188) Monetary policy - Following the Fed or not?

The fragile rupee and a relatively healthy financial system argue against monetary relaxation.

Roiling international markets, a declining currency, and stubbornly elevated inflation. These are fiendishly difficult and nerve-wrackingly uncertain circumstances for the RBI to be making decisions about monetary policy. As liquidity has dried up, the Fed has been cutting interest rates and the People’s Bank of China (PBOC) too has signalled a clear bias towards relaxing monetary policy by lowering its interest rate marginally. The obvious questions for the RBI are: should it follow the Fed? If not, why not?
At this juncture, the RBI, like the Fed, has two key objectives: bringing inflation down and maintaining confidence in the financial system in the wake of seismic events shaking world financial markets. The latter requires some combination of sustaining economic activity (or averting its collapse if one has a more dire prognosis) and maintaining the health of the financial sector to allow it to continue operating without distress.
Despite the common objectives and apparently similar circumstances, there are two reasons for the RBI not to follow the Fed. The first is the inflation outlook. Current inflation in both countries is well above policy-makers’ targets and comfort zones. But despite the relief that is on its way for both countries in the form of declining oil and commodity prices, the outlook for inflation is different for one important reason: the currency.
To the surprise of many, the dollar has remained relatively strong (until very recently) despite the US being at the epicentre of the financial crisis. In contrast, the rupee has depreciated sharply from 39 to the dollar to about 46. In terms of magnitudes, the exchange rate depreciation (about 20 per cent affecting all imported goods) will probably outweigh the favourable food and oil price effects. Declines in oil prices will not have much impact on inflation because domestic prices are controlled and remain well below world prices (they will have an impact via the fiscal channel but over time). Food prices, which do have a more immediate impact on inflation, have not declined dramatically. On balance, inflationary pressures remain, and a cut in interest rates could stoke them by contributing to a further rupee depreciation. This would risk turning what has already been a marked decline into a disorderly rout, undermining confidence.
The second reason relates to confidence and the financial system. The seizing up of credit markets and evaporating liquidity that have gripped US financial markets could afflict India. Here the actions of the US Fed are instructive for the RBI. The actions of the Fed make clear that all objectives including inflation control are subordinate to that of preventing the financial system from collapsing and taking the real economy with it. If the Weimar hyperinflation is etched in the collective German psyche, the Great Depression is its American counterpart, the nightmare outcome that Ben Bernanke will flout every orthodoxy to prevent.
The Fed has tried to maintain confidence through two levers. First, through emergency liquidity provision. It has radically departed from precedent by enlarging the institutions that can avail themselves of the lender-of-last-resort facility, to encompass even those (investment banks) that had previously been beyond the purview of Fed regulation, and by widening the set of collateral against which liquidity could be provided.
The Fed’s second lever has been interest rate cuts, which have the well-known effect of sustaining aggregate demand and real activity, thereby averting a further collapse of confidence. But rate cuts have had another, less recognised, motivation. Keeping the financial system functional in these difficult times has required banks and others to acquire capital and strengthen their balance sheets, thereby sustaining their lending operations. Lower interest rates have been an important mechanism for the re-capitalisation of banks. How so?
Lower short-term interest rates achieved by the Fed typically go with higher long-run interest rates (the phenomenon of positively sloped yield curves). Banks borrow short and lend long. Ergo, low short rates widen bank spreads and increase their profits, providing valuable capital. The Fed’s rate cuts have been guided by the need to restore the profitability of the US financial sector.
What are the lessons for India? If it is indeed the case that the balance sheet of Indian financial institutions are respectable and not immediately threatened, then the case for lowering interest rates, for reasons of sustaining the health/solvency of the financial system, is weakened. In other words, the problem in India, unlike in the US, is not, or at least not yet, one of solvency and inadequate capitalisation of the financial system.
In sum, there are two contrasts with the US. India cannot afford to lower interest rates because its currency movements, and hence its inflation outlook, are very different. At the same time, it does not need to lower rates to maintain the solvency of the financial system, which is mercifully healthier.
That said, liquidity conditions are tight in India, and there are worrying signals that the RBI needs to warily watch. The RBI should gear itself to be able to supply liquidity at quick notice should a need arise in the near future. One operational suggestion to improve this capability would be to re-centre the interest rate corridor so that the policy rate falls in the middle. Currently, the policy rate is at the upper end or above the corridor, which forces the RBI to keep the system chronically short of liquidity. This could become a potential problem should conditions turn worse.
Finally, a third, more general, reason also points to not relaxing monetary policy. Current decisions are being made under great uncertainty with substantial possibility of policy error. Tightening now could be a mistake if Indian markets are gripped by a loss of confidence. Equally, relaxing now could be a problem if past or future rupee depreciation entails elevated inflationary pressures and requires a switch back to tight policies. The key question then is which error is easier to rectify. The threat of a loss of confidence is still a potential one, and if it were to arise, could be relatively easy to address by flooding the system with liquidity. But this is less true of inflation control policies, which take longer to have effect.
This asymmetry favours maintaining a slightly tight bias to current policy. Central banking is a human art, involving difficult policy choices. To err may be unavoidable. To correct quickly is therefore essential.

