sensex falls 455 points, culprit being the poor economic growth data

• The BSE sensex and the Nifty declined more than 2 percent on Friday, marking their biggest single day percentage fall in about 14 months as lenders such as ICICI Bank reeled after economic growth data dashed hopes the central bank would cut interest rates next month.
• India’s economy grew 4.8 percent in the January-March quarter from a year earlier, in line with expectations and dashing hopes that a slower-than-expected growth would spark more aggressive rate cuts from the Reserve Bank of India.
• The dismal GDP number came when sentiment had already been hit after RBI Governor Duvvuri Subbarao warned retail inflation was still high and expressed worry about the current account deficit.
• Dealers added that any comments from the RBI, a further fall in the rupee and the arrival of the annual monsoon rains would be the key for the near-term direction.
• “The government needs to act for the RBI to cut rates further, nervousness may remain due to falling rate-cut bets and rupee depreciation,” said Deven Choksey, managing director of K R Choksey Securities.
• The BSE sensex  fell 2.25 percent, or 455.10 points, to end at 19,760.30, marking its biggest single day fall since March 22, while gaining 0.3 percent for the week.
• The broader Nifty declined 2.26 percent, or 138.10 points, to finish at 5,985.95, closing below the psychologically important 6,000 level. It ended flat for the week.
• The NSE’s sub-index of banking stocks declined 2.6 percent as lenders such as HDFC bank Ltd  fell on dwindling rate-cut hopes.
• HDFC Bank fell 3.4 percent, ICICI bank Ltd  ended 2.4 percent lower, while State Bank of India declined 2 percent.
• Recent outperformers such as Sun Pharmaceutical Industries Ltd and Mahindra & Mahindra Ltd (M&M)  fell on profit-booking after hitting their respective all-time highs on Thursday.
• Sun Pharma fell 2.8 percent while M&M declined 3.7 percent.
• DLF Ltd fell 5.4 percent after India’s largest real estate developer posted its first-ever quarterly net loss, weighed down by slowing home sales in a sluggish economy.
• Suzlon Energy Ltd fell 10 percent to a record low on Friday after the wind turbine maker said its January-March net loss widened from a year earlier.
• However, among stocks that gained, technology shares rose as the rupee depreciation is seen boosting their overseas earnings. Infosys  Ltd  rose 3 percent.

gold rising

• In recent interviews, Bill Gross, the legendary co-founder of Pimco and manager of the world’s biggest bond fund, has stated his belief that gold will do well in 2013. That Gross, renowned as the “Bond King”, would pick gold as the year’s best buy over a bond is very telling about what he expects for the future; but investors remain unconvinced.
• It was not that long ago that Bill Gross, the “Bond King,” warned that stocks were one big pyramid scheme. Of course, that was before the Dow Jones Industrial Average surged to over 14,000. But Gross, in a recent interview in Barron’s, now sees gold as the most compelling asset buy.
• He attributes this to two factors: the expected rate of inflation and real interest rates (the interest rate paid minus the rate of inflation). That Gross picks gold as the best buy rather than a bond is very telling about what he expects for the future. But for investors is the question of his record.
• Gross perceives that quantitative easing by central banks will inevitably lead to higher inflation. Quantitative easing is the buying of trillions of dollars of government debt by central banks around the world. The major objective of quantitative easing is to re-flate the economies through suppressing interest rates.
• The hope is that consumers will buy more homes and motor vehicles due to low mortgage rates and loan terms. From that banks, will then lend more to small businesses. That will all result in the greater hiring of workers due to more homes being built, automobiles and trucks being sold, and businesses borrowing cheaply to expand operations.
• Some of that has worked, but not to a degree where any central bank is ready to curtail quantitative easing. Federal Reserve Chairman Ben Bernanke, the world’s leading central banker, sees the need for a low interest rate environment until 2015. That is a solid indicator that Bernanke does not foresee any inflation threat for a number of years.
• Gross is predicting a rational response to quantitative easing that entails gold rising due to heavy duty money creation by central banks around the world. That was certainly the case in the early rounds of quantitative easing. But each additional round of quantitative easing has resulted in gold rising less in response than to the previous bouts.
• What is happening is that the low interest rate environment created and perpetuated by Bernanke is defeating gold as a yield hungry investment community seeks assets that pay income. Dividend-paying stocks and high yield bonds have become very popular with investors seeking income.  
• As gold is a commodity, it does not have an income component. Due to that, it is in disfavor as an investment in the current climate. The issue then becomes what will result in gold becoming more attractive, as Gross contends will happen.
• It could be, however, that investors seeking a safe haven in gold have been exhausted by all the rounds of quantitative easing since The Great Recession. That is certainly indicated by how gold has risen less after the announcement of each successive foray of quantitative easing. Every asset class has a natural constituency, and that group for gold could have reached its limit.
• With the US economy contracting in the most recent quarter, it does not appear as if inflation is the greatest threat. Therefore gold is not the greatest asset to buy for those looking to profit from macro-economic conditions. While Gross picks it as his top investment choice, it appears likely that gold will continue to lose out to income-paying assets as quantitative easing continues for years into the future. That is certainly what has been happening!

