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213) Should the RBI hike the SLR?

2009-03-02T07:30:00.000-08:00

An SLR hike will immediately translate into a rise in the demand (from banks) for government bonds, says Abheek Barua.

My colleague, Amit Dayal — astute money manager, foodie and recent convert to gym-ming — has come up with what seems like a pretty smart way to counter the upward pressure on bond yields. But before I get to the specifics of his suggestion, let me start with a bit of a prelude.

In the second half of 2008, the markets viewed expansionary fiscal policy as a deus ex machina that would lift it out of its funk. Ironically enough, as a number of government exchequers obliged by loosening their purse strings and President Obama handed out the mother of all fiscal packages, the market suddenly woke up to the fact that these fiscal steps entailed significant costs.

As governments turned to the bond markets to fund their fiscal binge, bond yields rose sharply and now threaten to stall lending rate reductions. In India, for example, the 10-year bond yield has risen by a hefty 160 bps between the low of early January and the level today. This has been in response to the huge additional government borrowing — Rs 46,000 crore for the current year despite which there is a fiscal hole of Rs 45,000 crore. The government is now filling this hole by transferring money locked up in Money Stabilisation Bonds (MSS).However with the stock of MSS dwindling fast it might not have that option next year. The central government incidentally needs to pick up at least Rs 3,70,000 crore from the market in the next fiscal, going by the calculations in the interim budget.

The fear of government ‘crowding out’ private spending might appear, at least at this stage, a tad irrational. Private credit demand is collapsing as the recession intensifies and government demand is likely to fill the void left behind. Thus neither yields nor interest rates should necessarily harden in the near term even if the government guzzles funds. Should the market rest easy then?

Perhaps not. For any forward-looking investor, the longer-term consequences of a fiscal bloat are difficult to ignore. For one, while it is easy to run up a large deficit very quickly, they are difficult to tame. A large deficit entails high interest costs for the government that feed the fiscal gap leading to more borrowings. In short, the government is likely to remain a large borrower for a good few years if there is a large fiscal overrun now. The implication — whenever private credit demand picks up, the competition from the public sector would push borrowing rates up and stymie growth. This anxiety is getting reflected in high government yields.

Is there a way to handle the increased government draft on resources without pushing rates up? Monetary policy rates at close to zero in the developed markets rule out further rate action; the only option for central banks would be to keep buying back government bonds, which de facto means monetising the fiscal deficit. Amit suggests that the impact of government borrowings can be handled better in India than in other markets. This is essentially because of the unique monetary device that we have called the statutory liquidity ratio or SLR (the fraction of the banks’ aggregate liabilities that they are mandated to hold in government securities). It is currently at 24 per cent.

The crux of Amit’s argument is the following — instead of focusing entirely on shoring up the supply of liquidity to check bond yields, the government might be better off in trying to best push up what he calls the ‘inherent demand’ for government bonds. If there is no inherent demand, he argues, growing supplies of bonds will keep pushing yields up. The easiest way to increase this ‘inherent demand’ is by hiking the SLR. This will immediately translate into a rise in the demand (from banks) for government bonds; as banks are forced to buy bonds, bond prices will move up and bond yields would head down. A 1 per cent increase in the SLR, incidentally, yields additional demand for government bonds of roughly Rs 40,000 crore.

What are the advantages of this somewhat unorthodox strategy? If bond yields come down, the government borrows at a lower average cost. This could dampen the fiscal spiral that high interest bills set off. Banks stand to make marked-to-market gains on their bond books and this could give them a cushion to absorb the costs that could follow from a rise in non-performing loans that are likely to rise in a downturn. The RBI, in its avatar of merchant banker to the government, can push through the government borrowing programme more easily.

A policy involving an increase in the government’s draft on funds in the middle of a slowdown might seem a little counterintuitive. However, if you follow Amit’s logic through, it appears to make sense. For one, the governments will remain the bigger provider of demand in a business cycle trough and the sensible thing to do is to ensure that their access to funds is easy and comes cheap. An SLR increase ensures this.

Are banks likely to worry about the impact on liquidity that a hike in SLR entails? Could this affect the flow of credit to the non-government sector? The way around this, Amit argues, is to provide refinance to banks against the entire additional stock of SLR that they need to hold. If liquidity does tend to tighten a little, banks can turn to this window to access liquidity. The refinance could come at the repo rate. If the RBI wants to signal lower cost of funds, it needs to cut the repo rate.

What happens as the economy starts picking up and private borrowers need more credit? The RBI would have to reduce SLR to accommodate this and this could potentially spike yields up. Amit accepts that while this could potentially lead to marked-to-market losses on banks portfolios, there could be a few offsets. Economic recovery is likely to coincide with an improvement in government finances. If indeed the government borrows less incrementally, the impact of a reduction in SLR on bond yields need not be sharp.

Amit mailed me a note on this titled ‘Wild Thoughts’. Perhaps his thoughts are not so wild after all. I wonder what Dr Subbarao would have to say.

The author is chief economist, HDFC Bank. The views here are personal

212) Are we going to face problems of deflation?

2009-02-25T21:53:00.000-08:00

Nowadays we keep on reading that global economies such as US and Europe will face severe problems of deflation due to recession. Fed fund rate in the US is between 0.00-0.25% or 25 bp (100 basis point = 1%). Inflation in these countries is close to 0. With the falling interest rates in India will we too face similar situation?

Deflation is a “sustained” fall in the general price level of goods and service below zero percent inflation. It results in an increase in the real value of money — a negative inflation rate. It is just opposite of inflation, which is the general increase in the price level of goods and services. When the inflation rate slows down (decreases, but remains positive), this is known as disinflation. Disinflation is a substantial drop in the rate of increase of the price level. Deflation should not be confused with temporarily falling prices; instead, it is a sustained fall in general prices.

Inflation destroys real value in money whereas Deflation creates real value in money.

Real Price ~ Nominal Price –Inflation

With the passage of time, the “real price” of any good or service is characterized by above equation. Hence, if it is positive inflation or normal inflation, real price decreases over a period of time. However, if inflation is negative i.e. deflation, real price increases with time. Alternatively, the term deflation was used by the classical economists to refer to a decrease in the money supply and credit.

Causes of deflation

1. Deflation is caused by the fall in aggregate level of demand i.e. there is a fall in how much the whole economy is willing to buy, and the going price for goods. Because the price of goods is falling, consumers have an incentive to delay purchases and consumption until prices fall further, which in turn reduces overall economic activity - contributing to the deflationary spiral. (As we can currently see that buyers believe real estate prices will fall further, thus delaying their purchase decisions. This in turn has reduced the demand for the real estate properties which in turn has reduced the construction activities. Thus, general economic activities such as cement production etc are down.)

As demand and economic activity falls, investments fall as well because corporate do not want to invest in increasing capacity as there is no demand. This leads to further reduction in aggregate demand. This is the deflationary spiral i.e. a situation where decreases in price lead to lower production, which in turn leads to lower wages and demand, which leads to further decreases in price. An answer to falling aggregate demand is stimulus, either from the central bank, by expanding the money supply, or by the fiscal authority to increase demand such as reducing interest rates or giving money to corporate or people at significantly lower rates.

2. In monetarist theory, deflation is related to a sustained reduction in the velocity of money (It is the average frequency with which a unit of money is spent in a specific period of time. Velocity affects the amount of economic activity associated with a given money supply) or number of transactions. This is attributed to a dramatic contraction of the money supply, perhaps in response to a falling exchange rate, or to adhere to a gold standard or other external monetary base requirement. In the present scenario it appears to be one of the prime reasons for growing fears of deflation.

3. Deflation also occurs when improvements in production efficiency lower the overall price of goods. Improvements in production efficiency generally happen because economic producers of goods and services are motivated by a promise of increased profit margins, resulting from the production improvements that they make. Competition in the marketplace often prompts those producers to apply at least some portion of these cost savings into reducing the asking price for their goods. When this happens, consumers pay less for those goods; and consequently deflation has occurred, since purchasing power has increased.

4. Deflation may be caused by a combination of the supply and demand for goods and the supply and demand for money, specifically the supply of money going down and the supply of goods going up. Historic episodes of deflation have often been associated with the supply of goods going up (due to increased productivity) without an increase in the supply of money, or (as with the Great Depression and possibly Japan in the early 1990s) the demand for goods going down combined with a decrease in the money supply.

Indian scenario – Last few years we saw massive boom in all the sectors. There were huge demands for real estate properties, IT services, Cements, Food products etc. Our economy was growing in excess of 9% and mood was upbeat. Everybody thought this growth will continue forever. Hence, corporate invested heavily in building capacity, developers invested billions of dollars in launching new projects etc. Suddenly the boom busted due to financial crisis. People lost jobs, interest rates went up through the roof and demand plunged. There was a huge mismatch between supply (more) and demand(less). This led to price correction - real estate saw over 40% drop in prices, commodities went down by over 70% and so on. Moreover, due to global financial crisis, there is acute shortage of liquidity in the market and hence less flow of money in the economy. People are holding back to their investments as well as consumption; thus, reducing velocity of money. Does it sound like symptoms of deflation?

Effects of deflation

1. Deflation leads to decrease in prices of good and services, increasing value of money. While an increase in the purchasing power of one's money sounds beneficial, it can actually cause hardship when the majority of one's net worth is held in illiquid assets such as homes, land, and other forms of private property.

2. Deflation raises real wages, which are both difficult and costly for management to lower. Moreover, falling prices and demand discourages corporations from investing. This frequently leads to layoffs and makes employers reluctant to hire new workers, increasing unemployment.

3. Deflation often follows a period of nearly zero interest rates. When the central bank has lowered nominal interest rates all the way to zero, it can no longer further stimulate demand by lowering interest rates. This is the famous liquidity trap. When deflation takes hold, it requires "special arrangements" to "lend" money at a zero nominal rate of interest (which could still be a very high real rate of interest, due to the negative inflation rate) in order to (artificially) increase the money supply.

Why deflation is bad?

While shoppers see falling prices as a good sign, economists see it as a threat to the economy or nation. Deflation hurts the economy much more than inflation. In fact a small positive inflation is good for the economy because it suggests growing demand as well as healthy economy. However, in deflationary conditions consumers postpone expenditure, because they think prices will decrease further. This decreases demand in the economy which badly affects firms, who then scale back production and investment plans, leading to job losses, further affecting purchasing power and demand, which leads to a downward spiral in the economy.

We will now take a look at the most infamous deflation in the history of modern world.

Deflation in Japan

Deflation in Japan started in the early 1990s. The Bank of Japan and the government tried to eliminate it by reducing interest rates, but this was unsuccessful for over a decade. In July 2006, the zero-rate policy was ended. There were several reasons for deflation in Japan which are explained below:

1. Bust of Asset price bubble: There was a rather large price bubble in both equities and real estate in Japan in the 1980s (peaking in late 1989). When assets decrease in value, the money supply shrinks, which is deflationary.