Arvind Subramanian

The author is Senior Fellow, Peterson Institute for International Economics and Center for Global Development, and Senior Research Professor, Johns Hopkins University

187) The currency futures market

There will be more transparency, but will it lead to lower bank margins for small and medium industries?

The currency futures market started functioning about three weeks back and, hopefully, it will have a more prosperous future than the interest futures contract, introduced with equal fanfare, in June 2003 — that contract did not take off at all, primarily, to my mind, because banks were only permitted to hedge. They could, therefore, only be sellers, and the market had a still birth. The strange part of the regulatory prohibition was that banks could effectively trade on bond yields in the over-the-counter (OTC) interest rate swap market, but not in the far safer exchange-traded one. (Interest/bond futures are also expected to be re-introduced shortly.)
Regulations regarding currency futures are more practical and hence the optimism for the success of the contract. On the other hand, one should not forget that the Dubai exchange introduced a USD: INR currency futures contract in the middle of 2007 but volumes have not really picked up, belying expectation based on the fact that there is a significant commercial interest in the rupee because of exposures to the diamond and gold trade. It was also expected that the market may be able to attract foreign investors from the OTC non-deliverable forwards (NDF) market in Singapore/Hong Kong. But this does not seem to have happened.
The currency futures market in India is, of course, no threat to the NDF market since, at least at present, only residents can participate. One natural end-user of the market would be corporates having “economic” exposures to exchange rates. These comprise a large segment of producers and consumers of commodity-type goods — metals, basic and petro-chemicals, etc — whose domestic prices get determined through the exchange rate. Under current regulations, such exposures cannot be hedged in the OTC forward exchange market despite recommendations from various committees appointed by the RBI (This is another regulatory anomaly: Companies have been permitted to hedge economic exposures to import duties in the OTC market, but not economic exposures to domestic prices of goods). In the normal course, such businesses would have taken recourse to the futures market where there are no restrictions about the underlying. However, for such businesses, the client level limit of open interest of $5 million is too small to be of much use. Reports indicate that this limit is likely to be reviewed and one does hope that a favourable view is taken by the authorities considering the genuine needs of the end-users.
How liquid can the market be? Will it, at some stage, dwarf the transaction volumes in the forward exchange market? There is a precedent of course: The transaction volumes in the equities derivatives market is far bigger than in the cash market. On the other hand, globally, despite the existence of exchange-traded currency derivatives, the market is predominantly over-the-counter. As per the latest BIS report, currency trading in the OTC market was of the order of more than $3 trillion every day; this compares with the notional principal of $72 billion traded on exchanges. The average transaction volume in the domestic OTC foreign exchange market is of the order of $49 billion, including $24 billion of outright forwards and swaps. In comparison, in the initial weeks, the daily volume on the futures exchange has been of the order of $50 million. But these are early days.
There is another technical issue in the forward/futures market in India. Globally, a one month forward transacted today (September 22) would mature on October 24 (i.e. one month from the spot date corresponding to September 22 — there are rules about maturity when the date happens to be a holiday etc., which we need not go into). Indeed, forward contract maturities correspond with the maturities of loans and deposits in the off shore market, leading to a close integration between the money and exchange markets. In contrast to the global market, the practice in India is that a one month forward contract traded today would mature on the last working day of the following month. The futures contract is also using the same rule. This is an old practice and probably needs to be changed in the interest of greater integration of the forward exchange market and term interbank money —in the latter market, one month maturity is broadly similar to the practice of the off-shore market, and not the last trading date of the following month.
Clearly, the futures market will have greater price transparency for the end-user. Will it, however, lead to lower bank margins for the small and medium industries segment? This is unlikely because while the underlying exposure could be hedged in the futures market at market prices, the settlement will remain in rupees and the final delivery of the foreign currency will take place only through the banking system. Indeed, FEMA precludes any foreign exchange transaction except through authorised dealers.
One other loose end: the tax treatment of the gains/losses in the futures market. Would this be treated as business income as in the case of equity derivatives?

