Yesterday's announcement from the Federal Reserve had the following key observations:

1.       The Fed described the recovery to be a “more modest” recovery.

2.       The Fed will stop shrinking its balance sheet by reinvesting the proceeds of the maturing mortgages into US Treasuries. (This is in contrast to its earlier stance of shedding the mortgage backed securities and reducing its balance sheet’s size from the current $2tn level by $10-20bn a month. Back in March, the purchases of MBS securities and treasury debt were discontinued.)

3.       High unemployment, modest income growth, lower housing wealth and tight credit were holding back household spending

Now, since the Fed has agreed to maintain its balance sheet levels by reinvesting the proceeds of maturing mortgage debt into treasury debt ranging from 2 year to 10 years, there are a couple of trade implications I’d like to share:

1.       Tax-credit to home buyers has been discontinued since April this year. And the home sales data releases ever since, have seen significant weakness, what with significant inventory holding up. With Fed looking to prop up the economy, the reinstatement of tax-credit benefits to first time home buyers seems to be a foregone conclusion. On the back of this, XHB, the ETF which tracks homebuilders in the U.S, looks attractive. Of late, given the weak home sales data releases, XHB has taken a whack and has been on a downslide since April end, and has plummeted ~23.5% since. (Until April, the etf had rallied 30%YTD.) If the revival in tax-credit benefits comes into being, XHB should find itself rallying once again.

2.       Given the Fed’s insistence on maintaining low interest rates and a likelihood of UST rates falling further, a leveraged play on an ETF like IEF (7-10 year Treasury bond fund) looks to be a good buy.

Sometime back we created this historical chart depicting oil price and Kuwait stock index since 1994. Last time when we checked this in 2008, the relationship showed a historical correlation of more than 90%. A plain look at the chart would also make one feel that they are not two different lines. (see chart)

 
However what caught our attention is the recent divergence between oil price and KSE Index.  While the long-term correlation (since 1994) stands at 93%, the last five years correlation is placed at 75%. A simple linear regression model (with oil price as independent variable) based on last five year’s data suggests the following:

In other words, the current index (at 7562) is at a discount of nearly 45% given the current oil price of USD80. Alternatively, the current index factors an oil price of only USD40 as against the current oil price of USD80.

Has something happened to Kuwait market that the strong relationship with oil price is slowly breaking away? Or does this spell a classic market opportunity? If the former is true, then the index will never close the 30% gap. If the latter is true, a USD100 oil price would mean an index level of 12,729 (68% higher from the current level). If the current index factors an oil price of only USD40, the downside risk appears minimal. However, if the 30% gap reflects fundamental structural weakness created by the financial crisis, then we may need more and more oil price to see the index make further moves.

In the past a strong and increasing oil price directly resulted in increased liquidity in the banking system passing finally on to end investors in the form of loans/credit. This meant money available for speculation and trading. However, in the current scheme of things a strong oil price will still create liquidity but may not create the same “pass through” effect given the fact that banks have turned more risk averse. It may also be worth noting that there are more negative catalysts than positive ones such as the corporate issues (Agility, Investment Dar, Global, Zain etc) in addition to the regulatory/political climate which have negative implications on investor sentiment. Also, lack of transparency is an issue raising negative investor sentiment. The market always had weak transparency but investors tend to care about it less in “good times” and given that the last couple of years have been bad, lack of transparency has been more of a negative catalyst than usual Hence, in our assessment, the discount is here to stay though the extent (30%) can be debated. So pray for more oil price.

Or will economic recovery in the US and a strengthening Dollar lead to Gold falling out of favor with investors?

Gold has traditionally been used as a hedging device against a weakening US Dollar, low interest rates and inflationary fears. These conditions prevailed in 2009, leading Gold to reach a record high of USD1,227.50. Additionally, the Reserve Bank of India announced a purchase of 200 ton of Bullion from the IMF, a symbol to the lack of confidence in the greenback. Gold, which typically moves inversely to the dollar, rose 24% last year as the dollar fell 4.2%. Analysts predict that the price may reach another all-time high this year. Analysts surveyed by the London Bullion Market Association said that in 2010, gold will average USD1,199, up 23% from last year, according to the average forecast in a survey of 26 traders and analysts.

As global economic and market conditions continued to be murky and unstable, Gold saw a spectacular rise in popularity, gaining 10% in November alone to close out the year with a 24% annual gain versus 6% for 2008. According to Mr. Raghu Mandagolathur, Head of Research, the sharp rise in gold indicates the cloudy global status in terms of pulling out of recession. In spite of huge fiscal and monetary stimuli being enacted so far, the world is still a place with significant imbalances. Such scenarios lead to a favoring of Gold and other commodities as stores of value or “safe havens” which leads to a direct increase in demand. “The demand side factor is further compounded by aggressive buying by some central banks (e.g. India). On the other hand, supply is constrained. It is estimated that new supply will significantly reduce from 2010 onwards. Recycling from scrap as well as government sales are expected to be muted thus constraining supply further. Strong demand and weak supply is further helped by low interest rates, which are a plus for any commodity investment.” (Mr. Raghu Mandagolathur)

However, gold is not an asset class. Prices will tend to come back the moment there is clarity on the global economy. Till then the gold price may sway due to intense speculation. (Mr. Raghu Mandagolathur) Gold is likely to see another year of gains in 2010, but not as “spectacular” as 2009, according to Mr. Roshan Chutkey, who tracks international markets. He cites “considerable uncertainty surrounding USD movement for the year” in addition to a “general consensus that the greenback is in for a long-term depreciation” as propellers of Gold prices gains in the coming year. “Gold has averaged USD950 for 2009 with the current prices hovering around USD1,150; I expect gold to swing between USD1000 and USD1300 for 2010.” (Mr. Raghu Mandagolathur)

-       Compiled and edited by Ms. Layla Al-Ammar, Investment Analyst, Research

The Markaz Analysts Club is an initiative launched by Markaz with an aim to collate the many varied and diverse viewpoints of Markaz analysts in an informal setting in order to share with the public the depth and breadth of analyst knowledge power within Markaz. On a periodical basis, a question concerning the topic/s of the day is posed to our analysts spanning various departments within Markaz (from Real Estate to Oil & Gas to Corporate Finance etc); these analysts’ responses are then compiled into a brief opinion piece for public viewing.