2. Insolvent companies: During the boom time (1980s) Japanese banks lent aggressively to companies and individuals that invested in real estate. However, when real estate values dropped, people were not able to pay back these loans to banks. The banks tried to collect the collateral (land or properties), but this wouldn't pay off the loan because their prices had fallen significantly. Banks delayed their decision to foreclose these loans hoping asset prices would improve. These delays were also allowed by national banking regulators. This continuing process is known as maintaining an "unrealized loss", and until the assets are completely revalued and/or sold off (and the loss realized), it will continue to be a deflationary force in the economy. Improving bankruptcy law, land transfer law, and tax law were suggested by leading economists as methods to speed this process and thus end the deflation.

3. Insolvent banks: Japanese banks had a larger percentage of their loans as "non-performing" i.e. they were not receiving any interest payments on them, but have not yet written them off. With high non-performing loans or assets, they were unable to lend more money; thus, their earnings declined significantly and risk of insolvency increased many a fold.

4. Imported deflation: Japan imports Chinese and other countries' inexpensive consumable goods, raw materials (due to lower wages and fast growth in those countries). Thus, prices of imported products were decreasing with the rise of economy of scale in China. Domestic producers had to lower their prices in order to remain competitive. This decreasing in prices of domestic products over a period of time led to deflation.

5. Fear of insolvent banks: Japanese people were afraid that banks might collapse so they preferred to buy gold or (United States or Japanese) Treasury bonds instead of saving their money in local bank accounts. Thus less money was available for lending and therefore economic growth. This meant that the savings rate depresses consumption, but did not appear in the economy in an efficient form to spur new investment.

Deflation alarms in the US?

With the fed fund rate at a historic low (0.00-0.25%), there is a growing fear of deflation in the US. Many economists believe that USA could face short term period of deflation. With the bust of housing bubble, acute shortage of credit and falling consumption, USA has more or less similar conditions that were prevalent in Japan in early 1990s. However, I believe there are some basic yet crucial differences.

Firstly, Japanese companies were far more dependent on commercial banks for financing than are today's U.S. multinationals, which have stockpiles of internal capital as well as broader access to capital markets. Moreover, US Treasuries are still considered as the safest investments in the world. This keeps the flow of money into the US economy.

Secondly, Bank of Japan’s exceptionally poor monetary policymaking was a big reason for the country's protracted problem. The central bank's failure to lower interest rates in the early 1990s ultimately drove the economy into a deflationary death spiral. They were just too slow and conservative to react to the situation. However, US Fed has been quite aggressive and proactive in taking sound monetary decisions and ensuring that they do not repeat those mistakes. In 1992, for example, amid negligible inflation and a comatose economy, the Bank of Japan's key interest rate was still nearly 4%. In contrast, after the tech bubble burst in the USA, the Fed quickly slashed its benchmark rate to 1 %. Also, the current fed rate is between 0.00-0.25%.

Thirdly, though both USA and Japan faced housing trouble and mortgage crisis, Japan's central bank was too slow to act. The country's banks hid their bad loans beneath opaque corporate structures rather than absorb the losses. But rather than write off the loans, Japanese banks extended additional credit to borrowers, allowing them to at least make minimal interest payments. Those made banks look healthier than they were, at the cost of impairing the flow of credit to new businesses. However, American banks have been forthcoming in absorbing the losses on their books and writing off loans. This has given fed a clear picture of true losses and subprime crisis in the economy.

Having said that I believe the US economy may bleed for some time and enter a period of deflation. However, that period would be short lived and not as prolonged as that of Japanese economy in 1990s. As per an estimate, avoiding a long period of deflation and recession might cost the US a staggering $3 Trillion.

Will India face deflation?

Let’s examine Indian economy vis-à-vis Japanese economy of 1990s. In the last five years BSE exchange went up from 5,000 to 21,000, an increase of 400% while real estate prices in Indian witnessed an increase of over 300%. This is phenomenal increase in prices and asset prices looked highly inflated. After the global financial crisis, Indian stock exchange plunged by over 60% and real estate values dropped by almost 30-40% in less than six months. Some welcomed this fall while majority believed Indian global dream is finally over. The mayhem still continues with stock prices and real estate prices further going down.

Compare this with that of Japan - In the five years before its 1989 peak, the Nikkei (Japanese stock exchange) stock average rose 275%. Property prices became so inflated that the tiny spit of land surrounding the Imperial Palace in central Tokyo was briefly worth more than the entire state of California. At the time, Japan's seemingly unstoppable rise inflamed fears among Americans that the United States had slipped into permanent economic inferiority. When the bubble finally busted in late 1989, stock and property prices nose-dived in tandem. In less than three years, the Nikkei stock average fell 63% from its peak of 38,916. It didn't hit bottom until April 2003 and a total decline of 80%. Do these two stories sound similar? Yeah they do!

Inflation figures for the last week was 3.92% which is far less than the peak rate of 12% less than six months back. Are we going into a period of negative inflation or deflation? We are currently in a state of disinflation which is a decreasing value of inflation as the inflation rate is still positive. However, this may lead to a situation where downward price movement continues and we enter a period of deflation. I believe this is highly unlikely because we are a growing economy with very young population. Moreover, we are not an export oriented economy and hence do not depend too much on external demand. Our economy is mostly driven by domestic demand and consumption, which is somewhat insulated from other countries and global events. We still have lot of room to maneuver our policies to regenerate demand and spending. Yet, with the growing globalization we too run a risk of deflation if our monetary and fiscal policies are not handled well.

How deflation can be avoided?

To counter deflation we have to revitalize our growth story, reignite demand and create confidence among people. Compare to the inflation rate, 3.92%, lending rates in India are still close to 10%, which is quite high. Unless lending rates do not come down people won’t buy properties, automobiles or other consumer goods. Moreover, corporate won’t be able to borrow money to launch new innovative projects, spend on infrastructure or build capacity. Thus, to create demand and investments, government as well as RBI has to bring down this lending rate by implementing ways to reduce cost of borrowing funds.

Hence, only monetary policy won’t be sufficient to tackle this menace; fiscal policy too has to play a significant role here. Government has to be more aggressive in implementing reforms and speeding up infrastructure spending. Let us hope better sense will prevail among our political class.

Rahul Singh

www.theindianmoney.com

211) Fixed Income Securities - Bonds Basics

2009-02-23T17:38:00.000-08:00

A bond is a debt security, similar to an I.O.U (I Owe yoU) .When you purchase a bond; you are lending money to the issuer which may be a government, municipality, corporation, federal agency, corporate or other entity. In return for the loan, the issuer promises to pay you a specified rate of interest during the life of the bond and to pay back the face value of the bond or the principal when it “matures,” or comes due.

Among the types of bonds you can choose from are: government securities, municipal bonds, corporate bonds, mortgage and asset—backed securities and foreign government bonds.

Types of Bonds

Zero coupon bonds do not pay any interest. They are issued at a substantial discount to par value. The bond holder receives the full principal amount on the redemption date. Zero coupon bonds may be created from fixed rate bonds by a financial institutions separating "stripping off" the coupons from the principal. In other words, the separated coupons and the final principal payment of the bond are allowed to trade independently.

Government Securities is a bond where government is the issuer or borrower. It is the safest form of bond as it is extremely unlikely that the government defaults (unless the economy is as bad as that of Pakistan). Government issues bonds to raise money for funding infrastructure development, support subsidies or several other initiatives. For example government of India has recently started issuing fertilizer and oil bonds to Public Sector companies to fund subsidies on fertilizers and oils.

Municipal Bond is a bond issued by a state, local government, or their agencies. Interest income received by holders of municipal bonds is often exempt from the income tax and from the income tax of the state in which they are issued, although municipal bonds issued for certain purposes may not be tax exempt.

Corporate Bond is a bond issued by corporate i.e. public or private companies to the investors. The company borrows money from investors and promise to pay interest at regular interval. The interest rates on such bonds are high compared to government bonds because the probability of government defaulting on interest payments is low compared to that of corporate. Hence, corporate bonds have high risk and hence require higher return.

High Yield Bonds are those bonds that are rated below investment grade (lower than BBB-) by the credit rating agencies. I will talk in details about rating agencies and bond rating. As these bonds are more risky than investment grade bonds, investors usually expect to earn a higher yield. These bonds are also known as Junk Bonds.

Inflation linked bonds are bonds where the principal amount and interest payments are indexed to inflation. The interest rate is usually lower than that of fixed rate bonds with a comparable maturity. Though, as the principal amount grows, the payments increase with inflation. The government of the United Kingdom was the first to issue inflation linked bonds in the 1980s. Treasury Inflation-Protected Securities (TIPS) and I-bonds are examples of inflation linked bonds issued by the U.S. government.

Other indexed bonds, for example equity-linked notes and bonds indexed on a business indicator (income, added value) or on a country's GDP.

Asset-backed Securities are bonds whose interest and principal payments are backed by underlying cash flows from other assets. Examples of asset-backed securities are mortgage-backed securities (MBS's), collateralized mortgage obligations (CMOs) and also collateralized debt obligations (CDOs).

Subordinated Bonds are those that have a lower priority than other bonds of the issuer in case of liquidation/winding up. In case of bankruptcy, there is a hierarchy of creditors. First and foremost the liquidator is paid, then government taxes, etc. The first bond holders in line to be paid are those holding what is called senior bonds. After these senior bonds have been paid, the subordinated bond holders are paid. As a result, the risk is higher. Thus, subordinated bonds generally have a lower credit rating than senior bonds. The main examples of subordinated bonds can be found in bonds issued by banks, and asset-backed securities. The latter are often issued in tranches. The senior tranches get paid back first; the subordinated tranches are paid later.

Perpetual Bonds are generally called perpetuities. They have no maturity date.

Bearer Bond is an official certificate issued without a named holder. In other words, the person who has the paper certificate that is the bearer can claim the value of the bond. Usually they are registered by a number to prevent counterfeiting, but may be traded like cash. Bearer bonds are very risk prone because they can be lost or stolen.

Registered Bond is a bond whose ownership and any subsequent purchaser are recorded by the issuer, or by a transfer agent. It is the alternative to a Bearer bond. Interest payments, and the principal upon maturity, are sent to the registered owner only.

Fixed Rate Bonds have a coupon (interest) that remains constant throughout the life of the bond.

Floating rate notes (FRNs) have a coupon which is linked to an index. Common indices include: money market indices, such as LIBOR or Euribor, and CPI (the Consumer Price Index). Coupon examples: 3 month USD LIBOR + 0.20%, or twelve month CPI + 1.50%. FRN coupons reset periodically, usually every one or three months. In assumption, any Index could be used as the basis for the coupon of an FRN, so long as the issuer and the buyer can agree to terms.

Features of Bonds

The most important features of a bond are:

Principal or face amount -It is the amount on which the issuer pays interest, and which has to be repaid at the end.

Issue price - It is the price at which investors buy the bonds when they are first issued, which will normally be approximately equal to the principal amount. The net proceeds that the issuer receives are thus the issue price, less issuance fees.

