindra. I have no doubt that bad governance will be paid for on account of both the Upaid action and class action suits resulting from the fraud perpetuated by Mr. Ramalinga Raju. Bad governance costs money. Going ahead, I do expect better corporate governance at Satyam; the prior leadership which was central to the moral decay has been cut out. Central to the new leadership is Mr. Keshub Mahindra, the group Chairman of Mahindra & Mahindra (the parent company for Tech Mahindra), who is widely regarded as amongst the top business leaders in India.

Unitech

This is one of the more respected real estate developers in India. Their land bank is of exceptional quality. Their project conceptualization and design are unrivalled in India. Yet, their failing has been in corporate governance. This is a company with what is potentially a great business model but with a bad balance sheet. Much of the damage to the balance sheet was caused by excess leverage and much of the damage has been repaired as a result of timely management action.

So what is the bad governance? Firstly, I cannot see how a Company unable to generate positive cumulative cash flow from operations between 2004 and 2008, could have justified the levels of debt it carried. What on earth was the management thinking? What was the independent board doing? The interest of shareholders and employees was blatantly disregarded. The cost of bad governance has largely been paid through a collapse in share values and by highly dilutive new capital.

Despite positive action by the management on some fronts, bad governance continues. Today, the customer interest is being blatantly disregarded. And this will be damaging to the company; for it shall drive away buyers; bad governance always carries a price.

One example of bad governance is the Unitech Grande Project. What occurred is simple. Unitech received substantial sums of money from various buyers for apartments with a unique style, format and character. These apartments were to be delivered during September 2010.

The character of the development has now been changed as a result of the financial crisis and Unitech's enormous debt burden. The buyers are no longer going to receive what they bought; you can read more about it here and here. The buyers were offered a significant reduction in cost to downgrade the quality of the final product; but the buyers who had paid in advance more than the full amount that is payable under the reduced cost scenario were not offered the excess cash paid back. To be fair they were offered the cash back together with 12% simple interest in two years time; not quite the market rate for interest being paid by distressed property developers in today's market. What more, buyers have written to Unitech following meetings concerning the alternatives discussed and agreed by mid June 2009. To date Unitech has not had the inclination or courtesy to respond; this is despite requests for a response by email.

Is this bad management, or bad governance? I think it is both; for governance to work the various interests of customers, shareholders, employees, government and society at large must be protected. In this instance there is bad governance within the company. Equally, there is no preventative law; a simple law requiring companies to hold advance monies in trust on behalf of buyers until delivery, would have made sure developers could not use funding for new projects to be utilized for older projects. There may be legal remedies available to buyers in both civil and criminal law; but there is a need for preventative law and equally there is a need for bodies similar to SEBI which protect consumer interests in the same manner that SEBI protects shareholder interests.

Reliance

Reliance Industries (RIL) is the largest Indian Company. It dominates the Sensex and Nifty Index. It is the creation of Dhirubhai Ambani, a gentleman and a colossus who created a formidable empire from nothing. After his death, the group, which includes much more than RIL, was controlled by his two sons. Mr. Mukesh Ambani and his brother, Mr. Anil Ambani are both formidable business leaders in their own right.

Mr. Mukesh Ambani in my view is amongst the best persons to make things happen; he is able to finance and bring in major projects in time and under budget. He also has the ability to convert risk into reward; in a sense he is a wealth creator. His organizations are well managed, growing, profitable and customer centric. He controls a vast empire with several subsidiaries across a diverse array of industries with Oil and Gas Exploration and Production and Refining being at the heart of the empire.

Mr. Anil Ambani, is a visionary and a tactician; he guided the group into key consumer areas, such as communications, financial services and retail, while maintaining keen interest in infrastructure. The consumer and financial services sector in India are prime beneficiaries of the rapid development and he had the vision to see this early. Unfortunately, I am not convinced that his group is sufficiently customer centric.

Both brothers together complemented each other beautifully, a great executer matched by a master tactician. Unfortunately, they fell out. No doubt each shall suffer, but so too shall their respective shareholders. There is no hint of bad governance here; no entity can assure unchanged management.

After the fall out, the group was carved up. The various entities, listed and unlisted, ended under the control of one or the other brother. I understand that it was agreed that RIL (a member of Mr. Mukesh Ambani's group) would supply a certain amount of gas to RNRL (a member of Mr. Anil Ambani's group) at an agreed price and for certain duration; this agreement was made through a memorandum of agreement brokered by their mother. This part of the agreement is also now the subject of litigation; to be heard by the Supreme Court shortly. And it is here that I believe there is some risk of poor governance.

My questions on governance are:

• A Company is quite distinct from its shareholders. Can an agreement between two shareholders rightly be imposed upon companies controlled by those shareholders?
  
• Can the company on which such terms are imposed, rightfully disregard the rights & interests of its other shareholders?
  
• Can the company on which such terms are imposed, rightfully disregard the rights & interests of its other customers?
  
• Can the company on which such terms are imposed rightfully disregard the rights & interests of the government, as the resource owner?
  
• Can the company on which such terms are imposed rightfully disregard the rights & interests pursuant to the Production Sharing Contract?
  

  
  

US Policy – Expectation Ahead of the Times

It is clear that the market has been driven almost exclusively by policy. The market typically prices in economic situations six months ahead of time. This kind of makes sense as known policy gives an indication of what might happen six months out. Today the market is declining partly in response to declining odds of further stimulus; and is also waiting for the markets to give an indication to earnings expectations which will help provide a reality check on expectations. What is forgotten for now is that the stimulus was always intended as a two year plan; so there is still juice left in it. Furthermore, with the deficit where it is, the chances of further stimulus were already low.

This post looks at future policy action which might occur. In a sense anticipating policy ahead of time is useful, once policy is known it gets quickly priced. The risk is huge, because the markets can continue to fall because of what is known as the knowledge gets priced; in addition the policy anticipation can be wrong. Nevertheless it is something I like doing, particularly as markets fall, because in the long term, nothing is really ever quite as bad as is expected during periods of stress. And it is never as good as is expected during periods of exuberance.

From a fundamental point of view, earnings and outlooks are important; my guess is that results will be in-line to positive as the adverse guidance ahead of results has been on the low side. And from a technical view point, it would be good to see where the fall is arrested by new money; ideally I would expect buying support to rise at 825-850 range; but even going to anything over 747 is okay (preferably over 806). An arrest of the decline at these levels would give a reverse head and shoulders pattern for the bear market with Nov 08 lows near 750, March 09 lows near 650 and then Aug/Sep lows near 8XX! We can never really know market direction, but there is no harm in making an educated guess and my guess is 806, then rising as the economy recovers. From a strategic viewpoint economics and policy are all important. My view is that the recession has or is very near concluding; a period of anemic growth can be expected for the foreseeable future and the degree of growth will be heavily policy dependent for at least one year. I see the recession as ending because lagging indicators now continue to decline, but at a slowing rate; at the same time leading indicators have started rising. It is not uncommon for recessions to end when this fact pattern emerges. My speculation on how policy might evolve is set out below.

