Friday, April 29, 2011

US Subprime Market – What Went Wrong?

Probably, no other issue in the recent times has caught as much global attention as the US subprime crisis, which surfaced in 2007; fittingly it was voted the word of the year by the American Dialect Society. The reasons are obvious. The lending crisis, which hit the US mortgage industry, while first appeared to be confined to only hedge funds (essentially owned by Bear Stearns), has now virtually affected the entire financial services sector in the US. And it’s after-effect is even felt now beyond the US markets – from Europe to even in far-off markets like India and China.

Indeed, the fears of a contagion effect became evident after the British lender, Northern Rock, disclosed in September last year that it sought emergency funding from the British central bank, Bank of England. But it was BNP Paribas, France’s top bank, which set the alarm bells ringing across Europe as it froze 1.6 bn euros ($2.2 bn) worth of funds in August, 2007, citing the problems in the subprime market, which prompted the European Central Bank (ECB) to add emergency liquidity. Commerzbank, Germany’s second-biggest bank in February this year became the latest to be hit by the subprime crisis as it cut $1.1 bn off the value of investments linked to the subprime mortgage crisis amidst warnings that its losses could worsen.

And the losses from subprime-related investments continue to mount. Within a year’s time since the subprime crisis whose first signs became evident when HSBC fired head of its US mortgage lending business as losses reached $10.5 bn in February last year the global economy has lost an estimated $400 bn in subprime losses, according to the finance chiefs of the G7 group. The crisis has impacted the who’s who of the financial institutions – from Citigroup to Merrill Lynch in the US to UBS, BNP Paribas, Swiss Re in Europe, from Mitsui Financial Group and Sumitomo Mitsui in Japan to Industrial and Commercial Bank of China to Bank of China.

Even some of the Indian banks have been hit by the crisis although the extent of losses is small as compared to the US and other international banks hit by the crisis. ICICI Bank became the first Indian bank to report a loss of $264 million in subprime-related investments (mark-to-market losses owing to its exposure to credit derivatives and investments) while it is afraid that some public sector banks with international operation might also have exposure to subprime-related investments.

While the subprime market is facing what is perhaps the worst phase in its history, the usefulness of subprime as a viable model, however, still remains relevant to millions of aspirant homeowners who do not have access to cheaper finance. Subprime lending has indeed helped fulfil the dream of home ownership for many consumers in the US. The US financial crisis, therefore, is a major blow to the dreams of tens of thousands of aspiring home buyers.

But the more serious issue is the impending threat in the form of a recession which is the global economy’s staring at in the aftermath of the crisis and amidst fears of spiraling losses in the financial services sector and growing liquidity crunch. The effect of subprime crisis is felt across a wide spectrum of industries, which include hedge funds, banks, investment banks, real estate and mortgage bond insurance among others. Hence for now, the challenge before the central banks across the globe is to prevent any further damage to the financial services sector and hence the global economy.

N Janardhan Rao, Lead Economist

Private Labels in India - An Emerging Trend

Private labels or store brands have been found to trigger customer loyalty. The basic objective behind introducing private labels is to offer quality products at lower prices compared to the national brands.

India is considered one among the top five emerging retail destinations in Asia and 11th promising retail destination globally. This is largely due to the expansion strategies adopted by business groups like the Future Group, the Tatas, the Goenkas and the Rahejas. The ever increasing retail clutter has forced retailers to differentiate themselves—introducing private labels has been one such differentiation strategy. 

Retailers basically go for imitating national brands in terms of quality and packaging. Although there are instances where store brands are successfully introduced, there are several challenges involved as far as introducing and sustaining store brands are concerned. Worldwide experience shows that as retailers become more powerful, they have increasingly focused on their own brands at the expense of manufacturer brands. Another factor driving retailers towards foraying into store brands is the current economic slowdown, globally.
Companies are also stepping up the introduction of private labels as margin on the products can be as high as 30 per cent compared with 10 per cent on branded products. The slowdown is also forcing consumer preference towards cheaper products, a trend also known as down-trading, which in turn is also helping boost sales of private labels. 