Maturity date -It is the date on which the issuer has to repay the principal amount. As long as all payments have been made, the issuer has no more compulsions to the bond holders after the maturity date. The length of time until the maturity date is called as the term or tenure or maturity of a bond. The maturity can be any length of time, though debt securities with a term of less than one year are generally designated money market instruments rather than bonds. Most bonds have a term of up to 30 years. Few bonds have been issued with maturities of up to one hundred years, and some even do not mature at all. In early 2005, a market developed in Euros for bonds with a maturity of fifty years.

In the market for government securities, there are three groups of bond maturities:

• Short term (bills): maturities up to 1 year;

• Medium term (notes): maturities between 1 and 10 years;

• Long term (bonds): maturities greater than 10 years.

Coupon -Coupon is the interest payment that the issuer pays to the bond holders. Generally coupon rate is fixed throughout the life of the bond. It can also vary with a money market index, like LIBOR, or it can be even more exotic. The name coupon originates from the fact that in the past, physical bonds were issued which had coupons attached to them. On coupon dates the bond holder would give the coupon to a bank in exchange for the interest payment.

Indentures and Covenants - An indenture is a formal debt agreement that creates the terms of a bond issue, while covenants are the clauses of such an agreement. Covenants state the rights of bondholders and the duties of issuers, such as actions that the issuer is obligated to perform or is prohibited from performing. In the central and state securities and commercial laws apply to the enforcement of these agreements, which are interpreted by courts as contracts between issuers and bondholders. The terms may be changed only with great difficulty while the bonds are outstanding, with amendments to the governing document usually requiring approval by a majority (or super-majority) vote of the bondholders.

Coupon date- These are the dates on which the issuer pays the coupon to the bond holders. In the India most bonds are semi-annual, which means that they pay a coupon every six months.

We will now discuss Government bonds in great detail in rest of the article.

Government Bond

A Government security is a tradable security issued by the Central Government or the State Governments, acknowledging the Government’s debt obligation. Such securities can be short term (usually called Treasury Bills, with original maturities of less than 1 year) or long term (usually called Government bonds or dated securities with original maturity of one year or more). In India, the Central Government issues both Treasury Bills and bonds or dated securities while the State Governments issue only bonds or dated securities, which are called the State Development Loans (SDLs). Government securities carry practically no risk of default and, hence, are called risk-free instruments. Government of India also issue savings instruments (Savings Bonds, National Saving Certificates (NSCs), etc.) or special securities (Oil bonds, FCI bonds, fertilizer bonds, power bonds, etc.) but they are usually not fully tradable and are not eligible for meeting the SLR requirement.

One of the world’s largest and most liquid bond markets is comprised of debt securities issued by the U.S. Treasury, by U.S. government agencies and by U.S government-sponsored enterprises.

Treasury Bills (T-Bills)

Treasury Bills, which are money market instruments, are short term debt instruments issued by the Government of India and are presently issued in three tenors, viz., 91 day, 182 day and 364 day. Treasury Bills are zero coupon securities and pay no coupon. They are issued at a discount and redeemed at the face value at maturity. The return to the investors is, therefore, the difference between the maturity value or face value (i.e., Rs.100) and the issue price.

For example, a 91 day Treasury Bill of Rs.100/- (face value) may be issued at a discount of say, Rs.1.80, that is Rs.98.20 and redeemed at the face value of Rs.100. Thus, the buyer will pay Rs. 98.2 today for 1 unit of Treasury Bill worth Rs. 100. After 91 days he will get Rs. 100. Hence, his return would be:

(100-98.2)/98.2 = 1.83% for 91 days period

= 1.83*4 for 1 year (Simple Interest payment i.e. 365/91 ~ 4 periods)

= 7.32% per annum simple interest rate.

Treasury Bills are issued through auctions conducted by the Reserve Bank of India usually every Wednesday and payments for the Treasury Bills purchased have to be made on the following Friday. The Treasury Bills of 182 days and 364 days' tenure are issued on alternate Wednesdays, that is, Treasury Bills of 364 day tenure are issued on the Wednesday preceding the reporting Friday while Treasury Bills of 182 days tenure are issued on the Wednesday prior to a non-reporting Friday. Currently, the notified amount for issuance of 91 day and 182 day Treasury Bills is Rs.500 crore each whereas the notified amount for issuance of 364 day Bill is higher at Rs.1000 crore.

An annual calendar of T-Bill issuances for the following financial year is released by the Reserve Bank of India in the last week of March. The Reserve Bank of India also announces the issue details of Treasury bills by way of press release every week.

Dated Government Securities

Dated Government securities are longer term securities and carry a fixed or floating coupon (interest rate) paid on the face value, payable at fixed time periods (usually half-yearly). The tenor of dated securities can be up to 30 years. The Public Debt Office (PDO) of the RBI acts as the registry / depository of

Government securities and deals with the issue, interest payment and repayment of principal at maturity. Most of the dated securities are fixed coupon securities. The nomenclature of a typical dated fixed coupon Government security has the following features - coupon, name of the issuer, maturity and face value. For example, 7.49% GOI 2017 would have the following features:

Date of Issue : April 16, 2007

Date of Maturity : April 16, 2017

Coupon : 7.49% paid on face value

Coupon Payment Dates : Half-yearly (October16 and April 16) every year

Minimum Amount of issue/ sale : Rs.10,000

Dated securities may be of the following types:

1. Fixed Rate Bonds

2. Floating Rate Bonds

3. Zero Coupon Bonds

4. Capital Indexed Bond

5. Bonds with Call/Put Options

State Development Loans (SDLs)

State Governments also raise loans from the market. SDLs are dated securities issued through an auction similar to the auctions conducted for dated securities issued by the Central Government. Interest is serviced at half-yearly intervals and the principal is repaid on the maturity date. Like dated securities issued by the Central Government, SDLs issued by the State Governments qualify for SLR. They are also eligible as collaterals for borrowing through market repo as well as borrowing by eligible entities from the RBI under the Liquidity Adjustment Facility (LAF).

How are the Government Securities issued?

Government securities are issued through auctions conducted by the RBI. Auctions are conducted on the electronic platform called the Public Debt Office – Negotiated Dealing System (PDO-NDS). Commercial banks, scheduled urban cooperative banks, Primary Dealers, insurance companies and provident funds, who maintain funds account (current account) and securities accounts (SGL account) with RBI, are members of this electronic platform. All members of PDO-NDS can place their bids in the auction through this electronic platform. All non-NDS members including non-scheduled urban co-operative banks can participate in the primary auction through scheduled commercial banks or Primary Dealers. For this purpose, the urban co-operative banks need to open a securities account with a bank / Primary Dealer – such an account is called a Gilt Account. A Gilt Account is a dematerialized account maintained by a scheduled commercial bank or Primary Dealer for its constituent (e.g., a non-scheduled urban co-operative bank).

The RBI, in consultation with the Government of India, issues an indicative half-yearly auction calendar which contains information about the amount of borrowing, the tenor of security and the likely period during which auctions will be held. A Notification and a Press Communiqué giving exact particulars of the securities, viz., name, amount, type of issue and procedure of auction are issued by the Government of India about a week prior to the actual date of auction.

Types of Auction

With the introduction of auctions, the rate of interest (coupon rate) gets fixed through a market based price discovery process. An auction may either be yield based or price based.

Yield Based Auction

A yield based auction is generally conducted when a new Government security is issued. Investors bid in yield terms up to two decimal places (for example, 7.85 per cent, 7.87 per cent, etc.). Bids are arranged in ascending order and the cut-off yield is arrived at the yield corresponding to the notified amount of the auction. The cut-off yield is taken as the coupon rate for the security. Successful bidders are those who have bid at or below the cut-off yield. Bids which are higher than the cut-off yield are rejected. An illustrative example of the yield based auction is given below:

Yield based auction of a new security

• Maturity Date: September 8, 2018

• Coupon: It is determined in the auction (8.22% as shown in the illustration below)

• Auction date: September 5, 2008

• Auction settlement date: September 8, 2008

• Notified Amount: Rs.1000 crore

The issuer would get the notified amount by accepting bids up to 5. Since the bid number 6 also is at the same yield, bid numbers 5 and 6 would get allotment pro-rata so that the notified amount is not exceeded. In the above case each would get Rs. 50 Crore. Bid numbers 7 and 8 are rejected as the yields are higher than the cut-off yield.

Price Based Auction
A price based auction is conducted when Government of India re-issues securities already issued earlier. Bidders quote in terms of price per Rs.100 of face value of the security (e.g., Rs.101.02, Rs.100.95, Rs.99.80, etc., per Rs.100/-). Bids are arranged in descending order and the successful bidders are those who have bid at or above the cut-off price. Bids which are below the cut-off price are rejected. An illustrative example of price based auction is given below:

Price based auction of an existing security 8.24% GS 2018
• Maturity Date: April 22, 2018
• Coupon: 8.24%
• Auction date: September 5, 2008
• Auction settlement date: September 8, 2008
• Notified Amount: Rs.1000 Crore

The issuer would get the notified amount by accepting bids up to 5. Since the bid number 6 also is at the same yield, bid numbers 5 and 6 would get allotment in proportion so that the notified amount is not exceeded. In the above case each would get Rs. 50 Crore. Bid numbers 7 and 8 are rejected as the price quoted is less than the cut-off price.

http://theindianmoney.com

210) Inflation and RBI’s response to it in 2008

2009-02-21T18:49:00.000-08:00

You may remember that the main culprits of inflation last year were:
1. Higher crude prices – Due to rapid growth of global economy in 2007 and early 2008 there was a huge demand for crude. Also, when stock market started showing weaknesses across the globe, investors started parking their money in commodities such as Crude.
2. Supply constraint – Unprecedented drought in Australia and some part of Americas caused shortage of food grains in the global market. India too had a very bad production year and we had to import grains from the global market. This led to increase in general increase in food grains prices.
3. Excess liquidity – High growth in emerging economies like India attracted huge amount of foreign capital. A situation like too much money chasing too few goods lead to inflation. This exactly what happened in India.

Why does rise in crude price lead to inflation?
Let us begin with a brief discussion on crude prices. It is an extremely important commodity which affects our day to day life in some form or other. Crude prices gave sleepless nights to almost everyone on this planet. It touched $140 per barrel within no time. Government across the world was busy thinking about how to tame inflation which resulted from crude prices. This indicates that the crude price directly affects the inflation. I have done a comparative analysis of increase in crude price and inflation to figure this out.

You can see the graphs for crude oil prices and inflation rate almost mirrors itself. Would it be safe to assume that crude influences inflation to a great extent? Well to a great extent YES. The crude price is an extremely important part of inflation calculation whether it is based on CPI or WPI. If we see the table below, fuel has over 10% weight in the WPI index, which is used to calculate inflation in India. Moreover, the change of fuel prices affects almost every goods and services in India because it increases transportation costs, cost of production for manufacturing and utilities prices. Thus, any change in fuel price affects inflation.

for more pls click the below mentioned link.

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209) High forex reserves can worsen recession

2009-02-08T06:21:00.000-08:00

High foreign exchange reserves have, in the current global recession, saved Asian countries (including India) from the travails they suffered in the Asian financial crisis of 1997-2000. So, they must aim for rising forex reserves in future too, right? Wrong.