1. Financial markets were illiquid following the near simultaneous explosion of the debt and property bubbles. The collapse of Lehman and the situation at AIG resulted in a complete loss of confidence in both self and counter parties. Suspect paper quality coupled with counter party risk make liquidity freeze.
   
2. Fed steps in as lender of the last resorts. Interest rates are aggressively cut.
   
3. Fed expands its balance sheet. Investors seek safety and interest rates turn negative; I am surprised with government's ability to borrow in the situation; I had expected use of seigniorage
   (creation of money by printing it). Deficit starts climbing rapidly as a result. Economy faces deflation despite a huge increase in money supply.
   
4. So far the deficits have not been inflationary possibly because of a circular flow of money; from the fed at near zero rates and into low yielding treasuries - Money supply exists but it's not going anywhere.
   
5. Financial Institutions (FI) take huge write-downs. They are shored up by fresh equity infusions from investors, sovereign wealth funds and the US. FI's cannot be allowed to fail. Leave aside the impact on financial markets and main-street; FI's have borrowed heavily from the Fed by now; to have the risk crystallize into liability is unacceptable. At the same time quality assets such as treasuries could be used to first pay other debtors with superior rights.
   
6. FI's further supported by changes to accounting rules. Credit markets slowly limp back towards life. FI's can start showing profits as write downs slow; also income from investments treasuries flow through while cost of funds from Fed is near zero.
   
7. Fiscal stimulus benefits start to creep in; deficit rises further. Since money is entering markets, deflation risks abate. Can you imagine where unemployment would have been absent the stimulus? The main target of the stimulus should be to reduce the adverse impact of the terrible economy on unemployment. The ability of human assets to generate income is critical; particularly during a time of stress to the consumer balance sheet.
   
8. FI asset portfolios improve in asset quality, the balance between risky debt and safe debt is changed dramatically because of write-downs in risky debt & new investments in safe treasuries. With additional equity and government guarantees, the risks recede. Credit markets start moving and risk appetite returns.
   
9. We are about here.
   
10. As FI's start to exit treasuries to more towards higher yielding debt that value could collapse. It is unlikely that there will be an active market because of the US$'s status as a reserve currency coming into question. In time the Fed could act as a buyer; but not yet. Deleverage and shrinkage of Feds balance sheet and the deficit are likely to occur after the economic risk abates visibly. The reduction in deficits will likely be financed through a combination of higher taxes, fiscal austerity and seigniorage. Future deleverage will be disinflationary. But before we get here we have to have reflation in response to the stimulus & as private borrowing rises. Expect future policy direction to guard against deflation as the bigger risk. Also expect future policy to focus on fiscal austerity; i.e. no further stimulus unless in response to new events. Expect policy to tame deficit through higher taxes and fiscal austerity; though use of seigniorage cannot be ruled out. I am moderately in favor of some seigniorage as it will be inflationary (weaken $) and offset the deflationary impact of deleverage; in addition I believe foreign investors in (China in particular since it played a part in creating the debt bubble – see more on this here) treasuries need to pick up part of the cost through devaluation. Expect higher tolerance of inflation to near 4% levels as low short term interest rates and a weak $ will be required to maintain sub-par economic growth rates while the de-leveraging process is ongoing. Expect long term interest rates to remain elevated as a consequence of rising risk premium demanded by lenders; expect treasuries to fall in value and drive up yield to maturity. In tax policy expect to see aggressive moves to widen tax base including illegal foreign accounts; see increase in capital gains & dividend taxes, see change in laws to dis-incentivize/disallow US resident corporate from sheltering offshore profits, thus deferring payment. See higher marginal rates of tax for $200k and over income levels.
    
11. But I am jumping the gun. Stimulating the credit market is no easy matter. First of all the FI ability to take risk has to be improved by removing some risk assets. Disposition of such assets will provide FI liquidity in addition to improving asset quality of the balance sheet. The profit impact of such an action will be muted because heavy write downs have been taken. A buyer can draw some comfort on valuation from government guarantees associated with the private public partnership plan targeted at buying distressed debt. Policy implementation in this area has been somewhat slow; it is something I hope to see recommence – and fast. This is an important step because restructuring debt by experts in the field, who have bough distressed assets at fair value, will lead to the benefits of debt destruction (it is already destroyed through the write downs but benefits needs to pass through to borrowers) passing on to consumers and business. Today consumers and businesses are not in a fit to borrow condition, but with debt write downs and restructure, be it through chapter 11 or otherwise, the borrower's balance sheet will heal and the ability to borrow will return. With FI's in a fit to lend condition, strong policy is expected to be enacted requiring tighter regulation including of the derivative market. I expect significant regulation to apply to outbound capital flows.
    
12. Once risky debt is in the hand of PPP owners, the process of allowing consumers and corporate borrowers to deleverage and be in a fit to borrow condition can commence. Restructure and write down of debt is the way to go. The process has begun - as the savings rates climb, net debt falls. Consumer balance sheets while far from healthy, they are starting the process of restoration to health. But there is a long way to go. Once balance sheets are repaired, borrowers in a fit to borrow condition will create demand for credit. While the home market deleverages, demand for credit from emerging markets will remain high. While emerging economies are suffering as a consequence of reduced US demand, the domestic foreign economies remain robust from a demand perspective. It is likely that monies will flow to emerging markets, especially for investment in infrastructure, resources and for industry with a high degree of dependence on the domestic foreign economy. Expect capital flows into emerging markets to keep the foreign currency strong. Expect higher inflation rates and nominal interest rates to prevail in emerging markets alongside higher growth rates. Expect high global inflation rates and a weak $ to lead to strong pricing in the materials and energy sector.
    

Trigger Happy on the Sensex

There is no change in my long term fundamental outlook which can be read here. On technical outlook, you can look here. The developments in technical outlook are largely negative. Since the budget disappointed, it is likely that the gap caused by election euphoria will be filled; thus the chances of 12,100 on the downside have risen. There are also several events such as the monsoon, the policy on foreign direct investment, the risk of a rising fiscal deficit and a Country downgrade, the disinvestment policy and the new tax code, which could take the market to closer to 9,700 if the event is viewed negatively. Long term investors who are at their standard allocation levels, who wish to go over-weight emerging markets can afford to wait for better entry points for deployment of their incremental investments. Those who are underweight and wish to reach a standard allocation should probably buy at current levels, and consider going over-weight if the market falls lower.