Taking on the might of MNCs with its private brands, the Future Group, India’s top retailer, is now poised to pit itself in a big way against the manufacturers like HUL, Bombay Dyeing and Samsung in categories ranging from FMCG to apparels to consumer durables. Some of the Group’s top private labels include John Miller, Indigo Nation, DJ&C in apparel, Tasty Treat, Care Mate, Fresh ’n Pure in FMCG and Koryo and Sensei in consumer durables. Rival Reliance Retail is entering the store brand segment in a major way. Interestingly, Reliance Retail derives around 80% business in the large format stores from private labels, particularly in the garments business. While its private labels in the commodity foods segment are Reliance Value and Reliance Select, it is launching, in a phased manner, private labels in the nonfood FMCG category. It has launched floor cleaning products under the Expelz label and Sudz washing powder recently. 

Others like More of AV Birla Group and Westside of Tatas too are stepping up their presence in this arena. However, retailers face slew of challenges. First and foremost, there is a lack of supply chain sophistication among Indian retailers. Most retailers still exchange information manually with suppliers. Indian retailers are yet to implement bar-coding techniques properly, let alone sophisticated technologies such as radio frequency identification (RFID). There is also a lack of integrated IT systems, coupled with low overall IT spending. 

As is evident, Indian retailers have a long way to go before they can be compared with international retailers such as Tesco and Wal-Mart, in terms of technology and supply chain sophistication. Further, while it is widely acknowledged that the ‘real' potential in Indian retail lies in rural areas, the rural retail scenario continues to be unorganised and highly fragmented. While FMCG manufacturers – such as Hindustan Unilever and ITC – continue their efforts to solve the rural ‘retail jigsaw' through projects such as Shakthi and e-Choupal, major retailers have tended to stay away from the rural scene. 

In light of high access costs due to infrastructure bottlenecks, along with absence of a successful rural retailing model, the above trend is likely to continue in the coming years. Therefore, the Indian private label market is expected to be largely confined to urban areas (metro cities), with some growth also coming from semi-urban areas (tier II towns). Therefore, unless retailers pay attention to these issues, they will be unable to develop successful private label portfolios. 

n India, private labels or in-store brands presently contribute to a turnover of Rs. 700 cr. There are various retail entities that have launched their private labels in the recent past and most of them have been either from the food or from the apparel industry. There are certain definite advantages of store brands. First, through store brands, a retailer assumes greater control over the development process of a product which allows him to gain more control over his business. 

Private label strategy is an effective option for a retailer in case he wants to market high products. Savings in terms of production cost is another critical advantage. There are no competitors in the market for any in-store brand which motivates sales people to sell the product to customers. At the moment, private labels do not have a dominant market share as they account for less than 5 per cent of the retail business and still have a long way to go. But Indian retail is extremely hot and it offers a proposition that can’t be seen anywhere else in the world. Only in China and India can retail chains have as many stores as they have in the US. In no other country can one imagine companies having 5,000-6,000 stores of their own. 

Global Experience
There has been a significant increase in private label brands in the recent years worldwide. In Europe, private label goods now account for about 45% of products sold in supermarkets, compared to 25% in the US. Wal-Mart, for instance, has a 40% private label representation in their stores. Pacific Rim countries, such as Australia, Singapore, and Japan, also have significant presence of private labels on their store shelves. The general feeling is that in times of recession, private labels increase their market share, but tend to maintain that market share as economies recover. All these suggest that the future of private labels is bright in India.

N Janardhan Rao, Lead Economist

Thursday, April 28, 2011

Gold Shines when Everything Falls

Gold shines when everything else falls apart. So goes an old adage. True, the glitter is back. A combination of falling stock markets, unrest in the Middle East, spiking oil prices and a slump in the value of the US dollar, seemed to have added to the sharp rise in gold prices. With the alternative investment opportunities deteriorating, gold enjoys good patronage among masses.

The sharp advance in gold price owes to a number of factors. A weakening US dollar helped boost the metal as it is denominated in US dollars. Therefore, when dollar weakens gold becomes more affordable to countries like India and China, which leads to increased demand for the precious metal and higher gold prices. Market analysts opine that it is poised to rise in a sustained manner in 2011 and the next, and possibly for a longer period.

