RBI Buys Gold, Why Don't You too?

In most papers today the first news was tanking Sensex and the next was rising gold. Gold story has an emotive appeal for us as less than two decades ago India had to pledge its gold reserve to survive and yesterday’s rise in gold price was described as coming on back of RBI’s purchase of 200 MTs of gold from IMF. At least two non-financial newspapers made it appear that gold prices rose because of RBI’s purchase, which is, of course, nonsense.

Gold is traded and priced mostly in USD. Gold price in India should therefore be a function of international gold prices in dollars and rupee dollar parity. (In addition to these two, of course, there will be local nuances – festival seasons, marriage seasons and so on.) Gold has been rising since 2002. It has risen a lot more in dollar terms than in other major currencies – GBP, EUR etc. This selective excessive rise in dollar term can have two interpretations:
a) Global investors are buying gold as a hedge against dollar
b) Gold is rising but USD is falling hence the rise in gold price in dollars is sharper than in other currencies.
Perhaps both are valid to some extent. If so, a rise in dollar (far fetched though it may appear today) should cause a fall in gold, ceteris paribus.

Where does it leave us, Indians? As noted earlier gold price in rupee will depend on gold price in dollars and dollar price in rupees. Thus a fall in gold price in dollars because of rise in dollars will mean that gold price in rupees should remain unaffected, again ceteris paribus. But cetera may not remain par.

Here is a list of cetera that may change:
1. Global inflation – inflation is a friend of gold price. With rise in inflation gold price goes up as people lose faith in paper currencies
2. Global deflation – This is interesting. Because of 1 above, one is tempted to conclude that deflation will lead to fall in gold price. But no, it is not so simple. Investors foresee how central banks will fight deflation – just the way they have been doing over last one year – to avoid recession central banks resort to quantitative easing – a euphemism for printing more money, lowering the interest to near zero. And if you get a whole lot more money supply but the same old gold-supply, price of gold is sure to rise. Thus in case of recessions, gold may dip at the beginning but will soon harden and prosper.
3. Gold supply – Future of gold supply is getting more and more predictable. Known mining nations – South Africa, Australia and US/Canada have near exhausted their mines, at least all the low hanging fruits have been picked. Some South African mines are 13000 feet deep! Mining gold is becoming more expensive. Developing new mines doubly so because new mines will come up in regions with high geopolitical risks – Middle East, Africa, Russia, and so on; will require massive investment in infrastructure like road / rail / refining etc. High risk means very high cost of funds and unless gold price really goes very very high funds for development of new mines may not be forthcoming.
4. Demand and supply from central banks – This has taken a U turn. There was a time when central banks were selling gold. Those days, perhaps will never come back. China has been buying gold regularly and had even evinced interest in buying the entire stock of 400 MTs that IMF is seeking to sell! And if The People’s Bank of China does decide to rejig its forex reserves, going by the tone of Governor Zhou’s speech of 23rd March 2009 (read here), it will lower its exposure to dollars. That means China will sell dollars to buy gold – increasing supply of dollars and increasing demand for gold in the same stroke. If gold continues to be traded and priced in dollars, this double whammy should cause a sharp increase in gold price.


It needs to be noted that peak gold price of ~USD 850 per troy ounce was reached in eighties. Gold has a long way to go to reach its inflation adjusted peak – may be another 25%.

Bottom line – buy gold ETF. (But do talk to Sahil, before doing so.)

Decoupling Theory

I came across a discussion on Decoupling Theory at a popular finance site I frequently visit. (I find it stimulating, check it out here.) I personally feel Decoupling Theory is not more than a high sounding name given to the trick adopted in 2006 by investment managers in US to encourage the potential investors to part with their monies for investment in emerging markets. I do not think any serious academic work has been done on this theory.

Decoupling theory contrasts with the concept of markets' integration on which a lot of work has been done and empirical analyses carried out to discover that markets are indeed more integrated today than earlier.

Many reports were published around 2006 suggesting that the rest of the world could continue to grow despite significant slowdown in the US economy. This view is commonly called “decoupling”. Its proponents pointed out:
· Emerging markets constitute 30 percent of the world economy and contribute 60 percent of global growth
· Consumption in emerging markets has risen to the extent where it can replace consumption declines in the US.
· Trade linkages with the US was becoming increasingly less important for many countries
· Demographic factors favor emerging market countries - while working age population in emerging market countries will rise by one billion people by 2050, this group will shrink by 120 million in developed countries.

In short, the position was that emerging market and developing countries may have decoupled enough from the US to continue on the path of economic growth even with a major slowdown in the US economy. Thus the theory as the name suggests, says that the emerging markets economies are no longer dependant of US economy for growth. The idea is that the growth in these economies is essentially domestic consumption driven. The driving force was said to be the rise of a substantial middle class appreciative of good things. The theory was supported by strong out-performance of stock markets in India and China (and other such economies) compared to the US stocks. The theory looked plausible till Jan 2008 when most Asian markets crashed after the crash of Dow John’s.