In truth, high Asian forex reserves are an important reason for the current recession. High reserves promise safety in a storm. But, beyond a point this safety becomes illusory, because rising forex reserves worsen the global imbalances that have precipitated the recession.

The global recession has many roots. One is the erosion of traditional US household prudence. US households used to save 6% of their disposableincome. But in recent years they went on a borrowing and spending spree, and household savings dropped to virtually zero. Corporations and financiers also ran up record debts, partly to buy assets such as houses, stocks and commodities. This created huge bubbles in all three markets.

When the bubbles finally burst, US households, corporations and financiers found themselves in dire straits. Many financial giants were rescued by the government. Meanwhile households, sobered by the turn of events, started saving 4% of disposable income, up from zero. More saving meant less spending, and made the recession deep and sharp.

Most Asians are smugly blaming US imprudence and loose financial regulation for the crisis, while portraying themselves as innocent victims. Yet, they must share the guilt too. US profligacy did not arise in a vacuum. It arose in part because Asian insistence on high forex reserves meant that they poured dollars into the US to buy US securities. This flood of dollars from Asia drove down US interest rates, making it very attractive to borrow. That spurred the borrowing spree, and the accompanying bubbles.

Historically, rich countries had surplus savings, manifested in a trade surplus. Poor countries lacked savings, manifested in trade deficits, with the deficit being plugged by an inflow of dollars from rich to poor countries. For the world as a whole, current account surpluses and deficits of countries must necessarily balance. Historically, the surpluses of rich countries were offset by the deficits of poor ones.

But after the Asian financial crisis, something strange happened. Asian countries, above all China, began generating huge savings surpluses, manifested in huge current account surpluses. Many used undervalued exchange rates to artificially create trade surpluses, which were then invested in US treasuries (that is what foreign exchange reserves are).

However, poor Asians could not run huge surpluses unless others were willing to run huge deficits. Remarkably, the rich US began to do so. This arose partly from the sophistication of its financial system, which found many ways - too many, in fact - of converting the flood of money from Asia into a borrowing and spending spree. This sharp rise in US spending boosted the global economy, and created the record global GDP growth in 2003-08. US demand sucked in huge quantities of manufactures and services from Asia, above all from China. Asian manufacturing sucked in huge quantities of commodities from Africa and Latin America, raising incomes there too.

Alas, this boom was based on huge global imbalances that had to be corrected at some point. No country, not even the rich US, could keep running gargantuan trade deficits forever, to offset the surpluses of Asia. US asset bubbles burst, the boom ended, and US spending and imports plummeted.

Ending the consequent recession means reducing global imbalances to manageable proportions. Americans will have to save more, spend less and export more. Asian countries, especially China, will have to consume more, save less, and export less. This re-balancing will restore global balance, and enable global growth to rise sustainably again.

However, such re-balancing means that Asian countries must stop piling up ever-rising forex reserves (and trade surpluses). Such reserves represent excessive saving, excessive exports and insufficient imports. Excess forex reserves have provided apparent safety to Asian countries in a recessionary crisis, yet are also a cause of that very crisis.

What will happen if Asians insist on trying to keep savings and forex reserves high? Well, if Asians keep savings high and Americans and Europeans do so too, then world demand will collapse and the recession will become a Depression. Asians must recognise that high forex reserves serve as a safety cushion only up to a point, and beyond that exacerbate global imbalances that threaten disaster. Saving too much can be as harmful as saving too little. Unless Asian countries recognize this and go slow on future reserve accumulation, the recession may become worse than anyone dares imagine today.

208) BASEL II roadmap

2009-02-06T18:11:00.000-08:00

The Reserve Bank of India (RBI) has worked out the roadmap for the Indian banks to graduate from the simpler approaches of the Basel II framework to more advanced ones.

Basel II is the second among Basel Accords, which are primarily, recommendations on banking laws and regulations issued by the Basel committee on banking supervision.

It sets up rigorous risk and capital management requirements aimed at ensuring that a bank holds capital reserves appropriate to the risk it exposes itself to through its lending and investment practices.

Since March 2008, foreign banks operating in India and Indian banks having presence outside the country have migrated to simpler approaches under Basel II framework. Other commercial banks are required to migrate to these norms by March 31, 2009.

These include standardised approach for credit risk which arising from default by borrowers, basic indicator approach for operational risk (arising from day to operations of the banks such robbery or power failure) and standardised duration approach for market risk (arising from fluctuations in interest rate and share prices) which affects the investment and market portfolio of the banks.

In the framework, the RBI had earlier specified the date by which banks may file application for approvals and the the likely date by which approvals can be obtained from the central bank.

While banks have the discretion to adopt the advanced approaches, they need to seek prior approval.

Under market risk, banks may apply to RBI for graduating to more advanced method of internal models approach (IMA) by April 1, 2010 and then, RBI may approve it by March 31, 2011. IMA sets out a framework for applying capital charges to the market risks (both on balance sheet and off-balance sheet) incurred by banks by an internal model. The current standardised duration approach specifies a specific average duration of the banks at large, which the banks follow and make it a basis for applying capital charges to only open positions.

Similarly, for operational risk, banks may graduate to standardised approach by April 1, 2010 and RBI can approve the plan by September 30, 2010. After that, they can graduate to advanced measurement approach for operational risk by April 1, 2011 and get RBI approval by March 31, 2013.

While advanced measurement approach (AMA) sets the framework for banks to develop their own empirical model to quantify required capital for operational risk, it can be used after they get regulatory clearances.

Under the standardised approach, a bank's activities are divided into eight business lines: corporate finance, trading and sales, retail banking, commercial banking , payment and settlement, agency services, asset management and retail brokerage. Within each business line, gross income is a broad indicator for the scale of business operations and so, the scale of operational risk exposure within each of these business lines. The capital charge for each business line is calculated by multiplying gross income by a factor .

Currently, banks are using the basic indicator approach as per which they must hold capital for operational risk equal to the average over the previous three years of a fixed percentage of positive annual gross income.

For credit risk, banks can use internal ratings-based approach which allows them to develop their own model to estimate the probability of default for individual clients or groups of clients. Currently, banks use standardised approach where they are required to use ratings from external credit rating agencies to quantify the required capital for credit risk.

207) The impact of slowdown on India

2008-11-21T03:43:00.000-08:00

After asserting that the global financial meltdown will not affect us, it is now being acknowledged that India is impacted and the effects will intensify. A flurry of activity to size up the happenings and counter the financial virus fast spreading across the globe is now being witnessed.

As early as April 2008, the early alarms had been sounded but our preoccupation with inflation-management made us virtually sidestep it, all in the belief that we were not vulnerable. This was somewhat naïve looking at the magnitude of the predicament.

The subprime crisis was translating into huge losses, and resulting in billions of dollars of capital raisings, including public offerings and asset-disposals. Market caps were plunging sharply, and not just in the US, but also of European banks. Central banks across the globe had begun to revive financial institutions, hit by what former Federal Reserve governor Alan Greenspan has described as ‘the crisis of the century’.

India may be one of the least open economies in Asia but its external trade already constitutes over 40% of its GDP. Net investments by FIIs in Indian stock exchanges by January 2008 were $65 billion. In the last four years India has received $50 billion as FDI.

On October 23, by which time FIIs had pulled out over $10 billion, the rupee plunged to 49.79 against the dollar, in comparison to under Rs 39 a year ago. GDP growth had started slowing and it had become obvious that the projected growth at 9% was untenable.

By mid-October, India was well in the midst of a global slowdown. Estimates of annual GDP growth had been lowered from 9% to 7.5%. During Q1 2008-09 growth was 7.9% compared to 9.2% in Q1 2007-08. Deceleration has been widespread. Industrial growth is much slower.

April-August 2008 saw 4.9% growth compared to 8.5% in April-August 2007 and 10% during entire 2007-08. Expansion in manufacturing, the emerging star of Indian economy, fell from 10.6% to 5.2%. Electricity generation nose-dived from 8.3% to 2.3%.

Agriculture declined in Q1 2008-09 from 4.4% to 3% and services from 10.6% to 10.2%. Foreign trade during H1 2008-09 registered a deficit of $60 billion as against $30 billion in H1 2007-08. Hitherto, export growth was being bolstered by rising commodity prices and the yet strong demand from emerging markets and oil producers. All such contributory factors are no longer there.

There has been a reversal of portfolio equity flows, largely because of foreign institutions’ need to enhance their liquidity positions and the overall reduction in the risk appetite of global investors. Equity market is down 30% since April 2008 and had dipped below the 10,000 level. A sharp decline in FII inflows exacerbated the downward pressure with the rupee depreciating by almost 25% and touching a five-year low of 50.18 on November20.

Since mid-September, the tight liquidity conditions in the economy have led to extreme volatility in the money market. Inter bank call rates have been posting significant jumps, well above the official repo and reverse-repo corridor.

By October 20, the call rates had become 20% and averaged 12% between mid-September and mid-October. By mid-October the economy had clearly deviated from its long run growth path. The positive cycle had turned negative and the actual growth had lagged behind the potential output growth. The manufacturing inflation gap has become positive, with the actual inflation being higher than warranted for many months.

Our response to the emerging global turmoil has been essentially monetary. The RBI, which for 18 months had been increasing interest rates and the cash reserve ratio to cool down the overheating economy, has since October changed tracks. Repo rate has been cut by 150 bps, CRR by 350 points and SLR reduced from 25% to 24%.

Such facilities aim at infusing greater liquidity and making credit cheaper. However, the additional liquidity of Rs 2 lakh crore has primarily gone to offset the sizeablemoney withdrawals which occurred upon issue of bonds to oil and fertiliser companies for not effecting price increases. Commercial banks have so far not significantly reduced their lending rates or started lending as before.

Till the fragile financial systems start functioning normally again, the various macro measures might not be fully effective particularly in the transmission of increased liquidity to investors and consumers. Many non-linear effects are anticipated as weaknesses in our trading partners spill over to us. There would also be reduction in investment financed through FDI, remittances, international debt and aid.

India, like many other Asian countries, is expected to suffer severely from the lagged effects of the commodities’ price shock. Also China, with whom Indian foreign trade has been steadily growing, is highly exposed to the downturn in the US and Europe. Already Indian iron ore mine owners have cut down their output by 40%.

The number of investor accounts at stock exchanges has surged. A crash in equity prices is affecting more people than ever before. Property markets have deepened substantially and the losing values of real estate have a potential multiplier effect.

The global credit crunch has caused more restrictive lending by commercial banks, upon which Indian corporates and households heavily depend for finance. The monetary measures recently initiated are not adequate to spur banks to lend more as they are concerned, and perhaps rightly, about short-term prospects of the economy.

Most Indian IT firms are vulnerable to the emerging global recession, 70% of India’s $40 billion software exports are to the US and 40% of it for financial services which are shrinking rapidly. Our manufacturing and construction trade face prospects of further slackening investment.

Financial services are up against tight liquidity and falling markets. Plummeting travel and tourism are slowing down transportation and hospitality sectors. More focused action, including fiscal, is needed to stem the worsening of the real economy.