Will GCC markets recover during 2010?
GCC stock markets have terribly underperformed other markets, both Emerging and Developed, during 2009. The overall MSCI GCC Index gained just 18% against 73% for Emerging markets and 27% for MSCI World. This depressed market activity comes in spite of decent crude oil prices (IPE Brent is up 85% for the year), low inflation (down to 2.5% in 2009 from 11% in 2008) in addition to fairly comfortable fiscal surpluses across the major economies.

The question then is; given such underperformance, do GCC markets present a good opportunity for 2010? And are we likely to see a recovery in market performance in 2010?

Mr. Ramadoss Venkateshwaran, who specializes in the Real Estate segment, pointed out that the question itself “tempts one to conclude that an upswing rally is due for GCC markets, especially when the region is slowly coming out of internal crises which emerged as a by-product of the global crisis and slowdown.” He notes that what distinguishes frontier markets such as the GCC is in the realm of systemic risks, pointing to events such as Gulf Bank, Saad & Algosaibi and Dubai World as a hallmark for such risks. “Although incidents of such systemic risk events increase during a downturn in all markets, like Lehman Brothers, the lag between the end of a downturn and the end of such incidences is bigger in frontier markets.” He goes on to point out that in the developed world; these events tend to act as precursors to a trough or bottoming out “as the number of such incidences recedes”. However, in frontier markets such as the GCC, such events followed the period in which the IMF and other such agencies had forecasted economic recovery. Consequently, such “risk perceptions have kept prices from rising and I believe that, if the global economy manages to avoid a double dip, as expected by the central consensus forecasts, GCC markets would pose a good upside from current levels as risk perception wanes.” (Mr. Ramadoss Venkateshwaran)

Moving from systemic risks in GCC economies to corporate earnings strength, Mr. Amrith Mukkamala (Senior Analyst, Research) notes that 2010 earnings “are not expected to be significantly robust. We are looking at +6 to +8% growth in earnings at a GCC level. The only country which is expected to witness a significant growth in earnings is Kuwait.” Furthermore, given the outflow of foreign money, he expects external liquidity to be neutral. Mr. Raghu Mandagolathur, S.V.P. for Research, notes that “even during good days, market performance can mostly be attributed to local liquidity and speculation rather than foreign investor interest. Foreign investors still view the GCC as a frontier market with serious limitations including lack of corporate governance, information and research. A good run on oil price may bring back some hedge funds that are keen on quick money but it will take fundamental changes at a market microstructure level to get the attention of quality institutional investors.” Moreover, internal liquidity is expected to be tight with negative investor sentiment due to “low corporate disclosures and comparatively poor corporate governance standards. Thus, in absolute terms I would expect a 15-20% return on MSCI GCC in 2010. This would mean a relative underperformance as compared to the other emerging markets. (Mr. Amrith Mukkamala)” Mr. Pradeep Rajagopalan suggests that rather than viewing the GCC markets as a whole, he would view it as a “barbell with some companies doing very well and some companies posting steep declines”, given that in many markets, it is a select number of companies which drive overall market performance, it would be more prudent for investors to take specific calls on undervalued firms, irrespective of country.

Nearly all analysts noted healthy crude oil prices as a driver for growth in 2010, with an expectation that crude oil prices will remain in the USD 60-80 range, however, Mr. Amrith Mukkamala, points out that the impact of such a range would be neutral for markets. Mr. Raghu Mandagolathur, agrees, noting that “the issue no longer rests with just oil price” and that the GCC is paying a high price for turning a blind eye to “much needed reforms in virtually every aspect of market functioning.” The current financial crisis has thoroughly exposed the gaps and weak spots throughout the GCC. He notes that “lack of CMA, corporate governance failures, family group defaults, banking failures, real estate meltdown, project cancellations, etc loom so large that a mere normal oil price scenario is just not enough to lift spirits.” Strong crude oil prices will undoubtedly strengthen government coffers; however, “successfully transmitting them down the line will need enormous straightening up on many fronts.”

In closing, our analysts believe that recovery will likely be patchy in 2010, Mr. Roshan Chutkey, who tracks international markets, believes that asset managers ought to lower allocation to the GCC in 2010 in favor of other emerging economies, noting that the GCC may provide some 2011 stories, but that he expects the region to be a laggard in 2010 as well. Mr. Raghu Mandagolathur points out that “the reasons why GCC markets underperformed emerging markets in 2009 will still be in force during 2010. Unless oil breaks out to frenzy levels (say above USD150/b), the GCC markets may deliver yet another year of normal returns (defined as anything between 10% to 20%).”