low for depositors and high for borrowers

• When interest rates are high savers are happy, but borrowers are not. When they fall, savers’ pain is debtors’ gain. It is a natural trade-off. But in the euro zone these days rates hurt everyone: they are low for depositors and high for borrowers. This is especially so in Italy and Spain, where the rates small firms pay to borrow are far above those set by the European Central Bank (ECB) and those paid to depositors. The link between the ECB’s “policy” rate and borrowing in the real economy is broken.
• The ECB had an easy start. It was able to rely on just one tool, its short-term interest rate. When the ECB lowered its rate by half a percentage point in 2003, firms’ borrowing rates fell by the same amount. When it tightened policy between 2005 and 2007, the pattern was the same. As the ECB rate went from 2% to 4%, firms’ borrowing rates rose from 4% to 6%. This predictable wedge between policy and market interest rates meant the ECB knew how its decisions would feed through to the interest rates that influence output and inflation.
• It also had a fair idea why its policies influenced economic activity as they did. The precise “transmission mechanism” had not always been clear: the Federal Reserve and Bank of England had been using short-term interest rates as a policy tool for years, and economists noticed that the timing and size of interest-rate influence could not be pinned solely on consumption, investment or exchange rates. The mysterious missing link was what Ben Bernanke, then of Princeton University and now the Fed’s chairman, and Mark Gertler of New York University called a “black box” in a 1995 paper*. Economists generally assume that higher prices reduce demand but raise supply. Messrs Bernanke and Gertler observed that when rates rise, credit supply might fall. One “channel” through which this happens is the supply of bank lending.
• The bank-lending channel works as follows. When a central bank raises interest rates, the return on government bonds rises. Banks lose deposits as customers buy bonds. To plug the gap banks switch to another source of funding—borrowing in wholesale markets—that is more costly. As their own costs rise, banks’ loans become scarcer, dearer or both. This slows the economy by raising financing costs for bank-dependent borrowers. The whole process works in reverse when central banks cut rates.
• The bank-lending channel would not hold in all cases, Messrs Bernanke and Gertler pointed out. Since it works because banks’ funding costs rise as they take on more wholesale debt, it is only relevant for banks that have a shortfall of customer deposits. Asian banks, which have more deposits than loans, are poor candidates. And it will be important only in countries where firms are dependent on bank borrowing. If firms can get financing via the capital markets the channel will be much weaker.
• Those conditions describe the euro area perfectly. Its banks make more loans than the cash they collect as deposits. The resulting gaps are filled by wholesale funding. A recent IMF analysis shows the gaps are large, around 40% of the total funding for peripheral countries. It is also an economic area in which small and medium-sized enterprises (SMEs) are crucial. They account for between 60% and 80% of employment, according to a recent study by the OECD, an intergovernmental think-tank. The euro zone is bank-dependent and its banks are reliant on market funding. Finance in Britain works in a similar way.
• That explains why central banks’ normal tools are so powerful. But it also explains why they can fail to work at all. In 2008, as the euro zone started to contract, the ECB slashed its main rate from 4.25% to 1%. But because investors were worried about the state of the banks, the returns that banks had to offer on their own bonds rose. This offset the ECB’s easing, so that firms’ borrowing rates fell by less than normal.
• When the euro crisis intensified in 2010, the ECB’s influence on interest rates in Spain and Italy waned even further. Banks’ bond yields rose in line with their governments’ cost of borrowing. As predicted by the bank-lending channel, but now as a result of a change that the ECB did not control, the supply of loans contracted. The amount of borrowing in Italy and Spain has started to fall again (see right-hand chart). Some of this may be due to weak demand. But a 2011 study by the ECB suggested that tight credit conditions could take two percentage points off annual growth in the currency area. Recent studies by the IMF and the Bank of Italy concur: credit supply is a big problem.
• Britain’s experience is so similar that it provides ideas the ECB can use. The Bank of England’s policy rate has been 0.5% since 2009, yet SME borrowing costs have been high and business lending has contracted. Since studies showed that tight loan supply was partly to blame, a new tool, the Funding for Lending scheme (FLS), was created in 2012. Banks first swap their assets, including bundles of SME loans, with the central bank. In return they get ultra-safe treasury bills. Banks can then offer this good collateral as security when they borrow. Because the bank’s creditor gets the safe assets if the bank defaults, this form of funding is cheap.
• Since SME lending attracts higher capital charges than mortgage lending, there is a risk that cheap funding will flow to home buyers but not firms. To ensure that its assistance hits the right spot, the FLS scheme was tweaked in April to target funding support to banks that increase net SME lending. The ECB was expected to cut interest rates again at its meeting on May 2nd, after The Economist had gone to press. If it went further and followed the FLS example, it would be controlling the bank-lending channel at both ends: directly setting banks’ wholesale-funding costs and influencing where credit flows. Such measures are extraordinary, but they may be needed to make interest rates work again.