The event risks are considered below:

Monsoon

So far the monsoon has disappointed. With rising El-Nino conditions it is likely that the monsoons will be a disappointment this year. The US Department of Agriculture has highlighted the possibility of drought like conditions in India if the rains do not arrive by mid July; we are now in mid July. Overall, this is a negative trigger for the following reasons:

• El Nino conditions persisting are indicative of a below average hurricane season in the Gulf of Mexico. This removes an upward momentum trigger from oil prices, which is very important for India. On the one hand it is positive as lower commodity prices are a positive for growth. But on the downside, Reliance, India's largest Sensex entity traditionally gains as oil prices rise.
  
• A drought or substandard monsoon will mean a weak agricultural economy. Higher food prices and rising CPI is one consequence; and not a pleasant one because CPI is in excess of 10% today. Rising CPI levels give rise to an expectation of rising interest rates, which is a negative trigger.
  
• With high food intensity (household budgets spend a very significant proportion on food) the rising food prices will leave lesser amounts for discretionary spending. Because over 60% of the population is agrarian based, the implications for domestic demand are grim. I believe the recently presented budget caters for a weak monsoon; what remains to be seen is whether market expectations will move towards an anticipated further increase in the fiscal deficit to support this sector. Such a move in expectations will be a negative trigger for the economy.
  

Policy on Foreign Direct Investment

• I do not see cause for concern in this area. India has made clear its desire to attract foreign capital. I expect evolution of policy in this area to be a positive trigger.
  

The Disinvestment Policy

• I do not see a cause for concern in this area. Disinvestment is high on the priority list, if for no other reason than to reduce the fiscal deficit. I expect evolution of policy in this area to be a positive trigger.
  
• There is a possible negative trigger too. It is unlikely that the government will reduce itself to a minority shareholder in the banking sector. While this was a possibility pre financial crisis, going ahead I believe the government will not give up its control in this area; it is also why I personally never invest in a public sector undertaking.
  
• The other possible negative trigger is that such disinvestment will mop up liquidity. Lower liquidity levels could lead to a sluggish wider market. This is unlikely to have a significant impact because as animal spirits return, so too shall liquidity.
  

The Fiscal Deficit

• The markets have started pricing in the risk of an unsustainably high fiscal deficit. The deficit when viewed at Central, State and subsidy levels is well in excess of 10%; this is unhealthy, but unfortunately, in this economy it is also necessary. The risk of a further rising deficit caused by a failed monsoon is also a negative.
  
• The high fiscal deficit points towards lower liquidity levels and higher interest rates because of the governments need to borrow. This is a negative.
  
• The risk of a Country downgrade by SP and Moody remain elevated. A downgrade would make borrowing more difficult and more expensive. These are negative triggers; given the constraints on global liquidity, it is even more negative.
  
• Despite concerns in this area, I expect the concerns to first act as a negative trigger and then expect the policy communication (expected in October) to be a net positive trigger. A return to fiscally responsible policy will act as a massive upgrade for the markets; the markets are pricing in a credit rating downgrade, as this risk recedes, the positive impact will be significant. There are several factors which can lead to positive surprises on the fiscal deficit. These include:
  
  • Reduced need for stimulus as private spending increases.
    
  • Removal of oil subsidy
    
  • Disinvestment proceeds
    
  • Improved tax compliance and enforcement through the recently initiated Unique Identification Project.
    
  • Impact of the proposed direct tax code.
    

The New Tax Code

• A draft New Tax Code is expected to hit the public domain by late August. It is expected that this code will greatly simplify the tax laws and will result in better compliance and enforcement and a broader tax base. The resulting incremental tax revenues will first reduce the fiscal deficit. This is a net positive. India has also committed to reduce tax rates as the tax base widens; an expectation of lower tax rates is also a positive trigger.
  
• For companies, we can look forward to lower tax rates; as a minimum we will see the surcharge go. We can also look for lower compliance costs and lower costs associated with dispute resolution. These are potential positive triggers.
  
• We might see the dividend distribution tax (DDT) go; however this will be neutral as it is likely that dividend income will be taxed in the hands of investors in lieu of the removal of the DDT.
  
• The impact on investors is less clear. My own view is that we shall see a removal of the Security Transaction Tax and a return of short and long term capital gains tax. This could be a negative trigger because the post tax return expectation will fall below where it stands today. It may lead to debt as an asset class gaining attractiveness relative to equity. In the short term it may lead to a run on the market as people try to book tax free gains during the year end 31/3/2009 and look to reinvest with a higher cost basis for the future.
  
• For foreign portfolio investors operating with no treaty privilege, the attractiveness of the Indian market versus other emerging markets will reduce as a result of a change in long term post tax return expectations.
  
• For portfolio investors operating with treaty privilege, the introduction of capital gains tax will be neutral. However, anti avoidance rules will certainly result in elevated disputes. At a minimum, foreign portfolio investors will need to substantially increase the substance of their inbound investing vehicles in order to qualify for treaty privilege. Because the cost of substance will be well below the tax savings, I expect a massive shift in the structures used to deploy capital. To be honest, any portfolio investor operating with treaty privilege, who operates through an inbound investment vehicle lacking in substance is either foolish or ill advised!
  

I expect the end result to be market neutral (with a moderately negative bias) in the long term because increased post tax earnings of will offset lower post tax post tax shareholder returns. However, with equity losing attractiveness versus debt and other emerging markets, the multiple achieved is likely to remain somewhat below the prior economic expansion.

The Decoupling Myth

The decoupling myth has made the rounds. Emerging markets stayed resilient despite a global crisis unfolding for several months. They then collapsed as it became apparent that no one is safe. Why did the decoupling rationale fail?

When people looked at decoupling, they looked at relative dependence of an economy on its domestic consumption versus its export/import dependence. This is a mistake, and an easy one to make.

Globalization is a much bandied about word. It is embedded in the worlds psyche and it is a model which such vast benefits that it cannot fail. Globalization in the long term will provide a resource and capital allocation model, which optimally allocates across all geographies. This will be far more effective that a domestic resource and capital allocation model.