A V Rajwade

186) Naked

The United States is supposed to have not just great markets and great enterprises, but also great regulators. The Federal Reserve and the Securities and Exchange Commission are respected and feared the world over. Those great markets also rely on institutional mechanisms, like the rating agencies — all of which are now American-owned. The amazing thing about this entire pack is that the financial crisis has shown all of them to be as naked as the emperor who strutted out in what he thought were his new clothes.

What, for instance, was the SEC doing when the great investment banks (Bear Stearns, Lehman Brothers, et al) were leveraging their equity 30 and even 40 times? If a company runs $600 billion worth of assets on an equity base of just $26 billion, then if those assets drop in value by just 5 per cent, the company goes bankrupt — which is what has happened. If the SEC wasn’t looking at the problem, what were the rating agencies doing when they gave these firms the best ratings in the book? If the risks are blindingly obvious today, why could the Fed not see them and ask for corrective action from the lawmakers or by the SEC?

It seems obvious now that the whole investment banking model is simply not viable. They made fat profits because they ran risky, over-leveraged businesses; and they were not regulated in the way that traditional banks are, so they did not have any defences in place for when things go wrong. That explains why it is banks like Bank of America which are now gobbling up the investment banks, and why Morgan Stanley is running for cover to Wachovia and others.

When Enron went bust, it was run by a bunch of Harvard MBAs, advised by McKinsey, and its accounts audited by one of the big accounting firms (which imploded). It turned out that the accounting firms were busy getting money from their clients for doing consulting work — which created a conflict of interest when it came to proper auditing. That same problem now affects the rating agencies, which were getting a lot of work and therefore revenue from the investment banks. So did they go soft in their ratings of the investment banks — and mislead the markets? In any case, did the people in the rating agencies actually read and digest the thousands of pages of legalese associated with every complex financial instrument before they gave a rating, for which the fee was relatively modest? You can guess.

In other words, it is not just the investment banking model that is broken, it is the entire system of complex financial instruments that no one fully understood, so that risk was not properly measured — and that is lethal when things start unraveling. The trading practice that makes things unravel even faster in such a situation is called ‘going short’ — a practice long frowned on by Indian regulators for being destructive of value, but advocated by market fundamentalists as being an inalienable part of an efficient market. Now, surprise, the SEC is talking of banning ‘shorting’ because that is causing the selling stampede behind the bankruptcies!

Someone said the other day that the worst is over. Don’t bet on it. All the assets owned by the firms that have gone bust (trillions of dollars worth) have to be sold, and it will be a fire sale at knocked down prices. That means enormous destruction of asset value, and someone has to feel the pain. AIG, for instance, has been given two years to sell down, so it is going to last a while.

