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Agenda

European Sovereign Crisis

The Chinese Landing Hard or Soft?

Relative outperformance of Asian economies

Operation Twist US Subprime Crisis

Currency Markets Yen & CHF Appreciation

Commodities

8/11/2011 2Beta Series on Finance


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Reaction to Sovereign risk gained credencewith Dubai World- An investment companymanaging the portfolio for the Dubai Govt

Efforts to tide over the crisis has beenreactionary at best Markets havehistorically lead in pre-determining the

culprits before the ECB



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Currency union enabled low borrowing rates acrosscountries

Maastricht treaty Countries pledged to keep

spending in check Greece & other countries through derivatives were

able to mask their deficits

A squeeze in credit, coupled with a fall in asset prices

accelerated the recession in these countries Market focus on PIIGS France too has entered the

fray



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European Sovereign Crisis -Greece

Main economic drivers: Tourism& Shipping

Highly cyclical both declinedduring recession (18%unemployment)

High level of public spending

External Debt/GDP : 182%

GDP ~ $320bn

Political turmoil has increaseduncertainty New unity govtpost referendum drama



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European Sovereign Crisis -Spain

Economic drivers: Real Estate(20% of GDP), Tourism (12%)

Low industrial production growth& high levels of leverage

Unemployment rate ~ 20%

Lack of labor reforms such ascollective bargaining by unions,high severance pay etc

External Debt ~ 180%, GDP: $1.37trillion

Political uncertainty due to harshausterity measures



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Issues

Single Monetary Union vs Different Fiscal Unions

Y = C + I + G + NX

In the euro zone, Governments find it hard to increase NX(depreciating currency) or G (austerity measures!), I

(dependent on interest rate set by the ECB), C (dependent oninterest rates as well)

Labor Mobility

One will not see the unemployed from Spain making a run for

Germany Transfer mechanisms

Bailout Mechanisms restricted to a block of power outside yournation



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EFSF (European FinancialStability Facility)

A fund created by 17 Euro member states in 2010

EFSF essentially raises debts in the capital markets to help distressedcountries

Member states guarantee up to EUR 780 billion of this debt; EuropeanCommission funds another EUR 60 bn; IMF another EUR 250 bn

EFSF mandated to lend to countries in financial difficulties

EFSF can also finance recapitalization of banks through loans to govts.

Recent capital raises

Issued EUR 3 billion bonds yesterday to help Ireland

Issued EUR 3 bn bonds in June to aid Portugal

ESM (European Stability Mechanism)

This is a permanent funding program to succeed the temporary EFSF



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Chinese Economy Growth VsInflation

Inflation 6.1%, mainly due to food inflation of 13.4%

Chinas central bank has raised interest rates fives times since October, 2010; reserve

requirement have been increased 9 times (currently at 21.5%)

A devalued currency has typically a role to play in inflation

PBOC is allowing Yuan to appreciate with respect to dollar

Inflation data of China should be taken with a pinch of salt



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Chinese Economy RealEstate

8/11/2011 Beta Series on Finance 14

Activities linked to Real Estate account for ~25% ofthe total GDP of China

Government is determined to control the priceincrease in Real Estate price

Steps such as high interest on mortgage payments,other credit controls has been taken

S&P has turned its outlook on Chinese Economy ondownturn

Banks in China & Hong Kong have huge exposuresto the Real Estate in China

Question is whether it will be soft or hard landing ?

Real Estate prices in China are finally stabilizing or is the cycleabout to turn ?

Real Estate Price Index in China


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Chinese Economy Issues?