GDP growth being more domestically dependent does not decouple an economy; it might insulate, but will not decouple. There are several areas of dependence which make decoupling impossible. These include; where there is a dependence on capital to finance the growth. Or, where there is dependence on international trade. Or, natural resource dependence will also work against decoupling. In the Indian market, capital flows is the re-coupling factor; it was a major positive during the boom and a massive overhang during the bust. Absent an efficient domestic market for debt, it is difficult to allocate domestic capital efficiently. Even if India had an effective domestic market for debt, to benefit from globalization, we would have to let the domestic resources compete with foreign resources; so we can never be truly decoupled. Make no mistake about it, without effective capital flows the economy cannot grow; for this reason the question of a decoupled economy cannot arise. The high contribution of domestic consumption as a proportion of GDP is no doubt an insulator. However, in addition to reliance on capital flows, the dependence on natural resources and international trade are both re-coupling factors. Within the domestic economy, each area of dependence can spill over and impact other areas of dependence. For example, even a small degree of dependence on export can damage domestic GDP as unemployment spreads through that sector. Natural resource price elevation can act as an impediment to growth as it did when oil prices shot through the roof; falling natural resource prices can also be a boon in nurturing an ailing economy back to health. Only an economy which shuns globalization can be decoupled and in my view an economy which shuns globalization is a failed economy. Policy actions by nations can insulate an economy, not decouple it.

In the past, boom and bust cycles were caused principally by domestic circumstances. Over time, reducing the severity of busts and the buoyancy of booms was attained through policy; more monetary than fiscal and regulatory, but all three remained an important part of managed growth. This was only possible because over the years cycles were understood; coming from that understanding, came an ability to manage the cycle. Today we live in a new era; the age of globalization. To manage an economy during this era is a different ball game. Firstly, globalization has to be accepted by governments. Secondly, it has to be incorporated into policy – regulatory, monetary and fiscal. Thirdly, there will be a learning curve; understanding causation will be an important factor; the lessons learnt will need to be incorporated into new policy and this process will ultimately cause better economic management for the new environment in which we live. This is possibly our third flirtation with crisis arising out of an increasingly globalized world – during 1997 we had the Asian contagion, coming into the new century we had the IT explosion and now we have the mother of all crises. Notice the short duration between each event; we need to learn from these experiences to manage the severity and extend the duration of the economic cycle. To do this we must first understand cause and then experiment with policy.

Crisis Cause – Source Nation US

In my view, the crisis was caused by the simultaneous explosion of the property bubble and the debt bubble in the United States. Globalization was in no small measure a great contributor to the creation of this bubble. The starting point is of course the voracious appetite of an irresponsible US consumer; but senseless lending to US is partly to blame for inflating the bubble. It is the demand for US treasuries despite low interest rates which propped the US$; it was low inflation rates caused by a strong $ (mainly vis-à-vis Chinese currency) which kept interest rates low, which in turn spurred US consumption onwards. It is the absurdly low US and Japanese interest rates which encouraged uncontrolled risk taking, specially as an illusion of low risk was created through mispriced derivative instruments. Globalization can also claim credit for the survival of the US. The risky debt had been repackaged sold throughout the world; had it all been absorbed in US financial institutions, I have no doubt the financial crisis would have crippled the US, and with the US; the rest of the world. Because of globalization, the global allocation of capital spread the risk globally. And because of this, good policy has a chance of restoring the global economies to health. The lesson to learn is that better regulation is necessary; more importantly regulation must be globally coordinated. There are many ways in which the nature of cross border capital flows can be re-characterized. Some of these methods can lead to excessive risk taking with sound domestic regulation at both ends; for policy to achieve its objective regulation will need to be globally coordinated.

Some blame the Fed in general and Mr. Greenspan in particular for keeping the interest rates low post 2001. Long interest rates (GS10) averaged 4.44% between 2001 and 2006; inflation averaged 2.66% during this period for a net rate of 1.78%. During the period since 1929, long interest rates (GS10) averaged 5.22% while inflation averaged 3.33% for a net rate of 1.89%. During this five year period, GDP grew at just under 3% annualized; a rate not inconsistent with the 3.22% annualized GDP growth rate since 1929. Fed funds rate averaged 2.7% during the five year period; which means net of inflation rate remained at near zero % which is far below the long term average short term fed funds rate. Perhaps interest rates should have been raised because it was abundantly clear that asset prices were rising because of excessive risk taking. But in theory, there was no real reason to raise rates as consumer price inflation remained under control, while GDP growth maintained growth consistent with long term growth rates. The policy failing was in my view caused by ignoring globalization; while everything in the US was chugging along quite nicely, the $ as the global reserve currency should have taken note of overheating global GDP growth and inflation rates. Lesson to learn includes consideration of global growth and inflation levels as an integral part of domestic monetary policy.

Fiscal policy measures also need to be coordinated at a global level. The level of co-dependence amongst economies now means that policy action needs to be more cooperative since a failing in one economy can lead to unintended adverse consequences in another. Lesson to learn is to empower and expand the G8. I suspect there is a lot of learning to be done at this level – particularly when it comes to taxation. I do not think taxing foreign profits of companies is good fiscal policy and over several years, I expect a transition to a territorial system of taxing together with globally coordinated transfer pricing regulations.

Contribution to the crisis

The US$ stayed relatively strong versus the Chinese currency despite mounting deficits, simply because of the insatiable Chinese demand for US treasuries. The Chinese currency should have appreciated as a result of a large recurring surplus in trade with US; large capital inflows into China would have added further to the appreciation. No appreciation was seen simply because of China's voracious appetite for US treasuries. Part of this crisis has arisen, because a key player in globalization was not a part of free markets because of its controlled and manipulated currency. China also utterly failed to diversify its asset base in order to keep its currency cheap. While this fed the flames of excessive consumption and risk taking. And did it help? Today China is sitting on vast holdings of US treasuries and risks a significant impairment in value of its assets. Versus other major trading partners, the US$ weakened because of low interest rates together with the balance of payments position. Other emerging markets saw their currencies appreciate because of a huge demand for the non US currency on capital inflows.

Outlook

China as the factory of the world served as a catalyst to usher in an era of low multi decade inflation levels. While the story of China remains untold, the inflation impact has been played out. We will see the US$ weaken and resource prices rise. The appreciation in the Chinese currency will raise inflation levels globally; at the same time contraction in global demand will make sure that we do not get into a hyper inflationary environment. To offset the adverse affect of reduced global demand, China will have to invest aggressively in building its own domestic demand. We can expect to see very significant fiscal stimulus for a long time as this is what will be used to maintain and grow domestic demand; we can also see significant continued spending on infrastructure. As China seeks to diversify its asset base out of US $, we can expect significant investments in resources and business, particularly those in emerging markets. We can see several resource rich African nations as being beneficiaries of inbound investment from China; this is one part of the world where Chinese capital and expertise will always be welcome. We can also see several currencies appreciating along-with the Chinese currency as China diversifies its US$ holdings. We can also see China target new export markets.

