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BW Businessworld

How To Prepare For The Inevitable Financial Crisis

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The world's problems are caused by excess liquidity and it cannot be cured by adding more. It's like treating the problem of alcoholism by alcohol. Whether we like it or not, the world has to go through 2–3 years of rehab before this problem can be cured.

What politicians are doing right now is just delaying the problem and not solving it. They are just giving more alcohol to an alcoholic to reduce the immediate pain, which is increasing the damage (bubble) rather than reducing it. Sooner or later, in the near future, they will have to solve this problem and the best of economists can't predict the time because it would be a fallout of political equations also rather than just economic equations. A doctor (economist) can only recognise the problem and suggest immediate treatment; ultimately the patient's (world economy) family members (people / voters & politicians) have to force upon the hard decision of going for rehabilitation.

The best way to solve a problem is to first recognise the problem. After that, generally, things are not that difficult. As individuals, once we have recognised the problem, while we are waiting for politicians to decide when they want to tackle the problem, we should do our own planning to ensure that impact of the financial crisis on ourselves is minimum.

Here we should recognise that once the world economy goes into rehabilitation, there would be periods of pain and if there is a bubble burst in the world, no matter how much we prepare, we cannot escape totally unaffected. The idea should be to minimise the impact to tolerable limits.

Again, we should recognise that impact may not directly impact us but can impact us indirectly. For example, your spouse or your brother might lose his job and you might have to support him. Or you might not be leveraged but your father might be and you might have to pay for his debts. Hence when you are getting your house in order it's important that you make sure that your near and dear ones for whom you feel responsible also gets their house in order.

I would suggest the following key steps to prepare for the rehabilitation:

Reduce Leverage: The first and the foremost thing that we need to do are is to reduce our leverage. We are lucky to have seen the trailer of this upcoming financial crisis in 2008 and should take clues from it. That time we saw what happens to the patient when he is put into rehabilitation, just that we could not see his pain and agreed to give him more alcohol. Just think of a situation when liquidity (alcohol) is sucked out of the financial markets (patient's veins). Remember, as individuals, we are not ‘too big to fail'. Our investment in bubble assets like real estate etc might be worth a fraction while our debts against them stand as it is. We should try to square-off our leverage positions as much as possible. In the greed to maximise returns, we might leverage now and also gain till music stops. But once it stops, we would lose even our principal.

Avoid Real Estate For Investment: In last 8 years, real estate has given an average annual return of around 30 per cent and hence out of fear of missing the bus, we want to buy property. Secondly, due to excess liquidity, no other asset class has been able to give similar returns, not even best of businesses. Hence everybody wants to invest in property where not only one is getting higher return but also has good opportunity to leverage. However, it's not sustainable and if you see the history of financial crisis, including USA's real estate market after 2007 or South East Asian market after the 1997 crash, each downturn (rehabilitation phase) is marked by a steep fall in real estate prices.

If you are buying a house for own use, with limited leverage you can go ahead, because it is difficult to keep postponing comforts for one's family members. However, if you are leveraging yourself to buy property only for investments, please avoid. Real estate is a depreciating asset and 20 years down the line you would not be able to live in the property you are buying today. Tell me how many properties you have recently considered buying is 20 years old?

Invest In Yourself: Go for the higher education you had been postponing for a while. Ask your employer to send you for the training you always wanted to go for. Read up when you get time, develop new skills. No investment can fetch you higher return than your investment in yourself. It can also protect you better in recession time when companies are cutting jobs across the board and you might find yourself in the wrong place at the wrong time.

Get Medical Insurance For Family: We should get medical insurance not only for ourselves but for all the family members for whom we are responsible, and in case of medical emergency we will end up footing the medical bill. We should not rely on the company provided medical insurance and should take a separate medical insurance because you if you lose your job you will also lose the medical cover provided by the company. During 2007 financial crisis in USA, many people were willing to work for zero salary just to take benefit of the company's medical cover. Medical emergencies are biggest risks to one's planning and in today's world can drain out all the savings you might have made for the rainy day.

Understand The Bubble Points (Real Estate, Commodities, Financial Sector): Due to worldwide excess liquidity, major bubbles are formed in real estate, financial sector and commodities. If you are exposed to these sectors due to your job or any other reason, create a good plan B. Lot of financial intermediary jobs like private equity, equity researchers, brokers, analysts, wealth managers have been created in the last decade due to extra liquidity. Once the liquidity is sucked out, a certain percentage of these people would lose their job and a certain percentage will have to live with pay cuts.

Similarly, due to excess liquidity, prices of commodity like crude, iron ore, coal etc. have run up. This excess demand is not only due to excess investment in unsustainable assets but also speculative investments by investors sitting on lot of liquidity and who believe in high leverage. The crash in prices would badly impact countries that are dependent on exports of commodities like Australia, Russia, Brazil, etc. On the other hand, countries like India, which is majorly an importer of these commodities, would gain from a crash in prices of commodities like crude. Hence, it's important to understand whether you are on the buy side or the sell side of these commodities to understand the risk.

Understand Currency Risk: Unlike many of the previous downturns, the relative purchasing power of different currencies is in the heart of this crisis. Hence people who are exposed to currencies like US Dollar, Euro, Brazilian real etc need to be aware of this fact and accordingly hedge themselves. It's difficult to predict whether hegemony of US dollar would end or not in the next few years but surely it's not a safe haven and should not be looked at like that. When the liquidity is sucked out, first reaction of the financial world might be to move to safe haven of US Dollar but soon they would realize that it's a ‘financial cliff'. Again, gold is not a safe haven. Chances of the world moving back to gold as the under-lying asset is very remote and the new standard would most probably be based on a basket of commodities/currencies.

Understand Cross Country Trade Risk: At the heart of current financial crisis is the currency risk and hence we should be very aware of cross country trade risk if we are into international trade or similar business. Proper hedging tools should be used for international transaction. Remember that one might be right about the movement of currency but one needs to get the timing also right which generally is much more difficult. Lot of people in the world are predicting that the US dollar would eventually crash and most probably they would be right but nobody is able to predict when and that's the crucial part. During the 2007 crisis, many people incurred heavy currency losses because they were betting against the US dollar while the currency appreciated as it was considered a safe haven.

If I have scared you, I must make it clear that this is not the end of the world. The economy always goes through such economic cycles every 5–7 years. People who prepare themselves well for the downturn are able to make most of the upturn. This downturn would be in many ways a blessing in disguise for India. Crash in commodity prices would lower our import bill of crude which will solve the current account deficit problem and also reduce our subsidy burden. Relative strengthening of the Indian rupee against developed country currency like US dollar and the euro will help us retain our talented manpower in India and utilise their talent to build domestic consumption focused industries. For example, an industry like infrastructure would be able to attract the much needed engineers who today are keener to work for IT assignments for foreign clients. While you are making investments in shares today, go for companies which are focused on domestic consumption specially those who are importing large part of the input commodity.

Remember in our life time we would see many such economic cycles. The art is to survive the bad times so that we can make most of the good times. By playing safe today you might not make as much money as your neighbor is making by leveraging, but at the same time, unlike your neighbor you would not lose everything that you have earned, when the bubble burst. Anybody can be ‘the king of good times', the real test is when the tide turn.

(The author is VP, Finance and Gas Business of H-Energy, a Hiranandani Group company)