Money- Why to worry on Hedge funds

Indian financial regulators get skittish when the word “hedge fund” is used. Recent announcements suggest some movement by Sebi and the ministry of finance in their favour, while the RBI continues to argue against. One source of fear of hedge funds is the notion that all hedge funds act in concert. However, the global hedge fund industry is highly competitive. Over $1 trillion is managed by more than 8,000 hedge funds, each of which fights to gain an edge over the others. Coordination between such a large number of adversarial entities is impossible. Though a herd mentality can set in, on any given day some hedge funds will buy and some hedge funds sell.

The customers of hedge funds are institutions and sophisticated individuals. They have the wherewithal to monitor hedge funds, and shift assets to the best return-to-risk ratio. They keep the hedge fund manager on his toes. Marketing gimmicks targeting retail investors can put money into the hands of an incompetent manager. Such gimmicks do not work in the hedge fund sector, which is meritocratic and performance-driven. Fearful third world regulators like the RBI harp on the LTCM episode of 1999. Just as one plane crash does not render all plane travel useless, the case for hedge funds is not invalidated by one problem. The recent demise of Amaranth—where losses bigger than LTCM took place—shows improving institutional structures. From a regulatory viewpoint, Amaranth was a pleasant episode. A few rich men lost money, while hedge funds as a whole continued to trade every day, making markets more efficient.
There are two alternative strategies for regulation. On the one hand is the US path, where the government is not involved in the relationship between the hedge fund and his customer. Alternatively, in the UK and in Scandinavia, there is some light-touch regulation. In either case, the activities of hedge funds in securities markets have to comply with all margin requirements, position limits, etc. In India, given the penchant for turning a whiff of regulation into an onerous licence-permit raj, the US route would be better. A US-style policy framework needs to be created, to support both foreign and domestic hedge funds. The international consensus today says that hedge funds engage in rational trades and supply liquidity. The smartest analytical financial economics, the best Ph.D.s, and the best computer technology for trading are now in the hands of hedge funds. India needs their risk-taking, their liquidity provision, their analytical minds, and their systems. Foreign hedge funds are useful since they would not get shaken by the ups and downs of the market in the way that local investors do. On the interest rate and currency markets, India has failed to build meaningful markets; the active and intelligent trading of hedge funds can induce a paradigm shift. On the equity market also, the volatility of May 2006 has given a drop in liquidity which has still not been erased. Monthly traded volumes in equity spot and derivatives markets have dropped sharply. The gutsy retail liquidity providers of India have been shaken by the volatility of May 2006. Globally diversified hedge funds are a useful source of liquidity provision in Indian financial markets.

BS-editorial

Dollar- Uncle Sam's worry

Those who react to last week’s fall in the dollar’s exchange rate and predict that the US currency is set for a further dip, would be well advised to read some of the forecasts made a couple of years ago, when the dollar had suffered a similar decline. Currency experts, bankers and economists were predicting then that the dollar would drop to as low as $1.50 against the euro, even $1.80 and $2.20. None of that happened, the dollar recovered, and life went on as usual. Now there is another round of nervousness, with the dollar dipping noticeably last week and having fallen by about 15 per cent this calendar year (though by barely 2-3 per cent against the rupee).

Is the long-predicted decline of the dollar about to happen at last, or is this another false alarm? That there is reason for worry, if not alarm, is easy to see. US housing has dipped for seven months in a row, US manufacturing has dipped for the first time in two or three years, and if the Federal Reserve drops interest rates (after a five-month hiatus) to try and revive the economy, capital could flow out of the US and further weaken the currency. If the Asian economies that hold foreign currency reserves of between $1.5 trillion and $2 trillion, decide that the dollar is not a safe store of value and look for alternatives, that will put still more pressure on the currency. ( Iran has decided to Euro against USD, thought it’s a different question why???) If, on the other hand, the Fed leaves interest rates untouched (for it is also worried about continuing inflation), it could slow down the US economy even more—and add to problems from another direction.

Surveying the flurry of comment on the subject, the most noteworthy is what has been said by The Economist. In a leading article it argues that, contrary to popular opinion, US productivity levels have not been improving faster than European levels, and that it is Europe which has greater room for productivity improvement. If true, that would argue in favour of a further weakening of the dollar as it argues in favour of switching to the euro as the currency of choice. With the dollar already close to its all-time low against the euro, some new currency benchmarks might well be set in the coming weeks. The other point worth noting is that the dollar has not really gained much ground this year against either the yuan or the rupee. Trade with India is not significant for the US, but that with China is—and if the yuan does not appreciate, much of the gains to be achieved from a cheaper dollar (through a reduced trade deficit) get nullified. From India’s perspective, the economy’s undoubted gains in productivity should help the rupee climb against the dollar, but the continuing weaknesses in the physical and financial infrastructure prevent that from happening, and the Reserve Bank is left with the task of pursuing an otherwise illogical currency policy and continuing to accumulate foreign exchange reserves in order to make up for the failures of the reform programme. There is no gainsaying that the US needs to do quite a lot of course correction in order to tackle its twin deficits (fiscal and trade), but if the dollar does fall further, it will test the quality of response from the other major economies—which now include India. If they fail the test, then global growth will be the casualty