Although physical off-take was reduced in the industrial sector in the recent past, activity in the investment market took gold prices higher as investors looked forward to mitigate their risk. In some countries such as India there has been very strong purchasing by both the mainstreet (in the form of coins and bars) as well as by the professional investors and speculators. Similar trends can be seen in parts of Europe, the Middle East and North America. The professional investor has been drawn to the gold market for a number of reasons: 

Concerns about the equity markets and lingering doubts about the global recovery; Japan's disaster; and the fact that the dollar, the yen and initially also the euro will all be under pressure. All these have combined to generate a desire on the part of the investors to hold an asset class that would diversify the risk. And, gold has been one of the favored beneficiaries.

The Gold Dynamics

Like any other commodity, gold reacts to the basic demand-supply equation, but tends to be more volatile in situations like war and social unrest. It is an incredible market. It is so cyclical that it is sometimes uncanny. The present rally is no exception. On the demand front, each year, gold is close to 50% higher than mine supply worldwide and it has been this way for many years. This is a long-term chronic problem that is not going away overnight. In short, it is a limited market. There is less than an ounce of gold above the ground per person on the face of the earth and most of this is not available to the market. In a small market, it does not take many new buyers entering the market at one time to push prices to extreme levels very quickly.

Glitters all the Way?

As an era of economic uncertainty extends this year, investors are likely to preserve wealth rather than look for quick returns. Gold has come to be an asset of last resort. In countries like India, the yellow metal continues to be a primary means for savings. There are strong cultural preferences for gold as a store of value and symbol of wealth. Though in the recent decades its ‘safe haven’ image lost ground to the US dollar, the recent weakening of the US dollar and a troubled global environment, investors have been buying gold largely because it is the only alternative for its traditional value.

There were periodic rallies, but for most part of the past five years, gold was traded at prices below $1000 an ounce and today cross $1500 mark. Gold will always have a historic intrinsic value. In case of a global meltdown, people will trade as they did many hundreds of years ago, opines a gold analyst. After years gold has made a strong comeback as a safe investment in times of international tension. “Gold has always been an important check and balance on the way in which a government uses its finances. I cannot gainsay Greenspan, former Federal Reserve Governor, who has referred to it as the ultimate form of money,” says Rhona O’Connell, Market Analyst, World Gold Council, US. 

However, in the present rally for gold, the fear is that the force behind the current investment-driven gold move, attributed to the fear of rising oil prices, has dashed hopes of a global economic recovery. Other worrisome factors are Middle East unrest, continuing European nation’s defaults rocking fragile international banking stability, fear that mines will not be able to extract the required gold to cover their positions, and they thus have to buy gold in the open market.

Historical Perspective 

In general, gold has proved to be an excellent hedge against high inflation. While gold has historically outpaced other investment categories during periods of high inflation, history shows that gold can increase in value in periods of low inflation also. This is exactly what happened from June 1982 to February 1983, when the price of gold increased 74% in just nine months, despite the fact that inflation was moderate. What prompted the price of gold to rise? The answer is weakness in the US dollar. History repeated itself from February 1985 to November 1987 when gold increased in value by 78% in just 21 months, again due to a falling dollar. Finally, from March 1993 through June 1993, the price of gold increased by 24.8% not due to high inflation, but due to currency turmoil in Europe.


If one considers the gold prices from a historical perspective, it is nothing more than a ‘normalizing process’. From January 1982 to January 1998, gold prices usually traded in the range of $300 to $400 an ounce. Since then, gold prices have usually traded in the $250 to $300 range. If history repeats itself, the present trend simply signifies the start of a more normal trading range where gold prices are locked into a range of $300-350. Says, Rhona O’Connell “There is undoubtedly a ‘war premium’ in the gold price at present. This is partly because the dollar is under some pressure for economic reasons and partly because of the high degree of uncertainty whether there will be a war and how drawn out and/or effective it will be. Financial markets dislike uncertainty above all else and this is one of the features that is keeping gold prices high.” 