Ajay Dua

(The author is a former secretary to the government of India)

206) G20 or 420 ?

2008-11-20T09:24:00.000-08:00

The "Group of 20" nations met in Washington over the weekend. The weather was cloudy and cool. The winds were blowing west-by-north-west at 14 miles per hour. But what came out was mostly hot air. Stale, hot air.

President Bush who is destined - unless saved by some miracle - to go on record as the worst President in the history of modern day USA laid the foundation for this nothingness.

Before the meeting began President Bush reminded us all that this financial crisis was not a failure of capitalism - there was no need to discourage financial innovation with excessive regulation.

Sure, the world needs a lot more financial innovation to be wrapped around the greed and slimy business practices of the financial geniuses.

The Europeans wanted more global oversight, more regulation. Eventually, the G-20 came out with a list of 20 points: a promise to do more and put in action with a notice that "we will meet again by April 30, 2009, to review the implementation of the principles and decisions agreed today".

Doctor, what’s the problem?

But before any doctor sets forth a prescription, there must be a clear understanding of the disease. A treatment can only be effective when one understands the illness and identifies the cure.

So, what are the events that led us to where we are? What are the crises that led to a dinner and weekend meeting of the leaders of 20 countries that represent about 90% of the global GDP and 75% of the world’s population?

This is what the statement of the G-20 had to say (points 3 and 4):

"Root Causes of the Current Crisis

3. During a period of strong global growth, growing capital flows, and prolonged stability earlier this decade, market participants sought higher yields without an adequate appreciation of the risks and failed to exercise proper due diligence.

At the same time, weak underwriting standards, unsound risk management practices, increasingly complex and opaque financial products, and consequent excessive leverage combined to create vulnerabilities in the system.
Policymakers, regulators and supervisors, in some advanced countries, did not adequately appreciate and address the risks building up in financial markets, keep pace with financial innovation, or take into account the systemic ramifications of domestic regulatory actions.
4. Major underlying factors to the current situation were, among others, inconsistent and insufficiently coordinated macroeconomic policies, inadequate structural reforms, which led to unsustainable global macroeconomic outcomes. These developments, together, contributed to excesses and ultimately resulted in severe market disruption."

Now let’s put that in English.

G-20: During a period of strong global growth, growing capital flows, and prolonged stability earlier this decade, market participants sought higher yields without an adequate appreciation of the risks and failed to exercise proper due diligence

The English version: After the technology bust in 2000 and the 9/11 terrorist attacks on the US, the global economies were on the edge of a long recession and - to prevent that from happening - the central bankers of the world kept on cutting interest rates with a view to encouraging economic activity. Whenever there is pain around the corner, the doctor prescribes the pain killer to remove the pain. The central bankers prescribed the drug ecstasy to turn that pain into the most orgasmic experience. The central bankers printed so much money that the financial geniuses figured out what to do with it: they gave it to people who could not really afford to ever repay it. And each time they lent money, the financial geniuses made a profit. And each time they made a profit, the financial firms rewarded themselves with salaries and USD 65 million bonuses.

G-20: At the same time, weak underwriting standards, unsound risk management practices, increasingly complex and opaque financial products, and consequent excessive leverage combined to create vulnerabilities in the system.

The English version: Hey, if you were cleaning out USD 1 million in salary every year (and there must have been 100,000 people in the field of finance, law, accounting, and consultancy who made that much money) and then getting a bonus and stock options over and above that - would you care about the vulnerability in the "system". Man, you were the "system"! People relied on you for ethical practices and you didn’t give a damn about that - your annual salary and the sound of the bonus money getting to your bank account sounded sweeter than God’s church bells.

G-20: Policymakers, regulators and supervisors, in some advanced countries, did not adequately appreciate and address the risks building up in financial markets, keep pace with financial innovation, or take into account the systemic ramifications of domestic regulatory actions.

The English version: Mr. Alan Greenspan was the head of the US Federal Reserve. He knew what he was doing: giving money away for free to encourage businesses to take risks - and spur economic activity. The European central bankers were appalled at the "cheap money" policy of the US. They knew what Mr. Greenspan was doing - building a bubble economy. An economy fuelled by higher debt at the consumer level. An economy oiled by financial products that needed more global supervision. Mr. Brown, the then equivalent of the Finance Minister of the UK (and now the Prime Minister) did not want more regulation and oversight in Europe. His reason: because the US was grappling with the post-Enron and post-WorldCom frauds by putting in place more reporting standards for corporate governance, financial businesses were moving more of their innovation to London and Europe. If Europe placed more regulation, then it would lose its "competitive" advantage. London could no longe r challenge New York as a financial centre. Mr. Brown’s arguments prevailed. Back in the US, the current "Finance Minister" Hank Paulson - who was then head of Goldman, Sachs pleaded with the SEC to allow Wall Street firms to borrow more. And the SEC approved that: more of Mr. Greenspan’s free money found its way into hands of the financial geniuses. The bonuses got higher and higher.

G-20: 4. Major underlying factors to the current situation were, among others, inconsistent and insufficiently coordinated macroeconomic policies, inadequate structural reforms, which led to unsustainable global macroeconomic outcomes. These developments, together, contributed to excesses and ultimately resulted in severe market disruption

The English version: Maybe the Chinese have not picked this one - but they are being blamed for the "current situation". Follow me on this line of thought. The US central bank wants to give money free in the hope that businesses borrow this money and businesses invest. This investment creates jobs. Job creation leads to higher income. Higher income leads to more consumption. Higher consumption leads to higher economic activity. This leads to businesses investing more. More jobs, more incomes, more consumption...a virtuous cycle is established. But that is in the text books.

This is what happened in real life: The US central bank gave free money. The Wall Street firms lent this money to individuals in USA to consume more. The individuals consumed goods that were "Made in China". Investments did increase: in factories in China. Salaries did increase: of the labour class in China. Businesses did flourish: that is how the Wall Street firms could afford to paid out the big bonuses. The "structural" imbalance was caused by the fact that the Chinese - and other exporting countries that benefited from the surge in US household consumption - did not allow their own currencies to strengthen. If the Chinese currency had strengthened, exports from China would have been more expensive - and China would have lost out to other exporting nations like Vietnam, Indonesia, Thailand, Malaysia, and Mexico. Exports to USA allowed China to create jobs and increase employment and brought stability within China. All this because China kept its currency low and allowed exports to flourish.

At the US end, the packaging and re-packaging of financial loans - as one commentator noted - was the only export. The US exported USD 300 billion worth of these loans mostly to the European banks (remember London wanted to be the centre of the financial universe) and some to the Japanese and Asian banks.

The "problem" was not that Wall Street was giving loans to US consumers. That is the job of any finance company: to arrange finance.

The "problem" was that Wall Street and the credit rating companies like S&P and Moody’s were rewarded to help sustain a lie: the lie that the loans being given to people who could not really afford them were able to pay these loans back.

Along the way, everyone got their pound of flesh: the Wall Street firms got the salaries and bonuses; the rating agencies got their fees; and the Chinese and the exporters got their jobs and built foreign exchange reserves.

And, yes, the US consumer - financially illiterate and unaware of www.personalfn.com - was able to buy new homes, new cars, new everything. All for some debt obligation and interest payments that seemed really cheap - and (due to financial innovation) began sometime in the distant future.

So, if this is indeed the problem - in simple English - what is the cure?

Complexities of drugs
The last time there was a problem - and, sigh, it involved the same Wall Street firms - the US Fed prescribed "cheap money" as the cure.
But drugs have side-effects. Any doctor knows that.
And in certain combinations - they can be lethal.
Mr Greenspan knows that by now - you mix free money, with the ability of Wall Street firms to borrow infinitely, and sprinkle that with self-regulation - you end up where the world is today.

So the action plan that the G-20 has recommended is one of more oversight, more regulation. And more transparency of the accounting standards used to evaluate the risks of the financial instruments created by the financial geniuses.

Good stuff, I am sure and the G-20 will figure what the new system will look like.

But they have not addressed two issues:
1) The G-20 statement was silent on whether they will punish the crooks who mis-sold financial products to borrowers and to the lenders, and
2) The G-20 statement did not spell out how "unsustainable global macroeconomic outcomes" will be addressed. Will China - and other exporters - allow their currencies to strengthen so that they stop exporting - and will China risk a social upheaval at home due to job losses from shutting down export factories? China had already announced a USD 560 billion stimulus package - to offset the decline in exports to countries like the US.

So the G-20 was what it was: a lot of good photo ops for the leaders and some long-worded statements.

But, "hot air" is sometimes a good thing.
It tells the doctor that the patient is still alive.
Still pretty sick - but alive.

The world will take some time to get back on its feet and run again.

And India? I hope that the policy makers get their act together and start chalking out some serious investments in infrastructure (and not just the electronic voting machines) to build the base that India needs to take it to an 8% rate of annual growth in the economy - on a sustainable basis.
And the Indian stock markets? Let me know when SEBI shuts down P-Notes then we can have a rational discussion.
Until then, it remains a casino.

A wonderful, no-failure-in-settlement-systems, highly efficient casino.

But a casino - not a vehicle to allow Indian companies to attract long-term capital to build out India’s economy.

205) Depression economics

2008-11-15T07:41:00.000-08:00

Throw caution to the wind and money at the problem

The economic news, in case you haven't noticed, keeps getting worse. Bad as it is, I don't expect another Great Depression. In fact, we probably won't see the unemployment rate match its post-Depression peak of 10.7 percent, reached in 1982 (although I wish I was sure about that).

We are already, however, well into the realm of what I call depression economics. By that I mean a state of affairs like that of the 1930s in which the usual tools of economic policy -- above all, the Federal Reserve's ability to pump up the economy by cutting interest rates -- have lost all traction. When depression economics prevails, the usual rules of economic policy no longer apply: virtue becomes vice, caution is risky and prudence is folly.

To see what I'm talking about, consider the implications of the latest piece of terrible economic news: Thursday's report on new claims for unemployment insurance, which have now passed the half-million mark. Bad as this report was, viewed in isolation it might not seem catastrophic. After all, it was in the same ballpark as numbers reached during the 2001 recession and the 1990-91 recession, both of which ended up being relatively mild by historical standards (although in each case it took a long time before the job market recovered).

But on both of these earlier occasions the standard policy response to a weak economy -- a cut in the federal funds rate, the interest rate most directly affected by Fed policy -- was still available. Today, it isn't: The effective federal funds rate (as opposed to the official target, which for technical reasons has become meaningless) has averaged less than 0.3 percent in recent days. Basically, there's nothing left to cut.

And with no possibility of further interest rate cuts, there's nothing to stop the economy's downward momentum. Rising unemployment will lead to further cuts in consumer spending, which Best Buy warned this week has already suffered a "seismic" decline. Weak consumer spending will lead to cutbacks in business investment plans. And the weakening economy will lead to more job cuts, provoking a further cycle of contraction.

To pull us out of this downward spiral, the federal government will have to provide economic stimulus in the form of higher spending and greater aid to those in distress -- and the stimulus plan won't come soon enough or be strong enough unless politicians and economic officials are able to transcend several conventional prejudices.