Closing thought: It isn’t funny any more to say that the Indian financial regulatory system shines because of its innate caution.

T N Ninan

185) Central banking overhaul?

The debate on the functions of a central bank will be a topic of hot discussion for some time to come.

It all started with the bailout of Bear Sterns by the Federal Reserve, the US central bank. The financial crisis got worse with the takeover of Fannie Mae and Freddie Mac, when the US treasury extended government guarantee to private debt worth $5.3 trillion, nearly five times the size of the Indian economy. On Monday, Lehman Brothers filed for bankruptcy and Merrill Lynch agreed to a takeover by Bank of America. Insurance giant, AIG, has also got emergency funding from the Federal Reserve. The financial crisis is getting worse by the day.
The Federal Reserve’s response to the current crisis has led to considerable debate in the popular press. It has been argued that the Fed set a bad precedent by bailing out Bear Stearns at the start of the crisis. Bailing out financial institutions creates expectations of future bail-out, and hence, does little to prevent excessive risk taking, a problem known as moral hazard. Rather, to avoid a future financial crisis, some have called for an overhaul of the functioning of central banks. A prominent advocate of this view is Willem Buiter, a Professor at LSE and a former member of the Bank of England’s monetary policy committee.
In a paper* delivered at the Federal Reserve Bank of Kansas City last month, Buiter criticised the Fed on numerous issues. Since all of his criticisms cannot be covered here, we focus on a few examples. While some of his analysis makes sense, certain assessments remain unproven and some other suggestions are even ridiculous, according to Alan Blinder, an economics professor at Princeton University and the former vice-chairman of the Board of Governors of the Federal Reserve System, who was given the task of discussing Buiter’s paper at the conference**.
Let us first look at the least controversial of Buiter’s suggestions. According to international regulations, the banking sector currently operates with a minimum capital adequacy ratio of 8 per cent. This ratio measures the shareholders’ equity as a percentage of risk-weighted credit exposure. It is, in essence, a cushion against loan defaults and other types of risk. Both Fannie Mae and Freddie Mac merely had a capital adequacy ratio of around 0.5 per cent, which meant they could hardly bear the losses as mortgage defaults began to rise owing to the US house-price collapse. In this regard, Buiter persuasively argues that capital adequacy criteria should be extended to all financial institutions — including those which are considered “too large to fail”. He also suggests that serious penalties should be imposed on existing shareholders and management in case of inadequate capital holding, which should prevent excessive risk taking in the first place.
Elsewhere in the paper, Buiter argues that the Fed has consistently overestimated the fallout from the financial and housing sector meltdown on the real economy, a charge which Blinder strongly disagrees with. Buiter believes that, “The Fed listens to Wall Street and believes what it hears”. As a result of being too close to the financial markets, the Fed overreacted to the financial market turmoil and cut the official policy rate too far and too fast. In the process, the Fed itself may have helped create an inflation problem. It will take some time to see if events prove Buiter right.
Some of Buiter’s suggestions are radical, to say the least. For example, he advocates transferring the responsibility of taking interest rate decisions to another authority, leaving the central bank to focus exclusively on policy implementation. This, according to him would improve the decision-making process as the nexus between the financial sector and the central bank would be broken. To most, including Alan Blinder, this does not make any sense. He asks, “if we take the interest rate setting away from the central bank, to whom shall we give? ... To an agency that will almost certainly be less independent than the central bank?”
There are only a couple of points where Buiter and Blinder agree. For example, both agree that Fed should charge a higher-than-market interest rate for liquidity support provided to troubled institutions. Indeed, in the plan put together for Fannie Mae and Freddie Mac, this is exactly what the Treasury has done.
Overall, the spat between world’s two leading macroeconomists shows that the debate on the functions of a central bank will be a topic of hot discussion for some time to come.

Vidya Mahambare
The author is Senior Economist at Crisil

184) Bright side of a total financial market collapse

If only one were to look, one can spot many collateral benefits in the current financial turmoil.