-  Compiled and edited by Ms. Layla Al-Ammar, Investment Analyst, Research

The Markaz Analysts Club is an initiative launched by Markaz with an aim to collate the many varied and diverse viewpoints of Markaz analysts in an informal setting in order to share with the public the depth and breadth of analyst knowledge power within Markaz. On a periodical basis, a question concerning the topic/s of the day is posed to our analysts spanning various departments within Markaz (from Real Estate to Oil & Gas to Corporate Finance etc); these analysts’ responses are then compiled into a brief opinion piece for public viewing.

Or do recent events spell the beginning of a long road of decline for the emirate?

Recent events in Dubai not only threw regional and global markets into an, admittedly brief, period of turmoil, but they also raised very justifiable concerns regarding Dubai’s ability to maintain its growth trajectory in addition to furthering its ambitions to be the region’s hub of .. well, everything. Dubai dominated the news in late November with a possible default of Nakheel’s USD 3.5 bn Sukuk, in addition to the danger of this event triggering further defaults within its parent company, Dubai World, which sought a 6 month standstill on debt repayments. Abu Dhabi threw its maverick cousin a last minute USD10 bn lifeline, USD4.1 bn of which was to cover the Nakheel Sukuk, while the remainder was to cover Dubai World costs as it engages creditors in debt restructuring talks. Analysts around the world quite accurately predicted that Abu Dhabi would not let Nakheel default on the Sukuk; however, this did turn analyst’s attention to the debt restructuring of Dubai World which amounts to over USD 25 bn. Given the complexity of Dubai World’s structure, this process is expected to take a fair bit of time to complete.     

On the question of whether Dubai will be able to redeem its pride as a tourism and financial hub of the GCC, Markaz analysts, by and large, have no doubt that the emirate will be able to recoup its position as the GCC hub, the question then becomes not one of “will it happen?”, but “when will it happen?”

Given that the emirate has spent the better part of the last decade aggressively building the infrastructure and regulatory environment needed to transform itself, far outpacing any other country in the gulf, it will remain, at the very least, the GCC’s tourism hub given that “there are no other alternatives so far and it will take a long time and lots of money for anybody else to build the requisite infrastructure” (Mr. Rajiv Bishnoi, Asst. VP, Oil & Gas). On the financial side, “Bahrain, Kuwait and Qatar have laid out their ambitions to become the regional financial centre as well, however, they lag behind Dubai considerably in terms of developing the necessary physical and regulatory infrastructure” (Mr. Ramadoss Venkateshwaran, Senior Research Analyst, Real Estate).

According to Mr. Venkateshwaran, the recent debt woes facing the emirate are “a hiccup in its growth path” and may provide opportunities “for others to advance and catch up.” Mr. Bishnoi posits that while it “may take a while – 5-10 years - for Dubai to regain its reputation as a financial hub. Bahrain and Qatar could now make a move to claim the sweet spot of GCC’s Markaz Al-Mali.”  

Dubai’s infrastructure was brought up by nearly all analysts; there is the perception that Dubai has spent the decade “spinning gold from sand” with “no fundamental economic bases” (Mr. George Kunnumpurathu, Senior Analyst, Corporate Finance), and while it is certainly true that Dubai has no natural resources (read: oil) to fall back on, it does have a resource-rich, more fiscally conservative cousin who has repeatedly stressed that the UAE is one family, thus implying its continued support of the emirate. Mr. Venkateshwaran notes that this restructuring could provide Dubai with an opportunity to plug the gaps in its existing regulatory framework, an example of which are concerns that have been raised regarding the inadequacy of the current insolvency system in the emirate. Mr. Raghu Mandagolathur, Senior Vice President for Research notes that while “Dubai’s ambition to become a financial hub is certainly dented with the current events. Observers could easily see that Dubai was missing the market microstructure that is needed to become a financial hub like London or New York. Given the scale of problems currently on hand, Dubai will definitely be busy putting its house in order for the next couple of years before embarking on ambitious projects.”

Dubai’s ambitions have been blatantly transparent in the last decade; some might argue that this has neared a point of vulgarity in recent years with Dubai’s obsession with having the “largest”, “tallest”, and, in most cases, “most expensive” projects in the region. While many of these have been admirable, such as the Dubai metro and the various “cities” that the emirate has invested in, other projects like The Palm and World Islands have recently been cited with a slight tinge of mockery by regional and international press when reporting on Dubai, thereby highlighting that perhaps the emirate has “bitten off more than it can chew” with its “build and they will come” strategy. Henceforth, Dubai may need to abandon its “old model of “grow come what may”, and may be forced to switch to a “grow with caution” model in order to emerge out of the crisis wiser.” (Mr. Raghu Mandagolathur)

Mr. Bader Asadallah, Assistant Analyst, notes that the “nearly a year and a quarter after the beginning of the global crunch, Dubai’s prices remain high and unattractive even after large declines relative to cities around the world. “ He feels that an argument can be made that “Dubai took advantage of the global crunch, by not supporting the city from day one and allowing it to free-fall till prices reach attractive levels” which would entice foreign investors to return to the emirate. He opines that while “Dubai did not “want” or “plan” for recent events, the emirate may be playing up the debt woes in order to push valuations down to a level which would ultimately attract new investors,” though this would obviously come at the expense of current investors.

Dubai has been, and will likely continue to be, a global focal point and regional/international markets will continue to watch Dubai World developments with interest. The Markaz Analyst Club does not see the Dubai World debt restructuring as “the beginning of the end” for the emirate, however, it is likely to rein in Dubai’s ambitions to more realistic levels for the coming decade.