Any economy has to make a trade-off between inflation and growth

Phillips curve Unemployment Vs Inflation

Chinas growth is export oriented low cost base

Increasing inflation has an impact on the cost structure

Increasing cost structure hurts export competitiveness

Currency devaluation helps in increasing competitiveness in globalmarkets

Currency devaluation has implications for inflation

Countries such as US are coming harder on currency controls

Proposed currency Bill in US

Maintaining Competitive Edge while stimulating growth


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China Other points to notice

Pushing for Yuan as an internationalcurrency

Role in Euro zone

Interested in buying debt

Looking for a market



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Relative outperformance ofAsian economies


Reasons for Asias outperformance:

Reducing public debt levels

Strengthening currency reserves

Applying discipline to fiscal deficits

Government packages for strengthening infrastructure etc.

Future outlook:

Greater uncertainty implies that Asian central banks are likely to pause

monetary tightening

Capital flows could re-emerge as a policy challenge for some Asian central

banks, especially if they are reluctant to allow their currencies to appreciateon a trade-weighted basis

Continuing search for yield by global investors will attract them to invest in

Asian markets


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What is Operation Twist?

US Fed targets inflation as well as unemployment

Ten year Treasuries as low as 1.95% but Unemployment 9%, Inflation 2% (but inflationary pressures rising - CPI)

Sell medium term bonds ($400B) due in the next fewyears and buy 6-10y chiefly10y Treasuries (long term)

Major interest rates (e.g. Mortgage rates, corporate bonds,long term bank loans) tied to the 10y Treasury rate

Tried once before in 60s pushed down rates by 0.15%and mortgage rates by even less so it really effective?

Also, treasury issuing long term securities at an evenfaster rate. So supply matching demand.



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Monetary easing (QE) withtreasury curve steepening


10y @1.95%

Source US Treasury website


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Effects of Operation Twist

BUT - 30 yr yields fell by 17bp on announcement and2s/10s curve flattened sharply, correcting to10bp flatter

May have been caused due to other effects weakeningEuropean economy, cut in IMF world growth forecast

from 4.5%-4% (risk off sentiment)

Support in favor of above equities/commodities fell(should have risen on announcement of a new stimulus)

Fed is not printing money to fuel the risk appetite to buy

risky assets and fund carry trades so no fall in dollar

Dollar rose against major currencies (risk off sentiment,higher short term yields attracting short term investors)



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Risk off sentiment takes hold



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Risk off sentiment takes hole



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Effects of Operation Twist

Fed running out of options liquidity trap. Fiscal policy outof Feds control high deficits, no stimulus

Flatter yield curve reduces incentives for banks to lend fall in Net Interest Margins Bank stocks tanked

Argument in support of Operation Twist MonetaryDisequilibrium theory easing demand for money

But yield rise on T-bills is capped by banks arbitragingbetween excess reserves and T-bills

Expectations - Should Fed commit to a nominal income andprice level target?

Investment alternatives Treasuries? Gold? Stock?



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Where to invest?


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The Subprime Credit Crisis

The business of banking

Anatomy of a bank run Panic: People think bank assets are falling in

value; they panic and start withdrawing money In other words the short term financing is notrenewed

Fire sales: Bank sells assets to repay depositors

Assets fall in value because of massive sales


Short Term Liabilities

(Deposits) BankLong Term Assets

(Loans, mortgages)

Vicious cycle

appears A bank run: From the movie Its a wonderful life


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In response, U.S. govt. introduced deposit insurance in 1934 which finallyended such bank runs

A new form of depository banking emerged the repo market

And this market is not insured!

So who are these new depositors? Institutional investors like pension funds and non-financial companies like Coke also

need to have some accounts where they can park money

But deposit insurance is limited and does not cover these huge amounts

So they go to the Repo market!

Example: Fidelity has $ 500 million which it wants to keep in a safe placefor a short duration say overnight


Fidelity Bear Stearns$ 500 mm

$ 500 mm collateral

Next morning, Bear repays $ 500

mm in exchange for collateral


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How does Bear Stearns earn income? The asset which it gives as collateral earns a higher interest than the interest it gives to

Fidelity on the $ 500 mm loan

So what happened in the crisis?