We see China as being the single most important economy to lead the world out of the crisis. Regulation will be an area of policy focus, and one important factor will have to be quality of inbound capital; at the same time because of a low dependence on inbound global capital flows, China will need to be very careful with regulating outbound capital flows. It is managing outflows which will be critical; the impact on capital outflows would normally depreciate the currency, but since outbound capital flows will flow from existing foreign currency reserves, it is unlikely to weaken the currency. On monetary policy, so far China has been very insular and inward looking. It is likely that its monetary policy will need to become more open and transparent. The currency will need to appreciate; the Chinese currency shall gain in stature as a foreign currency holding for other economies but for this to happen there will need to be more transparence and less currency control. On fiscal policy, continued fiscal stimulus will be a must to develop domestic demand and reduce dependence on exports; not only does it make sense, failure to do so would result in civil unrest in China. This will be inflationary to an extent and so it is likely that a high interest rate environment will persist.

Massive evolution in regulatory, monetary and fiscal policy is likely to be seen throughout the world. It is essential; but everything points towards China as a dominant party to lead the way out of the crisis.

Conclusion

In my view misguided regulatory, monetary and fiscal policy from governments throughout the world, which failed to address and understand globalization had a large role to play in the debacle which followed. No longer can a Country stand by and ignore what occurs outside its borders, for those events will have a profound impact on the home economy. Globalization is here to stay, ignore it at your own peril.

Bubbles - Reflexivity & Contamination

"The Crash of 2008 and What it Means", by George Soros is painfully difficult to read; the concept of reflexivity is not easy to understand; it is abstract and frankly, not very well written. But it has profound implications; it explains an important theory. Equally, it lets you into the mind of a highly successful speculator. If you take the time to read it, do so not for pleasure. Do so in the quest of knowledge. After plodding through it slowly, and re-reading parts to try and understand what it is all about, I can say, I believe I have gained some insight into the world of bubbles and into the marvelous mind of the man I see as the world's greatest speculator.

"First, financial markets do not reflect prevailing conditions accurately; they provide a picture that is always biased or distorted in one way or another. Second, the distorted views held by market participants and expressed in market prices can, under certain circumstances, affect the so-called fundamentals that market prices are supposed to reflect. This two-way circular connection between market prices and the underlying reality I call reflexivity." - George Soros – The Crisis & What to Do About It.

"Bubbles thus have two components: a trend that prevails in reality and a misconception relating to that trend. The simplest and most common example is to be found in real estate. The trend consists of an increased willingness to lend and a rise in prices. The misconception is that the value of the real estate is independent of the willingness to lend. That misconception encourages bankers to become more lax in their lending practices as prices rise and defaults on mortgage payments diminish. That is how real estate bubbles, including the recent housing bubble, are born. It is remarkable how the misconception continues to recur in various guises in spite of a long history of real estate bubbles bursting." - George Soros – The Crisis & What to Do About It.

Below I recap the workings of an idle mind after reading - "The Crash of 2008 and What it Means"

The theory of reflexivity is very hard to understand. It is something Mr. Soros understands by instinct; but it remains very difficult to express and perhaps too abstract for me to understand clearly. What is of critical importance in this theory; is that it explains why traditional equilibrium economics fails; it explains very simply why markets and asset values are in constant disequilibrium.

It explains well how the misconception can reinforce the primary trend to create a bubble; for example in Indian real estate there is a clear primary trend from a fundamental view point; massive liquidity/leverage is attracted because of the strong fundamentals. And it is this liquidity/leverage (the misconception) which drives asset prices and reinforces the primary trend. There comes a point in time when the asset prices react more because of the misconception than because of the primary trend. When the misconception is discovered, the bubble is pricked and asset prices rapidly decline to equilibrium and then far below. The timing of discovery of the misconception is subject to the vagaries of human nature – I suspect the most appropriate time is when capacity created is well in excess or present and near future demand. I say that this bubble has yet to burst because even today the real estate companies are able to leverage their balance sheets; during recent years, leverage came in the form of debt and by way of over-priced IPO's. Today, the leverage continues – for now it is mainly in the form of new equity issued to qualified institutional investors; and this is good as it repairs badly damaged balance sheets – what remains to be seen is whether this ability to leverage the balance sheet will strengthen the misconception/misrepresentation and continue to drive the bubble in valuation of Indian residential real estate (please read George Soros's Reflexivity & the Indian Real Estate Bubble for more complete details).

Until now, people with vision have had the ability to understand and accept that the market is in constant disequilibrium. So far as I am aware, this theory is the only one which seeks to understand why. Understanding why bubbles are created and why they burst is very important. In a sense, it is more important than the bubble or its bursting is; a solution shall arise only from an understanding of the underlying cause. Because the cause is more often than not human nature and the play off between greed and fear; it is my view that any solution will have to be enforced through policy and regulation.

In my view, if there is an ounce of sense amongst the academic community of economists, they will accept that economic theory is more art than science. The need to draw insight from human psychology and understand that cause is important. And then explain how human nature interacts with quantitative economics. I continue to see traditional equilibrium economics as very important, but feel there is a great need to understand why the markets are always in a constant state of disequilibrium. Simple acceptance of the fact that markets are in a constant of disequilibrium is a great first step. The second step is seeking to understand why.

In a sense, reflexivity can be predictive - a search of a primary trend together with a quest to identify misrepresentations/misconceptions can point to the direction in which asset values might go. I do not however see it as being predictive as to when direction might change. It is not quantitative, because it cannot predict how high asset values might go or how low they might fall. The misconception can be recognized, but for a bubble to burst, the fact that it is a misconception must be widely accepted - until then the herd mentality and psychology of markets will drive the bubble onwards - the misconception continues to work until it is too late. Yet, it is not the predictive characteristics of reflexivity that interests me. What does interest me, using this concept as a means to understand bubbles; from such understanding, comes two advantages. The first is an ability to exploit mispricing in the markets and profit from it while it exists; the second is far more important – the quest for policy solutions which will reduce the extent of mispricing in markets and promote better stability, so necessary for sustained long term growth.