-       Compiled and edited by Ms. Layla Al-Ammar, Investment Analyst, Research
 

The Markaz Analysts Club is an initiative launched by Markaz with an aim to collate the many varied and diverse viewpoints of Markaz analysts in an informal setting in order to share with the public the depth and breadth of analyst knowledge power within Markaz. On a periodical basis, a question concerning the topic/s of the day is posed to our analysts spanning various departments within Markaz (from Real Estate to Oil & Gas to Corporate Finance etc), these analysts’ responses are then compiled into a brief opinion piece for public viewing.

What counts as rational argumentation is as historically determined and as context-dependent, as what counts as good French.

Richard Rorty

A nonholonomic system in physics and mathematics is a system whose state depends on the path taken to achieve it. Path Dependence is the dependence of the outcome on the path of the previous outcomes rather than just the prevalent conditions. In real life, our experiences are path dependent rather than destination dependent. As individuals most of us remember the journey in greater detail than the destination. Indeed, a comfortable journey is the first step to a good vacation.  

In the financial world, investors look not only at return but also the risk of a security. One way of looking at risk is to examine the path taken by a security to reach a particular reference point. At an individual level, we expect that someone who has made US$ 10.0 mn from a steady US$ 5.0 mn investment would exhibit a different behavior than someone who went from US$ 5.0 mn to US $ 2.0 mn and then up to US $ 10.0 mn even though, at that instance, both of them have the same wealth. Other things being equal, a straight path is much more desirable than a convoluted path. Which is why during major market movements, volatility furrows the brows of even the seasoned investors. Given a choice, most investors would prefer the comfort of lower volatility (except when you are long the VIX or have derivatives). This is one of the reasons why Investors demand higher returns to compensate for the risk of holding “perceived to have higher volatility” securities.

The importance of path dependence was brought to the fore by the events preceding the repayment of the Nakheel US $ 3.52 bn Sukuk maturing on December 14, 2009.

Imagine two alternate paths

a)    Path A: It is life as usual, on or before the due date Nakheel PJSC repays the Sukuk proceeds in full.

b)    Path B: Three weeks before the due date, Dubai World announces that it would explore restructuring options. A spokesperson gently reminds the creditors about the relevant fine print in the bond prospectus highlighting that their exposure is to the company and not to the government. The government spokesperson reiterates that support will be on a case by case basis. A number of aggrieved investors contemplate legal action. There is a flurry of activity, a number of press articles are released, the offering memorandum is dug up, analyzed and a number of structuring related questions are raised. At the last minute, Government of Dubai announces emergency funding from the Government of Abu Dhabi for the repayment of the bond and repays the Sukuk proceeds in full

In both the paths the final outcome is the same. Investors have got repaid in full.

Now let’s further imagine   

Path A: The investors on getting repaid would have beseeched the Government of Dubai for a fresh bond issue/investment opportunity. Interestingly, Investors had offered $ 6.0 bn for the same Nakheel US$ $ 3.5 issue during the issuance in December 2007. There would have definitely been a few doubts on the sovereign support but then precedents would be cited to mute the critics.  After all, capital has to be deployed and cannot remain idle. In these crisis ridden times, what better and easier way to deploy capital than to lend it to a “low risk” quasi-sovereign entity!. It would have made all the more sense as detailed due diligence had already been done, thanks to the multitude of bond issues in the recent past from the Government of Dubai and related entities.

Path B: Despite getting paid in full, investors are now wary and are seeking legal opinion on the status of their other quasi sovereign bonds.

In an ideal world, purposeful, rational behaviour of forward-looking, profit-seeking economic agents should make path dependence irrelevant. As governments and regulators are learning, human participants are emotional, show strong aversion to losses and more often than not, emotion rather than rational behaviour drives crowds.

That was the question posed to our in-house analysts this week following the enactment of the Gulf Monetary Union agreement by four of the six GCC nations at the 30^th Annual GCC Summit which was held in Kuwait this past week. Oman opted out in 2006 while the UAE, the GCC’s second largest economy (and arguably its most diversified), pulled out abruptly in May 2009 in protest of locating the joint central bank in Saudi Arabia. The signing of the agreement paves the way for the creation of a joint monetary council, which, in turn, is a precursor to the formation of a joint Central Bank. The four member states have equal voting rights within the council, which is empowered with deciding on an appropriate peg for the GCC currency in addition to setting various standards which the union must abide by.

Our analysts responded with a resounding “Yes” to the first part of our question and believe that the enactment of the agreement is a de facto sign that the union will come to pass. In fact, Assistant Vice President for Oil & Gas, Mr. Rajiv Bishnoi, countered the initial query with a question of his own: “What is the monetary union likely to achieve?” He notes that most GCC currencies are either pegged to the US Dollar or “a large part, as in case of Kuwait, is pegged to [the greenback]”, thereby limiting monetary policy freedom. “The movement between GCC currencies is pretty limited and there is no hedging required/available among the GCC currencies. GCC currencies are also thinly traded in currency markets.” Consequently, he posits that the “the purported benefits of reduced transaction costs, greater price transparency and enhancing trade, are quite limited.”

The issue of the GCC currency peg, both in technical and political terms, was brought up in the majority of analysts responses. Senior Vice President for Research, Mr. Raghu Mandagolathur, believes that an issue of more importance than the unified status of the currency “is the [US] dollar peg. With the dollar doomed to decline for the foreseeable future, GCC leaders would be very unwise to play the game politically by keeping the peg and paying an extraordinarily high price” for it at a later date.