However, Dr. Stephen G Cecchetti, Professor of Economics, Ohio State University, US, disagrees that gold prices are doing well in a climate of war and uncertainty because of the absence of other investment avenues, thereby helping gold to retain its glory. He opines, “I am secure in my belief that gold is a poor investment in the 21st century. Analysts who believe otherwise are not analyzing the available alternatives properly; forces that are completely unrelated to economic fundamentals drive the gold market, he further adds. In contrast, David Wyss, chief economist, Standard & Poor’s, US, feels, “The absence of good alternative investments is clearly a factor. That is reflected in the low holding cost currently. 

With the fed funds rate at 1.25% and Japanese deposit rates at zero, there is little cost to holding gold. The social unrest adds another purpose. Still, flight capital is increasingly going into money markets, since they can be spent more quickly than gold coins. The weak stock market is helping to push gold higher, since stocks are clearly not a safe alternative for preservation of wealth.”

Whatever the reasons are, most gold analysts are of the view that the driving forces behind the present moves will continue to push prices higher in the coming days.  

Gold – A Pillar of Stability?

In general, gold has assumed a pillar of stability in good times as well as bad. Defensively, it has a natural stabilizer. However, Dr. Stephen G Cecchetti disagrees with the above premise. He articulates, “The world economy has exhibited remarkable stability in the face of the shocks it has withstood. And, while the financial systems of some countries have experienced instability, this is largely a consequence of poor regulation and poor government policy. Gold has nothing to do with this. Gold has more to do with theology than with economics and finance. It is mystical.”

In short gold is tangible, portable and anonymous. “Gold jewelry, in much of the world, is seen as a store of value as well as an adornment. In addition, gold in the international market is denominated in US dollars, although obviously in individual countries it is traded in the local currency. As a consequence of these and other features, gold has very little correlation with other asset classes. It has, also, in the main, a much lower volatility than other assets, and because it has ‘adornment’ and some industrial uses also it means that demand for gold can be a function of economic growth in the same way that it is for other metals,” observes Rhona O’Connell. Consequently, if economies are slowing and it means that ‘professional’ investors start looking at gold as a hedge against a downturn in the equity markets, so some day-to-day purchasers of gold for jewelry or electronics may have withdrawn from the market, he further adds. This is one of the factors, which gives it, in general, as lower volatility than many other asset classes.

However, David Wyss is of the view that calling gold a pillar of stability is a bit strange. When and if the economies improve, interest rates rise, and the war fears calm, gold prices will fall back. Until then, gold is expected to remain strong. 

To conclude, there is no doubt that the ongoing unrest in the Middle East, feeble US economic recovery, sovereign debt problems in the peripheral European nations have prompted investors to anticipate a further increase in the international prices of gold. 

N Janardhan Rao, Lead Economist

Mobile Virtual Network Operator Industry

MVNOs are a way to implement a more specific marketing mix, whether alone or with partners and they can help attack specific, targeted segments.

 According to Wikipedia, an MVNO (Mobile Virtual Network Operator) is a company that provides mobile phone service but does not have its own licensed frequency allocation of radio spectrum, nor does it necessarily have the entire infrastructure required to provide mobile telephone service. An MNO that does not have a frequency spectrum allocation in a particular geographical region may operate as an MVNO in that region. MVNOs can operate using any of the mobile technologies MNOs use, such as Code Division Multiple Access (CDMA), GSM and the Universal Mobile Telecommunications System (UMTS).

The first commercially successful MVNO was Virgin Mobile launched in the United Kingdom in 1999 and now has over 4 million customers in the UK. Its success was replicated in the US. There are currently approximately 360 planned or operational MVNOs world-wide, according to consultancy firm Takashi Mobile.

Countries including Algeria, The Netherlands, France, Denmark, United Kingdom, Finland, Belgium, Australia and United States have the most MVNOs. In these countries the MVNO marketplace is stabilizing and there are some well-known MVNO successes. Other countries, such as Portugal, Spain, Italy, India, Chile and Austria are just beginning to launch MVNO business models. According to Wikipedia, there are three primary motivations for mobile operators to allow MVNOs on their networks. These are generally: Segmentation-driven strategies – mobile operators often find it difficult to succeed in all customer segments.