One of these prejudices is the fear of red ink. In normal times, it's good to worry about the budget deficit -- and fiscal responsibility is a virtue we'll need to relearn as soon as this crisis is past. When depression economics prevails, however, this virtue becomes a vice. FDR's premature attempt to balance the budget in 1937 almost destroyed the New Deal.

Another prejudice is the belief that policy should move cautiously. In normal times, this makes sense: You shouldn't make big changes in policy until it's clear they're needed. Under current conditions, however, caution is risky, because big changes for the worse are already happening, and any delay in acting raises the chance of a deeper economic disaster. The policy response should be as well-crafted as possible, but time is of the essence.

Finally, in normal times, modesty and prudence in policy goals are good things. Under current conditions, however, it's much better to err on the side of doing too much than on the side of doing too little. The risk, if the stimulus plan turns out to be more than needed, is that the economy might overheat, leading to inflation -- but the Federal Reserve can always head off that threat by raising interest rates. On the other hand, if the stimulus plan is too small there's nothing the Fed can do to make up for the shortfall. So when depression economics prevails, prudence is folly.

What does all this say about economic policy in the near future? The Obama administration will almost certainly take office in the face of an economy looking even worse than it does now. Indeed, Goldman Sachs predicts that the unemployment rate, currently at 6.5 percent, will reach 8.5 percent by the end of next year.

All indications are that the new administration will offer a major stimulus package. My own back-of-the-envelope calculations say that the package should be huge, on the order of $600 billion.

So the question becomes, will the Obama people dare to propose something on that scale?

Let's hope that the answer to that question is yes, that the new administration will indeed be that daring. For we're now in a situation where it would be very dangerous to give in to conventional notions of prudence.

Paul Krugman is a Nobel Prize-winning professor of economics at Princeton University.

204) Brave new world of derivatives

2008-11-15T07:38:00.000-08:00

Greenspan never saw how derivatives would make the housing crisis a global one.

Some say that derivatives rank right up there with antibiotics and the microprocessor chip as one of the great innovations of the modern era.

Derivatives are financial instruments that are used to reduce financial risk, just as a fire insurance policy is used to reduce the risk of a fire by compensating possible damage in the event of one. Why did, then, Warren Buffett, whose financial acumen is legendary, describe them recently as “weapons of mass destruction”? Where did they come from and how did they become such objects of veneration as well as hate?

In downtown Chicago stands the 45-storey building that houses the Chicago Board of Trade, the institution that gave birth to the derivatives business. Beautiful as its art deco architecture is, there is nothing much to set it apart from the many other tall buildings that surround it. Except for one thing. Right at its very top there is a two-storey tall statue of a Greek goddess. This is Ceres, the Greek goddess of grain from who the word “cereal” comes.

This is where it all started. A group of merchants trading in the food grains grown in the surrounding Midwest came up with the ingenious and useful idea of offering farmers a firm “future” price for their crop many months before it came to the market reducing the risks that farmers took during their long season of labour. Grain “futures” prospered for decades till the US government, in the 1960s, started offering a minimum price for the crop. This considerably slowed down the grain futures trade. The Chicago grain future traders sat around their trading pits for a while, smoking cigars and reading newspapers with nothing much to do till one of them thought of the idea of starting trading in another kind of futures: using the Dow Jones Industrial Average of equity shares in the New York Stock Exchange as the “underlier” instead of grain.

But, before starting off this new line of business, they had to solve a problem: how to put a price on this new form of “future”. An out-of-the-box thinker among them, Mathew Gladstein, asked for help from a group of local Chicago economists, Merton, Black and Scholes. The mathematical model they came up with, the Black-Scholes model, did its job of pricing options so well that Gladstein made tons of money using it, Merton and Scholes won the Nobel Prize in Economics for it, and started the rush of mathematicians to the stock market.

Soon, other enterprising people thought up other “derived” financial instruments based on many other “underliers”: bonds issued by companies and municipalities, mortgages that people took out on their homes.

It is not hard to see why such “derived” securities or “derivatives” have become so popular. A bank that makes a loan, for example, for a house, faces many different types of risk. The borrower, for instance, may not be able to return the loan on due date. Or, he may not be able to keep up with interest payments. Or, the market interest rate may rise far above the rate the bank has given the loan, leaving the bank stuck with a loan at a low interest rate. Or an earthquake might hit the area demolishing the borrower’s business. Or, high inflation may reduce the value of the loan by the time it gets repaid. Derivatives are a way to “hedge” against these risks. For example, a housing loan to a borrower in, say, Cochin can be combined with a housing loan in Mumbai and another one in Bangalore under one common instrument and this combined “derivative” can be sold to an investor. This combination reduces the risk of disparate housing markets such as Cochin, Mumbai and Bangalore all suffering downturns at the same time. The investor in this derivative rightly believes that the instrument he holds has a balanced risk.

If derivatives can diversify risk, as just described, what can go wrong? For one, the borrowers may have mis-represented their income. Or, the loan issuer may not have verified their incomes. Or, they may have borrowed 95 per cent of the value of their houses such that if property prices decline by, say, 20 per cent, the asset cover may become inadequate. In all of these cases, should interest rates rise sharply, from say, 6 per cent to 10 per cent, these borrowers may no longer be able to meet their monthly payments. When Greenspan, who was Chairman of the US Federal Reserve Board, was told about similar issues developing in the US mortgage securities market he believed that such problems in the housing sector would be restricted to a city and could never become a national, let alone an international problem.

This would normally have been true, but mortgaged-backed securities were sold not only nationally in the United States but also throughout Europe and Asia. When the US housing bubble burst and borrowers started defaulting on their mortgage payments, the value of the mortgage securities fell precipitously.The shock waves were transmitted throughout the world. What started as a crisis in some specific parts of the US now became a worldwide financial crisis.

In the next and final part, we’ll examine why so many smart people in storied investment banks like Morgan Stanley, Lehman Brothers and Bear Stearns, in powerhouses such as Citigroup and Royal Bank of Scotland found these derivatives so attractive that they just couldn’t resist them.

Ajit Balakrishnan

203) Depressing times: Irvin Fisher's Debt-Deflation theory

2008-11-14T04:10:00.000-08:00

It seems Irvin Fisher's Debt-Deflation Theory, developed in 1933 during great depression, is repeating itself

during the present crisis, as indicated by present slump in oil & commodity prices.

IN JUST a few brutal months, the prospects for the world economy have deteriorated with remarkable speed. Rich countries had seemed set for a shallow, muddle-through recession; now a much deeper slump is on the cards. In a sign of growing concern about American consumers, the Treasury and Federal Reserve on November 12th focused their rescue efforts on loans for cars and college and on credit cards. Central banks, recently so fearful of inflation, are now slashing interest rates to stop it falling too far. It will not be easy: deflation—annual falls in consumer prices—is increasingly likely next year. But recalling the 1930s, policymakers will be anxious to ensure that it does not take hold and turn crisis into catastrophe.

To consider the possibility of falling prices may seem odd when inflation is still uncomfortably high. In America, it reached 5.6% in July, the highest rate since 1991. In the same month inflation in the euro area surged to 4%. Britain’s consumer-price inflation hit 5.2% in September, well above the government’s target of 2%. This high inflation was mostly the result of the surge in commodity prices in the first half of the year. “Core” inflation, excluding food and energy costs, was far more stable.

But since the summer the commodity boom has turned to bust, changing the inflation outlook dramatically. The price of a barrel of crude oil has tumbled from a peak of $147 in July to below $60 in recent days. The Economist’s index of non-oil commodity prices has fallen by 40% since July. If raw-material prices remain at these lower levels, the year-on-year change in the retail prices of food and fuel will turn sharply negative in 2009.

That will add to other downward pressure on inflation. As economies fall deeper into recession and spending shrinks, firms will have to compete harder for sales by pricing their wares keenly. A glut of supply is evident in America’s jobs market: the unemployment rate rose to 6.5% in October. A year earlier it was just 4.8%.

Falling food prices have quickly had an effect on inflation in China, which fell to 4% in October from a peak of 8.7% in February. In the rich world, a period of deflation seems more likely in America than in Europe. Crude-oil costs are a bigger slice of the prices American consumers pay for petrol: lower sales taxes and fuel duties mean swings in oil markets have a bigger effect on pump prices. Motor fuel also accounts for a larger share of Americans’ spending, so falling prices will depress inflation by more. Prices tend to be less “sticky”: they respond more readily to economic conditions because markets are more flexible than in Europe. A stronger dollar will add to deflationary pressures in America while easing them elsewhere.

The year-on-year fall in oil prices is likely to be steepest in the third quarter next year, when the base will be this summer’s peak. Economists at Goldman Sachs reckon that America’s inflation rate will briefly turn negative at that point. Inflation in the euro area seems set to reach a low then too, even if prices do not actually fall. Speaking after the European Central Bank’s (ECB) half-point cut in interest rates on November 6th, Jean-Claude Trichet, the bank’s chief, allowed that inflation could fall well below the ECB’s target ceiling of 2% next year. But such a drop would be “short-lived and therefore not relevant” to interest-rate decisions. The Bank of England sees deflation as more than just a remote risk. Its Inflation Report, published on November 12th, puts the spread of likely inflation rates at between -1% and 3% in two years’ time. It is the first time the bank’s fan chart, which projects where inflation is likely to lie nine times out of ten, has encompassed deflation.

A commodity-led fall in inflation ought to be good news for rich economies. It boosts consumers’ real incomes and fattens firms’ profit margins. Yet there is something pernicious about inflation falling too far, too fast. Because falling prices make debt more expensive, indebted households would be more anxious to pay off loans, even as other consumers were benefiting from a boost to their purchasing power. If deflation took hold, the gap in demand left by those fleeing debt would not be filled by cash-rich consumers, who tend to be less free-spending.

A deadly mix of falling prices and high leverage could foment a “debt-deflation” of the type first described by Irving Fisher, an American economist, in 1933. In this schema, debt-laden firms and consumers rush to repay loans as credit dries up. That hurts demand and leads to price cuts. The deflation in turn increases the real cost of debt. It also means that real interest rates can’t be negative, and so are undesirably high. That spurs yet more repayment so that, in Fisher’s words, the “liquidation defeats itself.”

Fisher’s theory is of more than just academic interest. Recent lending surveys by the Federal Reserve and the ECB showed a larger share of banks tightened their lending criteria in October than in July. Such is the concern in America that on November 12th regulators said they would scrutinise the dividend policies of banks that did not increase lending.

The surveys also revealed a reluctance to borrow, which tallies with signs of a collapse in spending. Foreign orders for German capital goods slumped by 14% in September, suggesting firms worldwide are cutting investment. Car sales in America and Europe are plummeting. American retailers, such as Neiman Marcus, J.C. Penney and Gap, reported double-digit falls in sales in the year to October. The retail data in Britain are grim too, which is a big worry for firms which have been through the private-equity mill and are loaded with debt. If sales do not respond soon to interest-rate cuts, some retailers may resort to deep discounts as Christmas approaches.