There are some parallels to be drawn between this endeavor and the experience of the European Union, however, Mr. Bishnoi notes that “some of the benefits (and costs) of the Euro to the European Union is not likely to be replicated in the case of the Gulf; unless bolder (and riskier – political and economic) steps of “real” de-pegging of the common currency from the US Dollar, and the pricing of the main export (hydrocarbons), are taken to establish the new currency as sort of additional “hard” currency for other countries.”     

Concurrently, the importance of setting a timeline for the creation of the Union was emphasized by His Highness the Amir of Kuwait, Sheikh Sabah Al-Ahmad Al-Sabah, at the opening ceremony of the GCC Summit, however, it remains to be seen whether such a timeline will be set, and more importantly, adhered to. Senior Research Analyst, Mr. Ramadoss Venkateshwaran, raises the concern that the member states may face difficulty reaching “a common ground” on such technical and political issues like the “determination of initial exchange rates, normalizing of economic parameters, role of the monetary authority etc”, not to mention the issue of the currency peg. However, Mr. Raghu Mandagolathur, going against the grain, is of the opinion that the economic boom of the past decade allowed the GCC nations to be quite lethargic in meeting the original 2010 deadline for the union. However, he states that “in the changed scenario where global events have pushed the region to great challenges, I feel they may now have a more changed and pragmatic position on this very important but ever delayed event. Hence, I feel that a unified GCC currency would be in place soon, much against the street estimate.”

As for the importance of UAE participation in the union, all respondents agreed that the UAE’s status as the GCC’s second largest economy, in addition to its continued goal of becoming the GCC’s financial hub, make it a potential major player in the union. The UAE’s recent debt woes, which many believe are a mere harbinger of more trying times to come, has “moderated [the country’s] bargaining power and, hence, would make it easier to pursuade” it to rejoin the union at a later date (Mr. Ramadoss Venkateshwaran). Given the UAE’s ambitions to be a “trans-shipment hub of the Gulf”, they would likely benefit the most and “may [re]-join the union sooner rather than later” (Mr. Rajiv Bishnoi).

The formidable size of the Saudi economy, in addition to the health and growth potential of smaller economies such as Kuwait and Qatar should provide demand and support of the joint currency. Additionally, UAE’s size and long-term attractiveness to foreign investors would also bring demand, resulting in a more stable and stronger currency (Mr. Bader Asadallah, Assistant Analyst). Given the steady increase in oil prices, with the resultant revenue, the GCC states should take this opportunity to make concrete, meaningful steps towards bringing the monetary union to active fruition in order to strengthen the regions global position as an economic bloc.

So, in closing, the consensus at the Markaz Analyst Club is that while the road to the union might prove to be a winding (and bumpy) one, the GCC will find its way to the end of it, and more likely than not, will pick up its UAE brother at some point along the way. 

The Markaz Analysts Club is an initiative launched by Markaz with an aim to collate the many varied and diverse viewpoints of Markaz analysts in an informal setting in order to share with the public the depth and breadth of analyst knowledge power within Markaz. On a periodical basis, a question concerning the topic/s of the day is posed to our analysts spanning various departments within Markaz (from Real Estate to Oil & Gas to Corporate Finance etc), these analysts’ responses are then compiled into a brief opinion piece for public viewing.

I think we're going to find, with climate change and everything else.. things like global warming and goodness knows what else and the cost of fuel for a start.. that things are going to become very complicated.
Prince Charles

 Background

“Human Driven Climate Change” debates tend to bring out quite a range of emotions amongst its proponents and opponents. There is an ongoing debate on whether humans are causing the climate change or are merely a sub link in a larger cycle of change. It is also unclear if the temperature fluctuations and changes in climatic conditions are leading or lagging indicators. The issue of Global warming is further complicated by special interest groups and lack of consensus amongst the scientists even at a definitional level. A number of climatologists have gathered at the Copenhagen conference to debate these issues. The UN climate change Copenhagen Conference during 7-18^th December 09 dubs itself as the largest and most important climate change conference aimed to protect the world from global warming. In the backdrop of the Climate change conference, it is useful to examine Carbon Trading (CT),  one of the more controversial topics under debate.

CT is a sub section of the broad category of emission control mechanisms known as Emission Trading or Cap and Trade. The concept behind CT is fairly straight forward. There are a many industries which are polluting the environment and there are industries which can reduce or are actively reducing the amount of pollutants spewed by them. How do you reward the good boys while penalizing the bad ones!.  A system of monetary checks and balances would accordingly incentivize or punish polluting utilities and firms into adopting specific technology, raw material or processes to reduce pollution. 

Taking this a step further, the firm can monetize its future potential “environmental” savings and it could also trade quotas or savings with other firms which are inefficient. This should result in higher profits to the “good guys” thereby incentivizing shareholders and directing resources towards environmentally compliant firms. To ensure a level playing field, this game could be refereed by a governmental body. A governmental body may impose quotas or allot emission permits which would enable the firm to generate a certain emission percentage.

There are two primary drivers behind the CT concept.

Cap- A cap on the emissions typically measured as tones of Carbon dioxide equivalent

Trade- Ability to monetize or transfer the emission quota to another firm

Interest in CT has been driven by the Kyoto Protocol. The Kyoto Protocol is a 1997 international treaty which came into force in 2005, which binds most developed nations to a cap-and-trade system for the six major greenhouse gases. Emission quotas were agreed by each participating country, with the intention of reducing their overall emissions by 5.2% of their 1990 levels by the end of 2012.

 (Source: http://en.wikipedia.org/wiki/Kyoto_Protocol).