One of life’s rules is that there’s bad in good and good in bad. The total collapse of the US financial system is no exception. Even in the midst of the current financial despair we can look around and identify many collateral benefits.
A lot of attractive office space seems to be opening up in midtown Manhattan, for instance, and the US government is now getting paid to borrow money. (And with T-bills yielding zero per cent, they really ought to borrow a lot more of it, and quickly.)
And so as Morgan Stanley Chief Executive Officer John Mack blasts short sellers for his problems, and Goldman Sachs CEO Lloyd Blankfein swans around pretending to be above this little panic, we ought to step back and enjoy the positives. To wit:
We finally get to see what’s inside these big Wall Street firmsWe’ve just witnessed the largest bankruptcy in US history and we know neither the inciting incident (though there is speculation that sovereign wealth funds decided to stop lending to Lehman Brothers Holdings Inc), nor the deep cause. But there’s now a pile of assets and liabilities smoldering in New York awaiting inspection.
The assets include subprime mortgages backed bonds and no doubt many other things that aren’t worth as much as Lehman hoped they might be worth. But it’s the liabilities that are most intriguing, as they include more than $700 billion in notional derivates contracts. Some of that is insurance sold by Lehman, against the risk of other companies defaulting.
The entire pile might be benign, but somehow I doubt it. We may well find out that Lehman Brothers, in liquidation, has a negative value of hundreds of billions of dollars. In that case the natural question will be: How much better could things be inside Morgan Stanley and Goldman Sachs, both of which were engaged in the same lines of business?
We are creating the financial leaders of tomorrowRemember when everyone believed in Alan Greenspan? When John McCain, running for president in 2000, said that if Greenspan died he’d have him stuffed and propped up against the wall at the Federal Reserve, where he’d remain chairman?
No sooner did Greenspan shuffle off the stage and sell his memoir than the financial system he helped shape fell apart. He’s left not only a mess but a void. No matter how well-educated we become in our financial affairs, we still need public officials to look up to, unthinkingly.
And there’s nothing like a government bailout to create new public-sector heroes. Hank Paulson, 62, is probably too old; in any case, he’s tarred by his association with both George Bush and Goldman Sachs. But 47-year-old Tim Geithner at the New York Fed is perfectly positioned to make Americans feel as if their financial system is in good hands for many years to come.
I have no real idea if Geithner knows what he’s doing and he may not either. (“Bail out that one. No! Not that one — the other one!”) It doesn’t matter. He’s in the middle of great events and should, by the end of them, know more about what happened than anyone.
Whatever happens to the US financial system, someone is bound to get the credit for something even worse not happening and, as no one really understands what Geithner does, he’s the obvious choice.
Ordinary Americans get a lesson in low financeIt’s been expensive but, then, so is kindergarten.
Our willingness to believe that we can hire some expert to tell us how to outperform markets is a big problem, with big consequences. It underpins Wall Street’s brokerage operations, for instance, and leads to a lot more people giving out financial advice than should be giving out financial advice.
Thanks to the current panic many Americans have learned that the experts who advise them what to do with their savings are, at best, fools. Merrill Lynch & Co, Morgan Stanley, Citigroup Inc and all the rest persuaded their most valuable customers to buy auction-rate bonds, telling them the securities were as good as cash.
Those customers will now think twice before they listen to their brokers ever again. Many, I’m sure, are just waiting to get their money back from their brokers before they race for the exits and introduce themselves to Charles Schwab.
Bank of America Corp will soon discover that the relationship between Merrill Lynch and its customers isn’t what it used to be, but Bank of America’s loss is America’s gain.
We have lots of new housesNot all of them have people in them, sadly, but that’s a minor detail. Even better, no one has had to pay for them, and probably never will. I’m betting that the US government will soon have no choice but to take the final step and guarantee every bad mortgage loan ever made by Wall Street.
I can hear you thinking: Doesn’t that mean the taxpayer foots the bill? That’s so negative! Sure, one day some taxpayer will foot the bill but if the government does what it does best, and continues to borrow huge sums from foreigners, it doesn’t have to be you or me.
Huge numbers of Wall Street executives will have the time to raise their childrenFor years now Wall Street has been far too lucrative for a certain kind of energetic and ambitious person to justify anything but the most perfunctory personal life. Now that the market for his services has collapsed, he has time to go home and figure out which of the children roaming around the mansion are actually his.
In time, he will learn to love them and they him, and they will gain the benefit of his wisdom and experience. Perhaps one day they will put it to use as traders and investment bankers, on the Wall Street of the future, where they will report to those exalted creatures of high finance: loan officers.
There, slowly, they can earn the money they will need to pay off the mortgages defaulted upon by their forebears.