Once a bubble bursts is when things get interesting. They say that the bull of the last economic cycle rarely leads the next expansion. This makes sense. The last bull is normally in bubble formation until it pricks; once it pricks, there is recognition of the misconception. The sector will run closer to fundamentals (and below) during the next economic cycle. My own theory of contamination, accepts bubbles. It pre supposes that the bubble contaminates sectors other than the sector (though to a lesser degree) which is the cause of the bubble. When the primary bubble bursts, the contamination spreads across all sectors. And it is these sectors where the best values shall be available. For example during the most recent bubble we have two cause sectors - financial services and consumer discretionary (including real estate). We had energy and basic materials as heavily contaminated sectors; the fundamentals (primary trend) are strong and remain so. They did get contaminated by liquidity/leverage/derivatives; but when the bubble burst, the sectors fell well below fundamentals (equilibrium economics suggests oil prices at $35 were well below the marginal cost of production; which is the point of equilibrium when it equals marginal revenue). In my view this is a repaired contamination and I expect these sectors to lead the next expansion because the primary trend remains intact; unfortunately for financial services and consumer discretionary products the bursting of the bubble has damaged the primary trend; it will take a long time to repair.

Finally, there is a case for bubbles as being essential for development. There is a case to be made for understanding capacity in the context of time. For example, during the internet bubble, miles of cable were laid; this resulted in the creation of huge over capacity. Once the bubble burst, the over capacity was financially worthless. Yet, the communications revolution shall be built on those very cables. Capacity creation in a very short period of time instead of over a long period of time is what caused this bubble. The collapse in values caused by over capacity will drive a new phase of development.

I suspect that something similar is occurring in emerging markets today. The need is humongous and across the board. In a sense, it is the creation of capacity which will convert the need into actual demand; for in the process of creating capacity, income levels to demand use of the capacity created will arise. This will drive the next phase of capacity creation. But there will come a point in time when liquidity will drive capacity expansion ahead of current need (though well short of tomorrows need). And this will cause a painful contraction, until the excess capacity, now at more economically viable prices shall drive the next phase of expansion.

Sensex Valuation and Return Potential

During the past five years, the Sensex has delivered annual average earnings of Rs 630. A market trading at 13,750 has a 21X prior cycle earnings multiple; it certainly looks expensive. Yet one has to consider that the year ended 31 March 2009 is expected to be a trough earnings year; Sensex delivered earnings of Rs 850 during this year.

Going forward, over the coming political cycle, GDP growth in India can be expected to grow at at least 6%. Because GDP growth reflects slower growth rates in the agrarian sector of the economy, this should translate to 9% growth in corporate earnings. With reversion to a 6% long term inflation rate, nominal earnings growth can be expected to hit 15%.

6% GDP growth is a fairly subdued cycle growth estimate; it marks growth expectation down from 8.5% achieved in the prior political cycle. I have used this low level because the high fiscal deficit (expected to be 6.8% of GDP at Center level and an additional 4% at State Level and some more due to invisible deficits caused by the petroleum subsidies) might trigger a credit downgrade if not controlled. In addition, a large borrowing requirement will ultimately push interest rates up; one outcome of higher interest rates could be subdued growth. Finally, India's dependence on exports is low relative to other emerging markets; nonetheless there is a degree of dependence since somewhere between 20% and 25% of GDP comes from exports.

With 15% nominal earnings growth, the forward cycle earnings average is approximately Rs 1,150; the markets are trading at approximately 12X this number. This is not overly expensive.

Consider where the Sensex might trade five years out. With earnings rising to Rs 1,700 (based on 15% annual nominal earnings growth) the market would be:

Cheaply Valued at 10X = 17,000 (absolute return of 23% over 5 years; annualized 4.5%)

Fairly Valued at 15X = 25,500 (absolute return of 85% over 5 years; annualized 13.5%)

Expensive Valuation at 20X = 34,000 (absolute return of 246% over 5 years; annualized 20%)

Bubble Valuation at 30X = 51,000 (absolute return of 370% over 5 years; annualized 30%).

With long term interest rates expected to run at 8.5%, there is an adequate premium because the expected (fair value) return is a full 5% points in excess.

$ investors could stand to gain even more. The Rs is valued at near $1=Rs 50. As risk aversion recedes and capital flows into emerging markets the Rs can be expected to strengthen to near Rs 42. Thus investing $1 today buys you Rs 50. When you exit, your Rs 50 is worth $1.19.

Of course the margin of safety and return potential was higher when the market traded at its lows in November last year and then again with a higher low in March this year. But that time is past.

The market should pull back short term. Personally, I expect it to fill the gap up from the euphoric election result rise (12.1k levels); it could go lower; it could go higher - NOBODY KNOWS. This is why I say buy when you have an expected return giving you a 5% risk premium; and then buy more when risk premiums rise!

George Soros's Reflexivity & the Indian Real Estate Bubble

"First, financial markets do not reflect prevailing conditions accurately; they provide a picture that is always biased or distorted in one way or another. Second, the distorted views held by market participants and expressed in market prices can, under certain circumstances, affect the so-called fundamentals that market prices are supposed to reflect. This two-way circular connection between market prices and the underlying reality I call reflexivity." - George Soros – The Crisis & What to Do About It.

Bubbles

"Bubbles thus have two components: a trend that prevails in reality and a misconception relating to that trend. The simplest and most common example is to be found in real estate. The trend consists of an increased willingness to lend and a rise in prices. The misconception is that the value of the real estate is independent of the willingness to lend. That misconception encourages bankers to become more lax in their lending practices as prices rise and defaults on mortgage payments diminish. That is how real estate bubbles, including the recent housing bubble, are born. It is remarkable how the misconception continues to recur in various guises in spite of a long history of real estate bubbles bursting." - George Soros – The Crisis & What to Do About It.

Authors Note: The intent of this article is to highlight the fact that while growth potential in Emerging Markets such as India is immense; so too are the risks.

Within emerging markets, certain industries face higher risks; including without limitation the risk of bubbles. Several focus areas such as fast moving consumer goods, financial and consumer services, information technology, infrastructure and natural resources, healthcare, consumer staples, utilities and telecom have major potential due to the sheer size and demographic profile of the nation. A lot of industries provide goods and services which are affordable to a substantial section of society; and the potential for an explosion in demand as income levels rise is immense. Overall valuations are not at all demanding in the context of growth potential backed by present and recently historical performance. Infrastructure and natural resources remain my favorite, because without viable infrastructure, the potential demand can never be converted to actual demand.

Yet, when we come to high value items such as houses, the real estate market is pricing based on a presumption that potential demand will be converted into actual demand very fast – thus we pay tomorrows prices today. India is a long term multi decade story; values in real estate have moved well beyond affordability in the context of the present and near future income levels; is there a bubble and if yes, when will it burst are two areas needing thought. I do not have an answer, but my thoughts are expressed below.

There is a trend which has a sound foundation in reality; the primary trend. And there is a misconception or misrepresentation that reinforces that primary trend.