MVNOs are a way to implement a more specific marketing mix, whether alone or with partners and they can help attack specific, targeted segments. Network utilization-driven strategies – Many mobile operators have capacity, product and segment needs – especially in new areas like 3G. An MVNO strategy can generate economies of scale for better network utilization. Product-driven strategies – MVNOs can help mobile operators target customers with specialized service requirements and get to customer niches that mobile operators cannot get to.

MVNO models mean lower operational costs for mobile operators (billing, sales, customer service, marketing), help fight churn, grow average revenue per user by providing new applications and tariff plans and also can help with difficult issues like how to deal with fixed-mobile convergence by allowing MVNOs to try out more experimental projects and applications. The opportunity for mobile operators to take advantage of MVNOs generally outweighs the competitive threat. 

There are profitable MVNO operations, from Virgin Mobile and Tesco Mobile in the UK to TracFone in the US. Moreover, interest in becoming an MVNO has not faded away by any means; the list of the companies exploring the MVNO opportunity continues to include big names from a range of markets. Europe has led the way over the past half-decade or so when it comes to MVNOs, but the marketplace in the United States is now surging as well.

From retailers to communications operators to gasoline companies, many different kinds of enterprises with strong brand recognition are testing the virtual waters. Experiences of MVNOs to date have underscored two things in particular. First, a virtual wireless venture can turn a healthy profit when planned, launched and operated effectively. Second, however, the downside risks of the MVNO marketplace are very real, and some companies may be underestimating the scope of the effort. Recent news about MVNOs has not been encouraging.

Failure of two high-profile MVNOs - Mobile ESPN and Amp’d Mobile in the US as well as easyMobile, Ten Mobile, and scores of others in Europe have raised some fresh questions about the viability of the MVNO business model, a report by Pyramid Research titled, “Rethinking MVNO and MVNE Economics: The Future of Mobile Virtual Models,” suggests. However, according to it, the model is not yet bust. And these challenges can be overcome, but success involves skills, resources and operational systems that are not necessarily within the core competencies of some of the players getting into the virtual wireless game. 

The fact that more and more companies are looking to explore this market that suggests that interest in becoming an MVNO has not faded away.

N Janardhan Rao, Lead Economist

Consumer Electronics Industry - Ushering in the digital era

Global integration is a key way to achieve the business model innovation that is needed to survive in the electronics industry.

The consumer electronics (CE) industry will reach a new industry peak in 2011, with revenues exceeding $186 billion, according to the semi-annual industry forecast released today by the Consumer Electronics Association (CEA). Industry revenues also had a stronger than anticipated 2010, growing 6%. According to the CEA report titled Worldwide Consumer Electronics Sales & Forecast, consumers around the world continue to embrace technology to improve their lives.

Countries with fast growing economies and large emerging middle classes, such as the BRIC countries (Brazil, Russia, India and China), will lead the way in new CE revenue growth. By 2009, China will account for nearly 15 percent of global CE revenue, trailing only North America (22 percent share) and Western Europe (16 percent share). However, the industry players are facing a slew of emerging challenges.

A major one is that of the recognition that industry leadership—even survival—is determined not only by how companies innovate but also by what they choose to change. Product and service innovation remains a high priority, but relentless competition, intense margin pressure, greater operational complexity and changing sales channels are prompting electronics firms to look at other areas of innovation—such as their global business models. 

Global integration is a key way to achieve the business model innovation that is needed to survive in the electronics industry. It means actively managing different operations, expertise and capabilities to open the enterprise up—focusing outward to connect more tightly with partners, suppliers and customers. Moving beyond the multinational Often seen as a primary agent of globalization, the multi-national corporation is taking on a new form. Until recently, the multinational typically operated as a collection of country-based subsidiaries, business units or product lines. Over the past decade, however, shared business practices have spread, along with shared modes of connecting business activity. Multinationals are handing over to outside specialists more and more of the work they had previously performed in-house.