Finally in September 2008 came the financial tsunami caused by the sub prime mortgages. It turned out that many financial institutions outside US faced bankruptcies and needed public support for survival. Growth rates plummeted across the globe and pat came the observation that “decoupling theory” has proved to be a myth. Some cautious observers have merely called it “pre-mature”.

It seems that that the proponents of the theory did not consider the multiple economic relationships and globalization trends. It came in very handy for wealth managers to encourage US investors to invest abroad. The rise and fall of the theory can be best appreciated by looking at the growth data of US and emerging economies. The chart compares the growth data of US and of India.



The proponents were most vociferous during the period when US growth was declining but India’s was rising. Even after it turned out that the emerging markets were not quite insulated with the turmoil of US markets, some proponents, perhaps unwilling to go back so soon on their words, maintained that the segments of the U.S. economy that were showing wear and tear then were those to which the rest of the world would never be heavily exposed.

One head of equity research in an American advisory firm shared his beliefs that “it is possible for globalization and decoupling to coexist”. His arguments: in fact, globalization gave rise to decoupling! With libaeralisation of economic policies, market forces rushed to fulfil the pent up demand. They could not have done so unless capital came from abroad. Thus the local growth, not linked to growth rate of the US, (decoupled) was possible because of foreign capital (globalisation).

Some prominent individuals / organizations propounding this theory were:
1. Merrill Lynch’s (see their 2007 Global Economics Report titled “Global Decoupling: A Marathon, Not a Sprint” here
2. Peter Schiff, see his write-up in The Money Map Report here
3. Jim Rogers (cofounder - with George Soros- of Quantum Fund)
4. Jonathan Garner (head of Global Markets Equity Strategy, at Morgan Stanley)
5. Jim O’Neill (head of Global Economic Research for Goldman Sachs)
6. Joseph Quinlan (Chief Market Strategist, Bank of America Capital Management)
7. Ralph Wiechers (Chief Economist, German Engineering Federation).

(No prescience is required to note that all, except the last, are connected with wealth management and have obvious pecuniary interest in propounding a theory that would encourage investors to part with their monies to these proponents.)

A Central Banker's Speech You Should Read

Mervyn King is the governor of the Bank of England. On the 20th Oct he made a speech in which he said: “Never in the field of financial endeavour has so much money been owed by so few to so many. And, one might add, so far with little real reform.”

Do read the full speech.

Dual Listed Companies

Late Mr B K Sinha taught my class chemistry for a couple of years in high school. BK Jee, as we called him, was a sensitive person with a very scientific bent of mind. He abhorred ambiguities. He once asked us to count the differences between a chemical and a physical change. We rattled off a number of points including how easy it is to reverse a physical change (ice to water and then back to ice etc). Tearing a sheet of paper, BK Jee wondered whether it (tearing a piece of paper) was a chemical or a physical change. In unison we declared it to be a physical change. BK Jee promptly invited us to reverse it.

I was reminded of BK Jee when about three weeks back all newspapers and many blog sites talking of dual listed companies assumed that dual listed structure entails the two partners getting listed in each other’s countries of domicile. See here, here, here, and here. BK Jee would have shaken his head in disappointment. Because it is NOT a must. What is a must? Well, many things, but then you have many options too. Dual listed structure is fairly liquid (in the physical sense), to some extent it can assume the shape of the container, i.e. it can be adjusted to some extent to suit the regulatory regimes of the two countries where the partner companies are domiciled.

Meenal mailed a few days back asking the exact meaning of dual listed structure. I hadn’t heard of it till some five months back, when at a popular finance site I frequently visit, someone had posted that that Unilever is registered in UK and in the Netherlands (Unilever plc and Unilever NV). I thought it impossible and dug deeper. This is how I learnt about the dual listed company structure. (The site for information overload is here.)

What is a DLC structure?

In most of the cross border merger / acquisition cases, one company “buys” the assets and operations of another company and pays the shareholders of the other company in terms of its own securities or cash or as happens most often, in a combination of the two. There are some other cases in which bi-national "horizontal groups" are created, where two entities, without subordination, integrate economically. The constituent companies are of different nationality, often both listed. These are the real “mergers between equals”. The companies agree to combine their operations and cash flows, but retain separate shareholder registries and identities. There are many examples of dual listed companies in Europe, some very old, and some more successful than others. The oldest perhaps relates to Royal Dutch and Shell. Unilever structure came some time in 1930.

There are different forms of DLC structure. I am describing three forms. One form involves the two companies transferring their assets to one (or more) jointly owned company. This jointly held company operates the assets and passes dividends back to the main companies according to a predetermined ratio, and the main companies distribute them to shareholders.