The Primary Trend

India is in the early stage of an urban revolution. The demographic profile in the country also points towards a new and growing class of youthful consumers. The demand potential exists; as the rural population migrates to urban centers, the demand potential will rise. Demand potential is the desire to possess an article; when the desire is backed by the ability and willingness to pay, then, there is actual demand. With rapid economic growth, income levels are rising; with this potential demand can be converted into actual demand.

Is this a primary trend? I have no doubt that the answer is yes.

The Misconception or Misrepresentation

What then is the misconception?

Misconception 1:

The World Bank estimates that over 40% of India's populace live below the poverty line; that is $1.25 per person per day. During August 2007, Reuters carried an article claiming that 77% (836 million people) in India live on less than 20 Rupees a day; this information is contained in the state-run National Commission for Enterprises in the Unorganised Sector (NCEUS) report presented to the Prime Minister during 2007. Then there is another large section of the population who lives in poverty; not abject poverty, but poverty nonetheless; these people earn less than 200,000 Rupees per year. Then we have the so called middle class; there are approximately 50 million people earning between 200,000 Rupees and 1,000,000 Rupees per year. Add to this perhaps another 2 million, who earn over 1,000,000 Rupees per year and we are done.

Many argue that, the cost of living is low and so low income levels afford a higher standard of living, comparable to developed countries. I would argue that this is true at the lower end of the lifestyle spectrum. However, at the higher end of the lifestyle spectrum, it is not. If you compare the cost of cars, electricity, schooling, petrol, quality housing with suitable infrastructural amenities, in United States to costs in India, you will be surprised at how expensive India is. At the lower end of the lifestyle spectrum, costs have risen rapidly; even today consumer price inflation is in excess of 10% compared with near zero in the United States. In my view India is poor by all standards. No doubt income levels are rising and will continue to do so; if growth can be maintained within two decades it will be a different story. And this story is the misconception that is causing people to pay tomorrows prices today.

What kind of home is affordable? Let's ignore the inconsequential population earning over 1,000,000 Rupees a year. Let's assume the building is targeted to meet future demand of people whose income is Rs 1 million per year. Let's assume that a person will spend 40% of salary for housing. Let's assume a 10% interest rate and a 20 year mortgage. To pay Rs 33,000 monthly in mortgage payments, a person can afford to borrow Rs 3,400,000. With income levels rising, there is a strong case to be made for rising demand from a growing and prosperous middle class, provided that the housing is affordable. In my view, demand for housing costing between 1.5 million Rupees to 3.5 million Rupees, depending on location, is what is viable. Because of the sheer size of the population, there is viable demand at these price levels and demand will grow as incomes grow. Prices had shot well above these levels, but new developments are now targeting similar price ranges once again.

Who is buying today? Where has the liquidity come from? To confidence as a provider of liquidity I say "Confidence creates success; over confidence kills it; be confident of success, but work hard and smart while you strive for it." National confidence and arrogance are in oversupply; this is causing payment of tomorrows prices today. In my opinion a substantial amount of liquidity comes from investors, not end users. And it comes from investors who have not clearly understood the demand dynamics; demand potential is confused with demand. The chain of investors seeing the prior investor profit has caused prices to rise beyond the fundamental value; and it is the last man holding the asset who shall cry. There is another worrying source of liquidity; India has an immense parallel economy. The income generated in this world cannot be easily dispensed and property is amongst very few options available to the beneficiaries of "black money". That is why you see very few resale property deals are cutely classified as "All Check" deals.

The misconception is irrational confidence and liquidity which has driven property prices well over affordability levels based on today's and near future income levels. We need a Dr Robert Shiller to bring us down to earth.

Misconception 2

Land by itself has little value unless it is developed. Developed land must include sustainable electric supply, water, sewage, roads, schools, hospitals and markets amongst other things. These I call the infrastructural facilities. I argue that the value of developed land in India is illusionary; and a twice paid illusion at that.

The Illusion

• You will have roads within the community; but the minute you leave there is a problem.
  
• You will have water, but it is ground water and supply is short. Municipal supplies are far from abundant in the rare cases where it is available. Did you know that India has access to only 1,211 cubic meters of internal renewable water resources per person. That is just about enough to sustain life after usage for agricultural, industrial and domestic consumption. Yet, India discharges 95% of urban sewage untreated into surface waters. Very few cities even have partial sewage facilities. Water is a major problem today and it will be a bigger problem tomorrow. The only Country in the vicinity which has an internal renewable water resource surplus is Russia - they have over 30,000 cubic meters per person. In these circumstances, I cannot view water supply as sustainable; certainly not without considerable investment in pollution control, waste disposal, water management resources, water distribution resources and the like. As a result of uncontrolled population growth, in my view, India will have a water deficit by 2050; we will buy water, not oil from Russia.
  
• Sewage is a major problem. The lines are laid within the community. More often than not there is no connection to carry the waste away.
  
• You will have electric supply, but it is generated off diesel generator sets. The supply from power companies is abysmally inadequate.
  
• Schools facilities are far from adequate.
  
• Hospital facilities are improving in major urban centers but still lacking at a national level.
  
• Markets; enough but still too crowded.
  

The Twice Paid Illusion

What is a twice paid illusion? When you buy property, you pay for an illusion. The developer creates the illusion of sustainable infrastructure where there is none and you pay a premium for these facilities in the per square foot price. You pay again through development charges, charges for electric substation and similar add on costs. In a sense you pay for the development of the illusion of infrastructure and then you pay again through a premium on the per square foot price. And that is not all; you pay for the rest of your life. For electricity, ultimately charges for back up supplies are over twice the rates charged by power suppliers. Then when in ten years your electric substation needs repair, you will pay for it again. When the ground water runs you will buy it.

The problem (misconception) is that a substantial land bank has been acquired not looking at the value of the land, but at the misconception of the worth of what will one day be built upon it. And people have been willing to pay for it.

A Bubbly Conclusion

Do we have a bubble in Indian Real Estate? When will it burst? I have no doubt there is a bubble; yet I have no idea on whether it has burst (I suspect not) or when it will burst. I suspect we are now at a point in time when prices will dip to test and then rise as speculative fervor takes hold anew. Hopefully, with all global economies needing to deleverage rapidly, liquidity will be constrained and so contain a potentially painful bubble. With the significant wealth destruction in real estate company valuations, the bubble might have been near priced; but the bubble will only prick when the actual real estate prices decline substantially. And this has not occurred.