 CT Trading

There is a spiritual side to our connection with the planet. And in this material world, that's anathema. It is somewhat worrying. What I say.. it makes life. It gives us fulfilment. It makes us whole human beings. And without it, we make mistakes. And, boy, are the leaders of the world making mistakes at the moment.

Bob Brown

So far so good, but why are the large financial institutions getting excited.

Under the Kyoto treaty, a framework is proposed such that nations that emit less than their quota will be able to sell emissions credits to nations that exceed their quota.

Anything which can be traded can be

a)  Monetized, Unitized and stored

b)  Speculated

c)  A valuable source of fee income

d)  And most importantly, has the potential to be arbitraged to generate ‘profits

 Figure 1: A Typical CT Structure


                    

(Source: http://www.foe.co.uk/resource/reports/dangerous_obsession.pdf)

Trading in CT has already started albeit on a small scale. Value of CT based transactions have jumped from under US 1.0 bn in 2004 to over US $ 6.4 bn in 2008. (Source: State and Trends of the Carbon Market (WB).)

The Marrakesh Accords of the Kyoto protocol defined the international trading mechanisms and registries needed to support trading between countries, with allowance trading now occurring between European countries and Asian countries.

The city of London is trying to position itself as a central market place for CT.

In the US context, Renewable Energy Certificates, or "green tags", are transferable rights for renewable energy within some US states. A renewable energy provider gets issued one green tag for each 1,000 kWh of energy it produces. The energy is sold into the electrical grid, and the certificates can be sold on the open market for profit. These are currently voluntary and there is no mechanism to check double counting.

 

Criticism of CT: Macro view

"Burn, baby, burn. That's a beautiful thing,"

Enron Trader caught on tape, singing about a massive fire which shut a Californian power line and dramatically increased the electricity prices. Enron had contracts which became profitable on price increase.

 (Source: http://www.cbsnews.com/stories/2004/06/01/eveningnews/main620626.shtml)

At the heart of the CT debate is the contentious issue of regulations relating to “Common Good”.

Common Good can be defined as “that result in the greatest possible good for the greatest possible number of individuals”.

There are two sides of the coin with respect to a Common Good. Just as the society at large, benefits by prudent use of a Common Good (think clean air), a Common Good can be exploited by a small number of unscrupulous short sighted individuals/firms to generate windfall profits for themselves and pass on the larger costs to the society. This is one reason why Common Good areas like environment, law and order, justice and financial supervision, among others are restricted to governmental systems.

Climate change, environment damage and pollution are particularly tricky as the effect can be felt by not only by the citizens of a country but also those downstream. Pollutants, in their effect, are quite the great leveler. They do not recognize the constraints like race, creed or manmade boundaries separating states/countries, their effects are uniformly deadly.

With respect to CT, the scenario is complicated as there is no global scheme/ treaty yet in place defining the emission targets for all countries. Instead we have four stage targets for emission.

a)    Kyoto Protocol Targets: Established by the Kyoto Treaty

b)   Supra National targets : Targets in the EU zone or the ASEAN region

c)    National Emission Targets: Targets mandated by the national pollution control board

d)    Sub National Targets: Targets established by individual state, district or city.

Various countries have the inherent conflict between preserving their domestic industries vis a vis environment protection. Countries can arbitrage CTs in many ways.

a)    Double counting CTs: There is no central repository available for CTs and hence a country can sell or buy more CTs than one is due. Add in derivatives and CTs based on future/potential savings one could have a situation where countries are complaint and yet nothing has changed on ground.

b)   Lax regulations: Countries with loose supervisory standards may either deliberately or through corrupt practices encourage falsification of CTs. Countries with troubled financials or those operating in war zones may deliberately violate environmental laws to promote employment or may be too powerless to enforce standards. The onus of enforcing and monitoring may fall on underpaid overworked low level regulatory staff. They could be co-opted by large firms into turning a blind eye to violations.

c)    Local laws may encourage loopholes. Many countries have a plethora of laws with power being shared between central and provincial authorities. These are further complicated by the action of special interest groups which may influence the development of laws and lobby for exemptions in certain areas. For e.g. power plants may be regulated on air pollution for carbon dioxide but they may not be strictly monitored for apparently non polluting particulate matter.

d)    Codification of CTs: CT is supposed to measure the carbon dioxide equivalent. However measuring and codifying the carbon dioxide equivalent for say nitrogen emissions may be difficult. Some of the pollutants may not have immediate impact, may impact in unknown ways or may have their effects substantially downstream. National Geographic in their April 2002 edition have documented that Atrazine, the top selling weedicide in US was responsible for affecting the sexual development of male frogs.         (source: http://news.nationalgeographic.com/news/2002/04/0416_020416_TVfrog.html). Similarly the effect of mercury on fishes is well documented. There is an ongoing and often acrimonious debate on the long term effect of various pollutants and their carbon dioxide equivalent.

e)    Spreading around the risk dilutes efforts to nail down serious offenders. Thanks to CT, countries may be able to claim compliance by trading rather than doing something worthwhile for the environment.  CT may in a perverse way also encourage pollution, imagine if a firm has some CTs which are due to expire in a month, there would be a strong motivation to pollute more just to consume the CTs.

 

Criticism of CT: Financial Perspective

Imagine if you had to

Buy your own daily refill pack of Clean Air™ *#.

*20% discount on monthly purchases in advance

## scheme does not apply for Lemony Lime and Orange Mist flavored air.

Can you see a supply chain network, revenue sharing mechanisms and profits

or

Are you horrified?