In the second form, instead of transferring the assets, the partnering companies contract to share the cash flows from each other’s assets. Under this arrangement, the individual companies retain their separate assets but align their operations by having either a single board of directors or identical (or near identical) boards elected through a joint voting mechanism. The companies pay equal dividends to their shareholders, and shareholders have equivalent votes in the decisions regarding the two companies, in line with the relative ‘weights’ of the two companies established at the time of the creation of the DLC. In the event that one company does not have sufficient earnings to pay the agreed dividend to its shareholders, there are arrangements for payment from the other company.

A third type of structure involves shareholders in each company receiving an equity unit that consists of a share in each company. In these cases the equity units cannot be split, so that the shares of the two companies do not trade as separate securities. Only for this type of structure the equity units (consisting of one share each of the two companies) must be listed on stock exchanges in both countries.

Why DLC?

There can be a number of reasons for preferring a DLC structure over the usual merger structures:

• Tax: DLC structure may save on capital gains tax (as there is no transfer of assets), withholding tax (cross-border dividend payments to shareholders are minimized).
• Accounting: Since there will be no goodwill amortization in DLC, some accounting regimes may favour a DLC over a conventional M&A structure.
• National identity, approval etc: In a conventional merger one of the companies ceases to exist, necessitating taking fresh approvals from regulators / national governments
• Pride: If the two companies are of similar size, they both wish to avoid the appearance of having been taken over.
• Operational and corporate governance issues. The existing contractual arrangements of the two companies may trigger various types of rights (e.g., options in debt contracts, rights of other companies involved in joint ventures) in the event of a conventional M&A structure. These may be avoided in a DLC arrangement.
• Better access to capital markets: Since merged companies will continue too remain listed in both countries where investors are already familiar, many people believe that DLC will have better access to capital markets.
• Concerns over investor behaviour: Suppose after a conventional merger the merged entity is listed in both countries, though domiciled in any one, where it will have primary listing. With the increase in size, floating stocks its weight in index in that country will increase. But in the other country the merged company will disappear from the exchange and the shareholders will receive equities in a company domiciled in a foreign market. A DLC may be chosen if it is thought that a merger would result in selling pressure in one market exceeding increased investor interest in the other market.

If DLC is so advantageous why do we not see more of it?

We know most cross-border mergers do not adopt a DLC structure. Here are some possible disadvantages to DLCs:

• Complex contractual arrangements: Complex arrangements are needed provide procedures for fair treatment of the interests of the shareholders of the two companies in the events of capital raisings, asset sales etc.
• Lack of flexibility: Existence of two sets of shareholders may at times constrain the flexibility of management and the full benefits of merger may not be realised.
• Regulatory issues: DLC needs to satisfy the accounting and regulatory frameworks of two countries. This may be costly, and may even restrict the ability of management to maximise the joint value of the two companies.
• Liquidity, transparency, and shareholder value issues: Existence of two separate companies may result in less share market liquidity. Investors may view the DLC structure as complex and less transparent affecting the values of the two companies.

Why MTN wanted a DLC structure?

I can think of only two reasons. First tax - remember the tax liability reported in transfer of shares from Hutch to Vodafone? I am not aware what has happened in that case. Second is pride – MTN is no small fiddle and would hate to be seen as having been taken over.

DLC and the Indian legal–regulatory environment

Let us first see the arrangement between Unilever NV and Unilever plc. This had taken place in 1930. It complied with the company law of UK. Our own Companies Act, the most voluminous piece of legislation in the country, is to a large extent word for word reproduction of the English Companies Act. Clearly the Companies Act will not be posing insurmountable hurdles.

Unilever plc and Unilever NV have identical boards. The directors are appointed by the general meeting, on the nomination of owners of a special class of shares held by a 100% subsidiary of both companies. Each of the two parent companies has its own operating companies – for example Hindustan Unilever is an operating subsidiary company of Unilever PLC. Income is received by each parent individually, but are pooled between the two parents due to a so-called "equalisation agreement". Under this agreement dividends will be determined in a set proportion between the two classes of shares. In case of losses by one entity, the profits, or reserves of the other will be affected to feed the dividends due by the other. The equalisation agreement lays down the policies, pursued by the identical boards to ensure that the two parents act as one entity, and avoids conflicting positions. (Arrows in the diagram indicate right to propose / nominate directors.)



This is by no means the best structure. In fact there cannot be one best structure. Whenever two firms decide to go the DLC way they will decide on the structure taking into account the tax, accounting and regulatory environments; managerial flexibility, shareholders’ expectations etc. I have cited this example just to see whether it is possible to adjust it to meet the requirements of the Indian company law.