Beyond the Bubble

Look at the financial statements of the major developer in India during the boom years of 2003-2007. You will see decent earnings and earnings growth. But turn to free cash flow and you see a dangerous degree of leverage. This is leverage through massive debt burden. There is also leveraged through raising equity at ridiculous premiums; which will give poor return on equity to those unfortunate investors. Negative free cash flow because of the "initial years" story is somewhat acceptable. But if we turn to operating cash flow we see this is negative too. This leverage has caused purchase of expensive land banks due to excess liquidity; the risk of impairment in land values, while in the ownership of developers exists; if it does not crystallize, buyers might hurt when the bubble bursts. Personally I feel the damage will be more contained in developer ownership compared with impairments in the hands of consumers after a bubble bursts; this is why the recent repair to damaged balance sheet is encouraging.

DLF (Source Reuters India)

Millions of Rupee (except for per share items)	2008 2008-03-31 Period Length 12 Months	2007 2007-03-31 Restated 2008-03-31 Period Length 12 Months	2006 2006-03-31 Period Length 12 Months	2005 2005-03-31 Period Length 12 Months	2004 2004-03-31 Period Length 12 Months
Net Income/Starting Line	95,585.2	25,401.9	3,595.0	1,138.0	802.0
Depreciation/Depletion	900.6	578.1	361.0	333.0	288.0
Amortization	--	--	--	--	--
Deferred Taxes	--	--	--	--	--
Non-Cash Items	1,569.1	(10,774.6)	1,068.0	315.0	308.0
Changes in Working Capital	(124,023.0)	(80,840.8)	(15,975.0)	3,968.0	(3,603.0)
Cash from Operating Activities	(25,968.0)	(65,635.4)	(10,951.0)	5,754.0	(2,205.0)
Capital Expenditures	(47,831.4)	(20,307.2)	(4,002.0)	(8,329.0)	(959.0)
Other Investing Cash Flow Items, Total	(12,310.6)	22,671.4	(14,658.0)	648.0	232.0
Cash from Investing Activities	(60,142.0)	2,364.1	(18,660.0)	(7,681.0)	(727.0)
Financing Cash Flow Items	87,660.7	(2,904.0)	(1,484.0)	(645.0)	(583.0)
Total Cash Dividends Paid	(6,819.8)	(15.5)	(16.0)	(16.0)	(14.0)
Issuance (Retirement) of Stock, Net	350.0	9,503.0	0.0	0.0	0.0
Issuance (Retirement) of Debt, Net	23,177.0	58,010.7	32,020.0	2,595.0	3,517.0
Cash from Financing Activities	104,368.0	64,594.1	30,520.0	1,934.0	2,920.0
Foreign Exchange Effects	--	--	--	--	--
Net Change in Cash	18,257.9	1,322.9	909.0	7.0	(12.0)

Unitech (Source Reuters India)

Millions of Rupee (except for per share items)	2008 2008-03-31 Period Length 12 Months	2007 2007-03-31 Reclassified 2008-03-31 Period Length 12 Months	2006 2006-03-31 Period Length 12 Months	2005 2005-03-31 Period Length 12 Months	2004 2004-03-31 Period Length 12 Months
Net Income/Starting Line	20,677.8	17,918.5	1,389.6	564.3	375.6
Depreciation/Depletion	205.3	73.4	112.2	112.6	108.0
Amortization	--	--	--	--	--
Deferred Taxes	--	--	--	--	--
Non-Cash Items	1,982.6	412.2	439.3	188.7	198.2
Changes in Working Capital	(32,616.0)	(39,149.1)	(4,187.7)	103.2	440.7
Cash from Operating Activities	(9,750.3)	(20,744.9)	(2,246.7)	968.9	1,122.6
Capital Expenditures	(24,810.3)	(5,513.7)	(3,999.6)	(989.0)	(535.8)
Other Investing Cash Flow Items, Total	(7,064.2)	(1,741.0)	916.9	25.7	96.8
Cash from Investing Activities	(31,874.5)	(7,254.6)	(3,082.8)	(963.4)	(439.0)
Financing Cash Flow Items	612.3	4,495.1	(32.3)	(98.2)	47.8
Total Cash Dividends Paid	(474.8)	(185.1)	(59.7)	(89.2)	(91.7)
Issuance (Retirement) of Stock, Net	--	--	--	--	--
Issuance (Retirement) of Debt, Net	45,342.7	30,017.4	6,603.3	1,820.2	(182.2)
Cash from Financing Activities	45,480.1	34,327.4	6,511.3	1,632.9	(226.1)
Foreign Exchange Effects	--	--	--	--	--
Net Change in Cash	3,855.4	6,327.9	1,181.8	1,638.4	457.4

We have DLF, the public company, selling property to DLF Assets and being owed large sums. An honorable promoter sold shares in DLF to inject capital into DLF Assets, thereby allowing the debt to be repaid, this is good; but it does not change the fact that much liquidity was created by investment in working capital.

Then look at Unitech; they have had to raise new equity to pay down debt and further repaired their balance sheet through the telecom stake sale. Yet, even today they have a long way to go. Even today they have delayed delivery on several projects. On some like Unitech Grande, they have collected monies in advance from buyers. The ground work on that project has barely begun and by all appearance, the amounts paid in advance have been diverted for alternative purposes. The project delay is inevitable; but what is truly dishonorable is the way buyers have been treated.

Firstly, the scope of the project has been significantly changed. Land is now being sold to people to construct their own properties; the project specifications have been considerably downgraded. Despite significant changes in the project profile, buyers have not been offered an exit opportunity. Compare this with DLF who offered their buyers in Manesar an exit.

Secondly, buyers were offered a significant reduction in cost to downgrade the quality of the final product; but the buyers who had paid in advance more than the full amount that is payable under the reduced cost scenario were not offered the excess cash paid back. To be fair they were offered the cash back together with 12% simple interest in two years time; not quite the market rate for interest being paid by distressed property developers in today's market.

Thirdly, buyers have been informed of a substantial delay in the project.

Fourthly, buyers have written to Unitech following meetings concerning the alternatives discussed and agreed by mid June 2009. To date Unitech has not had the inclination or courtesy to respond; this is despite requests for a response by email.

It would be interesting to evaluate whether any civil or criminal liability can be attached to developers. For instance, does selling one project and delivering another amount to negligence, misrepresentation or fraud. Has there been a breach of contract? Are there any remedies available in civil law?

What about criminal law? Does money paid in advance for a specific project, used by the recipient for other purposes amount to theft? Is an unreasonable delay coupled with no substantial project work in progress and a lack of responsiveness on part of the recipient of monies indicative of possible theft in progress? I have a feeling that such behavior by a Thekedar would not be viewed upon favorably by the law enforcers.