Investors like Fidelity want safe collateral, but Treasuries and AAA corporate bonds

were not sufficient for this collateral demand in comes Asset Backed Securities

The 21stcentury bank run

Around Aug 2007, when subprime bonds started deteriorating, the new depositorspanicked

Bear Stearns starts selling assets asset prices fall across all categories

Such prices are due to forced sales (called fire sales) and do not reflect fundamentals



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AAA corporate bond spreads wentabove those of AA corporate bonds!!

Most relevant points

Subprime by itself was $ 1.2 trillion (whichis not large enough compared to size of the

shadow banking system which is $ 20 tn) All asset classes (e.g. student loans, auto

loans) were not fundamentally bad it isforced sales which led to all assets tanking



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Currency Markets YenAppreciation

8/11/2011

Swiss bank intervention

Earthquake

BoJ Intervenes

31Beta Series on Finance


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Currency Markets - YenAppreciation

Yen recently recorded post World War-II highof 75.31 against US$ (83 at start of 2011)

This is hurting Japans exporters as

appreciating Yen makes their goods expensiveto foreign buyers

What is driving the Yen up? Two theories to

explain this.



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First theory: Repatriation of foreign assets

March earthquake caused destruction of life andproperty and therefore insurance claims

Insurance companies sold assets held abroad tobring proceeds to Japan for repaying claims

People who were devastated sold their foreignassets as well

Did these inflows caused the Yen to rise?

Market doesnt think so inflows were notsignificant & secondly



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Second theory: Negative real yields in U.S.

The real interest rates in the U.S. have gonenegative!

The Japanese real rates though low are still positiveWith Yen & US $ being the safe haven currencies

investors flock to them at the sight of distresssignals in global economy

With Yen now offering higher real yields, it is thepreferred choice



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Yen Appreciation

View Short-term: Likely to strengthen given the positive real rates

Risk in short-term posed by the Bank of Japan intervening toget the Yen to depreciate

Medium term: Likely to weaken as the U.S. economy recoversand the real interest rates rise



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Currency Markets CHFAppreciation

8/11/2011

Swiss bank intervention

36Beta Series on Finance


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Commodity Market Overview


Types of commodities Oil and Energy

Agri-Based

Metals

Usage Metals

Precious Metals

Gold!!!

What are the commodity based economies

Australia China

Canada/New Zealand


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Commodity Market Linkages


Commodity Market drivers Real world Demand Supply

Inflation and Price rises in other commodities

Currency Linked moves: Especially Oil and Gold Behavior common to all commodities

Tendency to high volatility

Highest Cyclicity among other commodities

Peculiarities of recent moves Extremely high volatility

Gold as single global currency


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Commodity Markets:Gold


The history: Traditional measure of value

Gold Valuation: Demand supply for use is small percent of total trade

Links to tulips story: Is there anything intrinsic?

Foreign Exchange reserves Asian economy demands very high

Inflation Hedge Tendency to high volatility

Trends: Rise and recent correction


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Exchange reserves and Goldreserves


Gold's share

Rank Country Gold of national

tonnes forex reserves(%)

1 USA 8,133.50 74.70%

2 Germany 3,401.00 71.70%

3 Italy 2,451.80 71.40%

4 France 2,435.40 66.10%

5 China 1,054.10 1.70%

6 Switzerland 1,040.10 16.40%

7 Qatar 950.3 7.10%

8 Russia 775.2 6.70%

9 Japan 765.2 3.00%

10 Netherlands 615.5 59.40%

11 India 614.8 8.10%

Rank Country Reserves

1 People's Republic of China 31,97,000

2 Japan 11,37,809

2 Eurosystem 8,86,355

4 Russia 5,16,800

5 Saudi Arabia 4,56,200

6 Republic of China (Taiwan) 4,00,770

7 Brazil 3,50,000

8 India 3,11,516

9 Republic of Korea 3,05,084

10 Switzerland 2,88,590


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Gold as currency backing



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Gold Price trends



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Thanks & All The Best!

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