Bond markets expect consumer prices in America to fall by as much as 2½% over the next year, according to Mark Capleton, of the Royal Bank of Scotland. Inflation in the euro area is expected to be close to zero. When prices were climbing rapidly, central banks fretted that consumers’ inflation expectations would rise in response. They will now be as keen to keep them from falling too far. That means interest rates in rich countries may soon fall to zero; some are already close.

Deflation is not the only fear, however. Investors seem keen to hedge against all outcomes. “The options market tells us that inflation uncertainty has rocketed,” says Mr Capleton. That reflects fears that policymakers, in their efforts to tackle deflation, will go too far the other way.

The Economist

202) The global economic summit - After the fall

2008-11-13T18:06:00.000-08:00

On November 15th world leaders are due to sit around a table in Washington, DC, to fix finance. They have their work cut out.

THE leaders arriving in Washington, DC, for this weekend’s economic summit are being presumptuous. If they want what they are calling Bretton Woods 2 to live up to the original, which took place in New Hampshire overshadowed by war and the Depression, it will have to establish a new economic order for the capitalist world. In 1944 that meant creating the IMF, the World Bank and a body to oversee world trade. Imagine Hank Paulson, America’s treasury secretary, as John Maynard Keynes; or picture Gordon Brown, Britain’s prime minister, as Winston Churchill (as Mr Brown himself secretly may), and you get a sense of the task ahead.

The Bretton Woodsmen of 2008 are grabbing the credit before they have earned it—rather as all those subprime householders did. More than two years of gruelling technical work laid the ground for the wartime conference of officials and finance ministers (prime ministers and presidents had other things to deal with). By contrast, the leaders gathering this weekend from the G20, a mix of industrial and emerging countries, plus the European Union, have cobbled together an agenda in a few frenetic weeks. They will doubtless produce no shortage of promises. Just what these are worth will depend on sweat and summits yet to come.

The summit is sure to stir up a debate about the institutions that oversee the international economy. By convening the G20 rather than the closed, rich club of the G7, the old order has in effect acknowledged that the rest of the world has become too important to bar from the room. But what new order should take its place? Answering that question has been a parlour game for economists since long before the crisis. By encouraging them to dust off their pet ideas, the summit will at the very least create a bull market in new schemes for global economic governance.

Because everyone agrees that something big needs fixing and that the world expects action, calling the summit Bretton Woods 2 could yet come to be seen as a rallying cry for reform. And yet there are lots of reasons to see it as vainglory. The agenda is vague and sprawling. With so many of the world's political leaders sitting around the table, it will be hard to escape platitudes and hypocrisy. There may be disagreements—especially where sovereignty or competitiveness is threatened. And most of all, the recent international financial collaboration is fraught with in-fighting and complexity.

At first sight, this summit seems no different. For instance, consider how Mr Brown and Nicolas Sarkozy, the president of France, have vied to claim paternity of the summit for their own domestic reasons. Mr Sarkozy sees a chance to show he is a man of action, and he will find it easier to force through domestic reform if he can show he is not in thrall to all that Anglo-Saxon free-market ideology.

Mr Brown has been calling for a global summit for weeks, emboldened by international acclaim for his plan to rescue Britain’s banking system. The prime minister is keen to show that the crisis is one of those worldwide messes that—honestly—has nothing to do with the past 11 years of Labour government. And he wants to play the lead in Washington so as to protect the free-market City of London from the Gallic machinations of Mr Sarkozy.

From despair, hope

But there is more to the summit than politics. Perhaps inevitably, the run-up to the summit has produced dozens of different proposals. Broadly, they fall into three areas. First and most urgent is the need to limit the crisis, which is even now spiralling from the rich world to emerging economies. Second is financial regulation: its flaws have been laid bare, and the summiteers will want to put it right. Third is global macroeconomics. The G20 needs to find ways to correct the imbalances—Asian saving and Western spending—that lay behind the boom.

Pervasive economic gloom is the best reason for hoping that something important will come of this weekend’s meeting. After savaging the financial markets, the credit crisis has broken loose into the real economy. This month the IMF lowered its forecast for global growth next year by 0.8 percentage points, to 2.2%. The rich world is already in recession. Unemployment, foreclosures and corporate bankruptcies are rising. Emerging economies have also been ensnared, as investors from richer countries retreat to their home markets. The fund cut its forecast for their growth rate by a percentage point, to 5.1%.

Such pain demands an ambitious policy response. On November 6th Kevin Warsh, a governor of the Federal Reserve, put it in dramatic terms: “We are witnessing a fundamental reassessment of the value of every asset everywhere in the world,” he said. “The establishment of a new financial architecture, thus, is the essential policy response to the greatest economic challenge of our time.”

The easy bit will be to harness that sense of urgency to produce concerted interest-rate cuts and government spending. Already, several countries are talking about a co-ordinated fiscal stimulus to help offset a collapse of private-sector demand. China set the standard on November 9th, with a huge spending plan worth 4 trillion yuan (nearly $600 billion), or about 15% of GDP (see article). Not everyone can muster such resources, but other countries, including America and Britain, are preparing to act too. Germany, which has promised a piffling €12 billion ($15 billion), may be shamed into spending more. With concerted action, countries will find that each national stimulus buys more confidence than it would do alone.

Many commentators also want to build confidence by increasing the spending power of the IMF. If a large emerging market, such as Poland or Turkey, were to need help, says Willem Buiter, an economist at the London School of Economics, its present resources of $250 billion “would be gone before you can say ‘special drawing rights’.” Although some European delegates want to strengthen the IMF, the Americans are resisting: the summit may produce nothing more than a pledge to find the money if the fund needs it.

In financial regulation, some changes ought to be easy to agree on—such as ensuring that banks stop holding assets off their balance-sheets and put capital aside against possible failures in a wider range of securities. The summit is also likely to try to bring order to the market for credit-default swaps, which trade the risk that borrowers will not honour bonds, by concluding that, within 120 days, the business should be routed through clearing houses rather than settled privately by investors.

That is progress, to be sure. But it is small potatoes next to the summiteers’ ambitions. And little else will be easy, even if the leaders can issue a declaration that sets out their common principles and a schedule of negotiations for further reform. To see why, leave behind the first Bretton Woods conference for the more recent history of international financial regulation.

The difficulty with cross-border rules in finance is explained by Barry Eichengreen, a professor at the University of California, Berkeley, and one of 20 economists from around the world who have written an “e-book”* that describes what this weekend’s summit should do.

On the one hand, finance is every country’s business. This crisis has shown that what happens deep inside one national financial system can wreck another halfway across the world. In the United States subprime lending was a relatively small bit of the mortgage market—itself just a part of America’s financial markets. And yet the cascade of failing credit and risk aversion that began there, partly as a result of inadequate supervision, has spread not just to the overstretched banking systems of Europe, but also now to untroubled banks in emerging markets.

On the other hand, nation-states jealously guard the right to oversee their own banks. This is not just out of principle, or a desire to see that the regulations suit their own financial institutions—although most regulators would think these alone to be sufficient reason. It is also because, when a crisis comes, the nation-state foots the bill for a bail-out. In addition, Wendy Dobson, of the University of Toronto, notes that regulators need intimate local knowledge of their charges and their own financial structures if they are to have a hope of prevailing—and even then, as the world has seen, the odds are against them.

The tug between national and supranational regulation has gradually led to an ad hoc arrangement for the international banking system. In the 1980s America and Britain grew worried about the expansion of Japanese banks, which by 1988 accounted for nine of the world’s ten largest by assets, up from one at the start of the decade. What bothered the West was that Japanese regulators allowed their banks to count shareholdings as core capital. Cheap capital fed their growth. And it was indeed reckless, as the subsequent collapse of the Japanese stockmarket showed.

Under the auspices of the Bank for International Settlements (BIS), a central bankers’ central bank in Basel, in Switzerland, the big economies agreed to set common standards for what counted as capital and how much a bank should hold in order to qualify as safe. Their negotiations were partly about rules to make the global financial system more resilient. But they were also, in effect, about a trade dispute, over what the West saw as a subsidy to Japan’s banks. This ambiguity between the common good and national interests complicates all financial negotiations—including any that will follow the G20 summit.

Andrew Gracie, who worked on regulatory design at the Bank of England and founded Crisis Management Analytics, which advises central banks on financial stability, points out that right from the start regulators looked at systemic risk one bank at a time. The assumption was that if each institution was safe, then the system as a whole would be too. Similarly, when banks had many subsidiaries, regulators short of money and time tended to worry only about their own piece of the jigsaw.

This “micro-prudential” philosophy was always questionable. Now it looks absurd. Banks tend to own similar assets. In a crisis the capital of the entire industry tends to fall, which means that the instability of one bank can undermine the standing of the next. Hence the talk about a new “macro-prudential” sort of regulation that seeks to take account of the whole system’s vulnerabilities, as well as the health of individual banks, by, say, adjusting capital charges over the economic cycle.

The strengths of the original Basel standards (Basel 1) lay in being reasonably simple to negotiate and administer. But therein lay their weaknesses also. Banks soon started to favour business that was profitable (ie, risky) but which, under Basel 1’s crude definitions, escaped the appropriate capital charges. As the banks adapted to Basel 1, so the rules became less useful.

That gave rise to the effort to create Basel 2, which began in the late 1990s. This sought to strike a different balance, by asking banks to be more sophisticated in assessing the riskiness of their assets and thus their capital requirements. But sophistication came at a high cost. A recent book† by Daniel Tarullo, a professor of law at Georgetown University who is fancied for a senior economic post under Barack Obama, describes how the negotiations dragged on for years as governments jostled for a deal that would give their own banks some advantage. Mr Tarullo observes that the banks would accept all sorts of arbitrary provisions as long as the end result was to reduce the amount of capital they had to put aside.

Faults and lessons

Basel 2 is a flawed agreement. Although it is not yet in force, it already needs updating. Its chief failing is its reliance on rating agencies and the banks’ own models of the risks that they are carrying—an idea that has been discredited by the way banks have been caught out. In addition, the accord did not allow for the evaporation of liquidity that prevented the banks from financing their businesses. It is hardly reassuring that the minimum capital that rescued banks are aiming for today is far above the minimum set by Basel 2.

The story of bank-capital standards contains important lessons for the leaders gathering at the G20. The talks dragged on because their objectives were unclear, the subject matter was complex, negotiators were fighting for the upper hand and there was little sense of urgency. Even if all that can be put right, the schedule of work has expanded. Supervision may need to extend beyond banks, to any financial institution whose failure could threaten financial stability, which might include some large hedge funds and non-bank financial companies such as GE. The capital-standards regime also needs to become more macro-prudential. Regulators need to be able to put more trust in banks’ risk models and rating agencies and supplement them with simple rules about the level of borrowing. Mr Tarullo suggests that banks should issue new securities to serve as gauges of investors’ faith in them.