Michael Lewis

183) IFRS: Are Indian Banks ready?

While regulators, standard setters and law makers sit together to rollout the road map for implementation of International Financial Reporting Standards (IFRS) in India, a wide section of the industry is already debating the impact and the implementation challenges of transitioning into IFRS. A remarkable and important element of smooth transition into IFRS is the convergence of RBI guidelines with the principles laid down in IFRS.

In other words, the successful adoption of IFRS is based on flexibility and acceptability of IFRS by RBI. Banks will have to soon adjust to accounting changes that are enforced by IFRS. The Following are a few areas of impact: Loan / Investment impairment : Currently, banks consider provisions on loans based on RBI guidelines, which are very prescriptive and require limited use of judgment. However, IFRS require a case by case assessment (for significant exposures) of the facts and circumstances surrounding the recoverability and timing of future cash flows relating to the credit exposure. For investments, fair value is also considered as an input in addition to the financial/ credit standing of the issuer. Fair Value : Under IFRS, a significant percentage of the balance sheet would have to be fair valued compared to the current practice of carrying it at historical cost /lower than the cost or fair value. Accordingly, fair value methodologies and practices would need to be re-examined to ensure that they are current, up to date and are validated and back tested in current market conditions. Derivatives and hedge accounting : Application of hedge accounting would bring down reducing income statement volatility.

However, this will entail onerous and stringent documentation requirements, mandatory effectiveness tests and determination of fair value based on observable inputs. This will also call for a much heightened awareness of rules for hedge relationships and certain processes and system changes. De-recognition of financial assets : Under IFRS, de-recognition of financial assets is a complex, multi-layered area that follows the principle of transfer of risks and rewards. In the Indian context, this will impact mainly the securitisation activity. Securitsation transactions — where credit collaterals are provided or guarantee is provided to cover credit losses in excess of the losses inherent in the portfolio of assets securitised — may not meet the de-recognition principles enunciated in IAS 39. This will result in failure of de-recognition test under IFRS and lead to collapse of securitisation vehicles into the transferor’s balance sheets. Banks will need to assess the impact and consider the potential impact on capital adequacy and ratios such as return on assets.

Consolidation : Under IFRS, consolidation is not driven purely by the ownership structure of an entity but will have to focus on the power to control an entity to obtain economic benefit. IFRS provides more rigorous consolidation tests and in practice can result in the consolidation of a larger number of entities as compared to under Indian GAAP. Banks will need to perform consolidation assessments as early as possible, particularly for non-shareholding related factors that impact consolidation, to assess its impact. Are banks ready ?

Convergence to IFRS is likely to pose significant challenges for banks, as shown by global experience. Certain large Indian banks, which have the benefit of going through the process of international GAAP such as US GAAP in the past, have recognised the challenges of convergence and have already started planning their detailed roadmap to achieve a smooth convergence. It is time for other banks to take the cue and follow suit. Critical to the successful implementation of IFRS in the Indian context would be the level of regulatory sponsorship, the appropriate level of investment in systems and processes and consistency in market practices for areas where judgment is critical. A move to IFRS can be a compared to the mountain peak which can certainly be scaled if well planned and appropriately executed!!

Manoj Kumar Vijai

(The author is KPMG India executive director. The view is personal)