The arrangement, as can be seen is based on a set of private contracts with the two companies, their shareholders and their subsidiaries as parties to the contracts. There should not be any major issues here. Problem arises in dividend payments when one firm does not make sufficient income. Suppose MTN in a particular year makes nominal profits but Airtel makes spectacular profits. To ensure equal dividend Airtel would have to transfer funds to MTN, and we do not have capital account convertibility!

I have not gone through the clauses of the listing agreements but I am sure listing agreement will not pose a problem that cannot be managed. Then why MTN / Airtel DLC could not take place? Well, because they did not want to. Perhaps the real reason may be in consideration – for ensuring that the shareholders of the two companies receive same amount of dividend (in one currency) the two firms will need to be valued now and cash / shares would change hands to ensure that in the joint operations one share of Airtel would have the same economic interest as one share of MTN – then only the shareholders of the two companies will receive the same dividend. In future too the two companies would commit to transfer cash (equalisation amount) whenever needed.

They were not keen on merging is also clear form the general nature of question put to Indian regulators – how does the Indian regulatory regime deal with DLC. This is a question that can be of academic interest but of little importance to two merging partners. They would have said – here is the structure we propose how do you react to it. Since there can be as many DLC structures as there are pairs of dual listed companies, a general query on DLC is of little value to merging firms.

Can we do without securitisation?

We did without securitisation till recently. Last year saw the investors' faith evaporating from securitised products. The reason: - arrangers were selling securitised products to make money and could not be trusted, rating agencies were out to make money and could not be trusted, in any case the models for securitised products proved all wrong, since no one can understand the risk no one is in a position to price them and no one is buying.

Till last year investors thought that they understood the products, if not they at least the bankers and the rating agencies did; no longer. NewYork Times has a good piece, please read it.

It seems so far only Fed is buying securitised products and is nearing its limit. What will happen then?

Can we go back to the old days when banks accepted deposits and made loans? Should we?

Market Efficiency

Last week John Kay wrote in Financial Times on market efficiency, worth reading.

Valuing a Greenfield Project

Typically for project valuation the different risk return models of finance help us determine the discount rate to be applied on the expected cash flows. The common practice is to look up the cost of capital of the firm undertaking the project if the project has the same risk profile as the firm’s existing operations. If the project is in a new line of activity we seek the cost of capital for “typical” firms engaged in that line of activity. If using CAPM the almost standard practice is to go for “bottom up beta”.

The cost of capital so obtained is for running firms. Is it justified to take the same cost for green field project? Greenfield projects create facilities from scratch. Even if a project follows a standard, tried and tested technology still such a project should have more risks than established firms in that line.

After all, there can be delays in the start of work, under-estimation of costs and deadlines, uncertainty over climatic and geological conditions, very high initial fixed costs with no guarantee as to when cash flows will be positive, etc. Another important feature of a new project is potentially conflicting relationships with subcontractors. Thus new projects launched in different sectors have the risks associated with those sectors (captured in the cost of capital of established firms) and many other risks that are not captured in capital market data as these risks are not present (as they are now overcome) in the firms which supply those capital market data.

In a recent research, researchers (one from BNP Paribas and the other from ESCP Europe) examined the need of factoring in a specific greenfield risk for projects involving the construction of new facilities. They sought from capital markets data whether firms specializing in creation of new facilities are perceived as being more risky than companies in the same sector that did not invest in new facilities.

If investors are assumed to be diversified, only demanding extra return for the firm specific risks they assume, the beta of greenfield companies should be higher than companies that only replace or upgrade existing assets. They identified such firms in the energy sector - the wind farms and energy transportation segments. Both types of firms operate in same regulatory environment and their risks are comparable at most levels, except for the greenfield risks. Firms in energy transportation have a base of established assets, but wind farms firms will need to build new infrastructures on a massive scale over coming years. This led them to conclude that the wind farm risk is a greenfield risk.

They identified three listed pure play firms in the wind farm segment and four firms active in energy transportation. Using this sample, they extracted the greenfield risk premium. By focusing on firms specialising in wind farms and energy transportation they avoided some of the errors that can arise with wide, multi-sector samples, but on the other hand the sample is perhaps less representative of the risk they are trying to measure..

They found the weighted average cost of capital of wind farm firms is higher than that of energy transportation firms and that the expected additional return from wind farm firms is between 1.85% and 2.28%.

The research has some design limitations- first the sample size is rather small but more importantly the construction risk for wind farms may not necessarily be comparable to the construction risks in other sectors. We must also note that generally there is a wide margin of error when estimating the parameters required for computing the cost of capital.

Notwithstanding these limitations, the researchers recommend using a greenfield premium of between 1.5% and 2.5%, when valuing such projects, which is compatible with their simulations and also consistent with the practices of a number of firms.

I find it interesting (and important) and hope to see a lot more work on the greenfield risk premium in future.