From a financial perspective the issue at the heart of CT is that of structuring the incentives and rules for an organized approach to tackle a truly challenging problem. Financial firms argue that monetizing environmental damage would help allocate society’s resources towards the problem. CT currently has evolving regulations, governments are keen to pump billions of dollars to combat pollution and there are areas of severe inefficiencies. In short, there are areas where the private sector can pitch in with their efforts and make a significant contribution in partnership with the government.

Environmentalists have alleged that CT could be kidnapped by large financial firms through the use of derivatives and speculative trades such that they lose their original purpose of reducing pollution and instead fuel rampant speculation. They allege that due to lax regulations and disparities across countries it has all the makings of a financial trader’s arbitrage paradise. There is a real danger that CT would be commoditized and desensitized.

The experience with electricity deregulation in US, particularly California has shown that, in the absence of strong checks and balances, some Traders may manipulate a system to the extreme detriment of the society.

"He just f---s California," says one Enron employee. "He steals money from California to the tune of about a million."

"Will you rephrase that?" asks a second employee.

"OK, he, um, he arbitrages the California market to the tune of a million bucks or two a day," replies the first.

(Source: http://www.cbsnews.com/stories/2004/06/01/eveningnews/main620626.shtml)

The experience with clean water has also been quite disappointing. For centuries mankind has taken for granted the right to clean water and good quality air. In many parts of the world, thanks to runaway water pollution and environmental degradation, water quality has suffered so much that individuals are moving to bottled water. This in turn exacerbates the problem as bottled water is highly polluting if the costs of manufacturing the bottle and disposing it are taken into account. The problem is all the more serious as less than one percent of water on our planet is both accessible and potable. (source : http://www.environmentalgraffiti.com/green-living/what-is-cost-of-bottled-water/1129)

Of course it definitely creates profits for a few players who are able to commoditize and brand what was essentially a free product. In a depressing but repetitive scenario across geographies, bottled water industry tries to service those who can pay for it rather than those who need it.

In the context of CTs, Bloomberg notes that Derivatives may be the driving force behind the future CTs.

The banks are preparing to do with carbon what they’ve done before: design and market derivatives contracts that will help client companies hedge their price risk over the long term. They’re also ready to sell carbon-related financial products to outside investors.

(Source: http://www.bloomberg.com/apps/news?pid=20601086&sid=aXRBOxU5KT5M)

Many financiers themselves have also admitted to the potential to manipulate CT.

Even George Soros, the billionaire hedge fund operator, says money managers would find ways to manipulate cap-and-trade markets. “The system can be gamed,” Soros, 79, remarked at a London School of Economics seminar in July. “That’s why financial types like me like it — because there are financial opportunities”…

Hedge fund manager Michael Masters, founder of Masters Capital Management LLC, based in St. Croix, U.S. Virgin Islands [and unrelated to Blythe Masters] says speculators will end up controlling U.S. carbon prices, and their participation could trigger the same type of boom-and-bust cycles that have buffeted other commodities…

The hedge fund manager says that banks will attempt to inflate the carbon market by recruiting investors from hedge funds and pension funds.

“Wall Street is going to sell it as an investment product to people that have nothing to do with carbon,” he says. “Then suddenly investment managers are dominating the asset class, and nothing is related to actual supply and demand. We have seen this movie before.”

(Source: http://www.bloomberg.com/apps/news?pid=20601086&sid=aXRBOxU5KT5M)

 

The top buyers of carbon credits have not been utilities but mostly financial and trading firms.

                                                            Table 1

Source: http://www.foe.co.uk/resource/reports/dangerous_obsession.pdf  page 32

(The Corner House submission to the UK Environmental Audit Committee Inquiry, 2009; original data from United Nations Environment Programme Risoe Centre: www.cdmpipeline.org)

Potential solutions

Many developing nations prefer an absolute and gradual reduction in green house gases. That way, they can continue to develop their infrastructure and living standard of their citizens. Developing countries also argue that it is unfair to compare them with developed countries and expect them to shoulder the burden of accumulated pollution. On the other hand, many poor developing nations are immediately threatened by climate change. Climate change is impacting downstream nations either in the form of decline in soil fertility, raising sea water levels or pollution related health care costs.

Governments across the globe are also wary of the impact of environmental restrictions on the life style and consequently the freedom and “way of life” of their constituents. CT based legislations are a politically balancing act for government and law makers as the constituents tend to vote based on a mix of rational and emotional thought process.

In this context, Friend of Earth have proposed the following steps to refix the present system of Carbon Trading.

(source: http://www.foe.co.uk/resource/reports/dangerous_obsession.pdf page 38

a)    Set a low enough cap: to ensure that reduction takes place in an equitable fashion.

b)   Remove all forms of offsetting: Offsetting would promote focus on the offsetting mechanism rather than a focus on pollution control.

c)    Prohibit speculative trading activity: Prohibit the involvement of all non compliance actors i.e. utilities and industries to be the key player rather than financial firms

d)    100% Auctioning of carbon permits: to enable fair pricing of the permits and prevent windfall gains to those who get privileged access to permits

e)    Agree on a global regulation of emission trading: Essentially standardize the rules around CT.

f)     Drive Real Innovation: Address the perverse incentives created by CT and promote incentives for real pollution reducing incentives

 

Conclusion

CTs have the power to transform our world. Significant capacity build-up and awareness has been developed. In the near future, once rules are codified and a level playing field is set up, it is expected that CT would take off.  The influx of financial firms in the CT market is inevitable but better regulatory framework would help manage an orderly market.