Despite undergoing major upheaval, the consumer electronics market achieved impressive growth in recent years due to strong shipments of products including Digital Televisions such as HDTV (High Definition TVs), LCDs, Plasma TVs, MP3 players, DVD recorders and digital still cameras. However, the biggest factor driving the phenomenal growth has been the convergence.

The consumer electronics market consists of the total revenues generated through the sale of audio, video, and games console products designed primarily for domestic use. The digitalization of consumer electronics, has led to the convergence of technologies between previously distinct market segments. The market generated total revenues of $162.9 billion in 2005, representing a compound annual growth rate (CAGR) of 6.2% for the five-year period spanning 2001-2005. According to reports from global research firms, isuppli and GfK Group, we are in the midst of a very exciting growth phase for consumer electronic (CE) products.

New digital technologies are now reaching consumers through an array of products for the home, car, and personal (portable) applications. Also, there is a strong growth trend for consumer audio-visual-communications (AVC) equipment including flat TV–both plasma and LCD–digital TV, and DVD recorder (DVR) products. Emerging economies like India and China and other parts of the Asia-pacific region are increasing competition for the design and manufacture of low-cost consumer electronic products.

In the recent past events like the Common Wealth Games 2010 to be held in New Delhi, FIFA World Cup 2010 in South Africa and World Cup Cricket 2011 in India are fuelled  the adoption of HDTVs including LCD and Plasma TVs and other electronics gizmos like digital cameras and camcorders. Another interesting trend that has clearly emerged and augmenting the growth of the industry is – convergence. Today consumer electronics products and PC technology are converging. This should aid economies of scale within the design process in terms of design reuse and familiarity.

N Janardhan Rao, Lead Economist

Bank-bailouts: Global Experiences

The greater the size of the bank, the greater the impact since larger values and more number of people get affected. In the limit, the risk of failure of large banks becomes systematic risk which everyone has to share.

Banks are interconnected, with large ones having their tentacles in every piece of the economy, real or financial. Not only are they lenders to every sector in the economy, but also financial intermediaries. This means they transform one type of security into another which atomistic investors like us hold as a financial asset. Thus, when banks fail two things happen. People credit lines go dry and the value of the financial assets we hold plummets.

The greater the size of the bank, the greater the impact since larger values and more number of people get affected. In the limit, the risk of failure of large banks becomes systematic risk which everyone has to share. This rationale for bailing out banks is labeled the “too big to fail” argument. Thus when banks become so big that the entire financial system gets threatened by their collapse, we as tax payers have to bear our share of the cost, i.e., the systematic risk.

The rush on part of governments to “bail” banks out after a spate of recent bank failures in Europe and North America (especially the US) makes one wonder what happened to these model societies of capitalism. USA was mockingly referred to as United Socialist Republic of America when the US Treasury Secretary Paulson first proposed the bailout plan for banks on September 20, 2008.

The irony is not lost since “markets-know-best” proponents of capitalism in the west not only permit efficient firms to keep the entire surplus but also conclude (unanimously) - let the inefficient firms fail. The intention is that tax-payers should not have to bear a cost to save them. Then why not let banks fail? It is not just the US which has resorted to bailing out banks. Europe, as a whole, had decided to inject its banks with over $2 trillion by middle of October 2008. On the other hand, China announced in November of 2008 a $586 bn fiscal stimulus package, though not a bank bailout. 

Although the financial system needs such treatment, long-term state ownership of the banking system is an unattractive prospect. Academics have found a wealth of evidence that state-controlled banks can become politicised and misallocate capital. Paola Sapienza, of Northwestern University, found that Italian state-owned banks directed cheap credit to companies in regions which voted for their political patrons. 

A decade after Japan’s financial crash, up to a third of firms were “zombies” kept alive through uncommercial lending by banks under government pressure. From Italy to Japan to China there is a host of evidence that state-controlled banks come under pressure to direct loans to favored constituencies and to keep uncompetitive companies alive with subsidized credit.

N Janardhan Rao, Lead Economist