Looking beyond trading, it is critical to recognise that at stake is the future of the planet. There is a growing recognition that there is no single solution to reducing green house gases.  Rather than pick and choose among the multiple tools available, governments need to use all of them. Ominously enough, we may have overshot the point where we, as humans, would have any say in the matter.

References

Papers

a)    A Dangerous Obsession: The evidence against Carbon Trading and Real Solutions to avoid a climate crunch : FOE, Sept 2009: http://www.foe.co.uk/resource/reports/dangerous_obsession.pdf

b)   Climate Change 2007: Synthesis Report. Summary for Policymakers, IPCC: http://www.ipcc.ch/pdf/assessment-report/ar4/syr/ar4_syr_spm.pdf

c)    Fairness in Global Climate Change Finance, ippr, 2009, p4: http://www.ippr.org.uk/publicationsandreports/publication.asp?id=677

d)    Mark Lazarowicz, Global Carbon Trading: a framework for reducing emissions, July 2009, Executive summary, pviii: http://www.decc.gov.uk/en/content/cms/news/pn082/pn082.aspx.

e)    Ten years of experience in Carbon Finance: Insights from working with carbon markets for development & global greenhouse gas mitigation, World Bank http://siteresources.worldbank.org/INTCARBONFINANCE/Resources/Carbon_Fund_12-1-09_web.pdf

f)     Towards a comprehensive climate change agreement in Copenhagen, Communication from the Commission, 28 January 2009, p11: http://ec.europa.eu/environment/climat/pdf/future_action/communication.pdf

Websites

1. http://www.bloomberg.com/apps/news?pid=20601086&sid=aXRBOxU5KT5M
2. www.cdmpipeline.org
3. http://www.cbsnews.com/stories/2004/06/01/eveningnews/main620626.shtml
4. http://en.wikipedia.org/wiki/Kyoto_Protocol
5. http://www.environmentalgraffiti.com/green-living/what-is-cost-of-bottled-water/1129
6. http://news.nationalgeographic.com/news/2002/04/0416_020416_TVfrog.html
7. http://www.pointcarbon.com/research/carbonmarketresearch/cdmhostcountryrating/cdm/
8. http://www.woopidoo.com/business_quotes/authors/ 
    

Capitalism is the astounding belief that the most wickedest of men will do the most wickedest of things for the greatest good of everyone.

John Maynard Keynes

Introduction

The Wealth Bulletin on 1^st September 2009 carried an article titled “Wealthy Asian clients re-embrace ‘accumulators’”. The article mentioned that accumulators are making a surprise comeback .
(Source: http://www.wealth-bulletin.com/portfolio/content/1055052584/).
 Yes, it has a “Spiderman Returns” flavor to it.

 There was also small snippet in the newspapers about the adventures of a few Hong Kong investors with structured financial instrument called Accumulators.

Which brings us to the question, “What are Accumulators?”

Let the share price of a quoted liquid firm be at 30 fils.

Suppose you, the Investor, is offered the right to purchase the share at 25 fils, ….

Hey, this is nice, the Investor starts off by making a tidy profit right from the beginning, Wow, isn’t this a cute and cuddly  product.

These were roughly the sentiments of the Hong Kong Investors. Of course, cute and cuddly come along with a baggage of “trouble”.

The Bloomberg article went on to mention that a Hong Kong client sued a large Swiss Bank for alleged negligence and reckless misrepresentation in inducing her to buy so-called accumulators that resulted in losses of more than US $25.8 million equivalent.

(Source: http://www.bloomberg.com/apps/news?pid=20601080&sid=afEAZInxFRLw)

......Oouch.. Accumulators, like tigers, look cute but they pack a mean bite.

Background

Accumulators are structured products which bind Investors into a series of transactions resulting in buying securities at a fixed price over a specified period of time. Investors get the underlying security at discount and sacrifice upside beyond a particular barrier.

Err.. what does that mean in English. An illustration would be better to translate this gobbledygook.

Let’s start from the beginning.

Suppose the share price of a liquid traded security is at 30 fils. If you buy a one year accumulator contract then here is what you get on each trading day of the year.

You can buy a predetermined number of shares at a set price say 25 fils (usually at a discount to the current market price) for the entire year. Typical duration is one year with monthly settlement.

As long as the share is above 25 fils, you can receive the shares and sell it in the market and make money.

Of course there is an upper bound to the “party”. If the share touches, say 35 fils then the contract is terminated and the Investor cannot buy any more shares.

If the share goes below the market price then the Investor’s obligation to purchase continues. A twist to this contract would be wherein, if the share falls below another preset level say 15 fils then the Investor has to “step up” the purchase of the specified shares. The “step up” would typically be between two to five times of the original purchase quantity.

So far so good, the structure looks fairly benign but then why has this product been popularly labeled “I will kill you later” contracts

(Source: http://www.eurointelligence.com/Article3.1018+M5223dd2ef5f.0.html)

Further, In Nov 2008, how did Citic Pacific manage to suddenly lose $ 108 mn and over $ 1.8 bn in mark to market losses.

Citic Pacific, the Hong Kong listed arm of Citic, China’s state owned Investment company was under the impression that they had a “sure thing in the bag”  in the Australian Dollar/US dollar market and entered into Accumulator equivalent currency contracts.

(Source:  http://english.caijing.com.cn/2008-10-31/110025046.html)

Analysis

An Accumulator can be analyzed as a series of options

Aspect 1: Investor can buy shares at 25 fils when the prevailing market price is 30 fils: In the money call option being sold to the Investor.