There are two difficulties in all this. The first is that it will take time and, as urgency fades and the negotiators drown in complexity, national interest may gain at the expense of collective safety. The second is that original dilemma: international rules require enforcement, but nation-states demand sovereignty. Dominique Strauss-Kahn, head of the IMF, wants an inspectorate. Mr Eichengreen has proposed a World Financial Organisation, with disciplinary panels. The EU wants “colleges” of national regulators for each bank and an IMF to give warning of crises. The summit looks most likely to back the EU idea—but it ought to be more ambitious. The system will work only if governments heed outside warnings. But just look at how they browbeat the IMF into giving favourable assessments of their economies.

Although this summit looks likely to dwell on financial regulation, it cannot ignore the macroeconomics that preoccupied the original Bretton Woods conference all those years ago. As Martin Wolf, a columnist at the Financial Times, explains in a new book‡, the boom was fuelled by the imbalances that grew out of the Asian financial crisis in 1997.

Countries that had grown used to incoming foreign capital suffered terribly when it suddenly flowed back out again. To protect themselves in future, they started to run current-account surpluses and to amass foreign-exchange reserves. Spendthrift America and Britain were happy to help Asia save, even if that meant running the corresponding deficits.

Surpluses are all very well, but they cannot continue to accumulate for ever. Perversely, if they unwind violently, they will create instability. Much of the cheap money recycled from the saving countries found its way into housing and other assets in the West. It was too much to hope that it would flow back out of those assets in an orderly way.

The conflict between sovereignty and safety here is even less easy to disentangle than it is in financial regulation. Clearly, no country would agree to live by a rule that it should balance its current account. Raghuram Rajan, a professor at the University of Chicago and a former chief economist at the IMF, points out that current-account surpluses and deficits can indeed help countries cope with shocks and finance investment. At the same time, no international organisation like the IMF could plausibly have the independence or the resources to make a credible promise to back all the economies suffering from capital flight in a crisis.

This conundrum leads straight back to a souped-up IMF—still too small to save the world, admittedly, but bigger than today’s, and backed by swap lines from the three large regional central banks, the Fed, the European Central Bank and eventually the People’s Bank of China. For that to work and for the IMF’s help to lose some of its stigma, rich countries will have to admit more emerging economies to the fund’s board. Cue yet more difficult negotiations.

There are two ways of thinking about this weekend’s summit in Washington. To be charitable, look on and wonder at the sheer ambition of taking on so many hard, important questions. A severe financial crisis may be the only time when the technicalities wallowing near the bottom of policymakers’ agendas receive the attention they deserve. But there is a more cynical interpretation. Perhaps the summiteers will bask in the headlines and then, out of the glare of the television lights, set about something disappointingly modest.

The Economist

201) Credit Derivatives: The great untangling

2008-11-12T18:05:00.000-08:00

Some of the criticism heaped on credit-default swaps is misguided. The market needs sorting out nonetheless.

THEY are, says a former securities regulator, a “Ponzi scheme” that no self-respecting firm should touch. Eric Dinallo, the insurance superintendent of New York state, calls them a “catastrophic enabler” of the dark forces that have swept through financial markets. Alan Greenspan, who used to be a cheerleader, has disowned them in “shocked disbelief”. They have even been ridiculed on “Saturday Night Live”, an American television show.

Until last year credit-default swaps (CDSs) were hailed as a wonder of modern finance. These derivatives allow sellers to take on new credit exposure and buyers to insure against companies or governments failing to honour their debts. The notional value of outstanding CDSs exploded from almost nil a decade ago to $62 trillion at the end of 2007—though it slipped to $55 trillion in the first half of this year and has since continued to fall. Traded privately, or “over the counter”, by banks, they seemed to prove that large, newfangled markets could function perfectly well with minimal regulation.

That view now looks quaint. Since September a wave of large defaults and near-misses, involving tottering banks, brokers, insurers and America’s giant mortgage agencies, Fannie Mae and Freddie Mac, has sent the CDS market reeling. Concern that CDSs are partly to blame for wild swings in financial shares has frayed nerves further.

The failure in mid-September of Lehman Brothers showed that the main systemic risk posed by CDSs came not from widespread losses on underlying debts but from the demise of a big dealer. The aftershock spread well beyond derivatives. Almost as traumatic was the rescue of American International Group (AIG), a huge insurer that had sold credit protection on some $440 billion of elaborate structures packed with mortgages and corporate debt, known as collateralised-debt obligations (CDOs). Had AIG been allowed to go bust, the swaps market might well have unravelled. Similar fears had led to the forced sale of Bear Stearns in March.

Foul-ups with derivatives are hardly uncommon, but CDSs have been causing particular consternation. One reason is the broad threat of “counterparty risk”—the possibility that a seller or buyer cannot meet its obligations. Another is the rickety state of back-office plumbing, which was neglected as the market boomed. A third is that swaps can be used to hide credit risk from markets, since positions do not have to be accounted for on balance-sheets. They make it beguilingly easy to concentrate risk. AIG could have taken the same gamble in other ways, for instance by borrowing heavily to buy mortgages. But the CDS route was quicker and less visible.

If counterparties pay up, CDSs are a zero-sum game: what the seller loses, the buyer gains. Counterparty risk upsets the symmetry. It is tempting to write lots of swaps in good times, when pay-outs seem improbable, without putting aside enough cash to cover the potential losses. Being AAA-rated, AIG was able to post modest margin requirements—the deposit it had to pay against the risk of the contract being triggered. When its credit rating was cut, a lot more margin was suddenly demanded and it had to turn to the public purse.

“We sent out a signal that the stronger you were, the crazier you could be,” says Mr Dinallo: highly rated companies were allowed to write reckless volumes of swaps. Originally conceived as a means for banks to reduce their credit exposure to large corporate clients, CDSs quickly became instruments of speculation for pension funds, insurers, companies and (especially) hedge funds. And with no fixed supply of raw material, unlike stocks or bonds, bets could be almost limitless.

The industry is scrambling to limit the damage. Robert Pickel, head of the International Swaps and Derivatives Association (ISDA), says he is determined to combat “misconceptions” about CDSs. The true amount at risk, after cancelling out offsetting exposures, is only about 3% of their notional value (that is $1.6 trillion, even so). Opaque as CDSs may be, they are less complex than CDOs. In essence, they unbundle the interest on a debt from the risk that it is not paid back. Selling credit protection is similar to writing certain kinds of common options on shares.

The root cause of the crisis, Mr Pickel argues, is bad mortgage lending, not derivatives: swaps on subprime mortgages grew unstable because the loans themselves were dodgy. Last month JPMorgan’s Blythe Masters, one of the market’s founders, urged regulators to distinguish between tools and their users: “Tools that transfer risk can also increase systemic risk if major counterparties fail to manage their exposures properly.”

That will not reassure everyone. Still, there has been “more fear than facts” around the CDS market, says Brian Yelvington of CreditSights, a research firm. Essentially, it provides fixed-income investors with “a liquid way to do what equity and futures participants have been doing for years: to take a negative as well as constructive view on credit.”

Furthermore, the market has held up better than many expected. The process for settling claims after Lehman’s default and the government’s seizure of Fannie Mae and Freddie Mac “performed as designed”, says Darrell Duffie of Stanford University. Only $6 billion had to change hands in the Lehman auction, overseen by ISDA, because most payments had already been made as swap-sellers marked their positions to market; in all, $21 billion had been theoretically at risk. Margin payments are widely thought to cover two-thirds of total CDS exposure.

The CDS market has remained fairly liquid throughout the crisis, even as cash markets dried up. At the moment, derivatives spreads reflect fundamental values more accurately than those in corporate-bond markets, reckons Tim Backshall of Credit Derivatives Research (CDR). Swap spreads have become a key barometer of financial health. They provided an early indicator of trouble at investment banks, although they became distorted as more and more firms scrambled to hedge or speculate.

But if credit swaps were not a primary cause of the past year’s conflagrations, they were, in certain respects, an accelerant. Financial eggheads used them as building blocks in “synthetic” CDO-type structures, which are based on CDSs rather than actual bonds. The market value of some tranches has slumped to less than ten cents on the dollar. And CDSs share some problems with securitisation. A paper last year by economists at the Federal Reserve Bank of New York concluded that they “give banks an opaque means to sever links to their borrowers, thus reducing lender incentives to screen and monitor.”

Some fear that worse may be yet to come. The failure of another big actor in the market would send dealers and other counterparties scurrying to replace trades, almost certainly at a higher cost. Replacing those struck with Lehman, as spreads widened after its bankruptcy filing, is thought to have cost some dealers upwards of $200m each.

That risk remains, judging by CDR’s counterparty-risk index, which measures the health of CDS dealers (see chart 1). The next shock could be the failure of a hedge fund with a big swap book, given the spike in redemptions and margin calls many funds face, thinks Pierre Pourquery of the Boston Consulting Group. Hedge funds wrote almost a third of all credit protection last year (see chart 2).

Sellers of protection will be watching nervously for a wave of corporate defaults as big economies slip into recession. Standard & Poor’s expects the default rate on junk-grade debt to leap to 23% by 2010. Sovereign debt is looking wobbly too, especially but not exclusively in emerging markets. The cost of insuring against a default by the United States has quadrupled since January.

As rising defaults trigger CDS payments, the effect on other markets is likely to grow. Credit insurers are increasingly having to find money to pay claims that once seemed merely notional. Christopher Whalen of Institutional Risk Analytics, a consultancy, calls these commitments a “liquidity black hole”. Because banks lack the liquidity to cover these positions, they must raise it in interbank markets. This may be keeping the rate at which big banks borrow from each other higher than it would otherwise be, thinks Mr Whalen (though it has fallen from its peak last month). It may also be causing rushed sales in equity and bond markets.

Concern about the damage that the failure of a big swap-seller might yet do has created pressure for the CDS market to be regulated. New York has charitably offered to oversee “covered” swaps—those where the protection buyer holds the underlying bonds; Mr Dinallo labels uncovered CDS trades as “naked”, likening them to abusive short-selling of shares. Federal regulators, who passed up several opportunities to police the market during the credit boom, are circling too.

Dealers are hoping to head them off with a series of initiatives, which have been stepped up recently at the prompting of the Federal Reserve. Chief among them is the creation of a central clearing house for credit derivatives. Several groups, including a dealer-backed venture led by Intercontinental Exchange and a tie-up between CME Group, another exchange operator, and Citadel, a hedge fund, are vying for licences. One or more is likely to be awarded in the next few weeks.

The biggest benefit would be less counterparty risk, since each member firm would face only the clearing house, not lots of partners. Standardised collateral arrangements would reduce the sort of payment disputes that have flared up this year, including those between AIG and buyers of its insurance. This set-up has worked well for trading of energy swaps.

Although it would ease one problem, it may create another by concentrating risk in the clearer—“like the military putting all its artillery shells in a single dump,” says a banker. Any clearer will need to have “tremendous creditworthiness” and iron-clad risk controls, says Craig Donohue, chief executive of CME, which is planning to back its venture with its $7 billion guarantee fund and $115 billion in collateral.

Besides a clearing house, the market could do with more transparency. A lack of disclosure on CDS exposures has frequently led the market to overestimate risks: had it been realised that settlement payments on Lehman swaps would be only $6 billion, rather than the hundreds of billions feared, much of the turmoil in debt markets could have been avoided. To provide more clarity, the Depository Trust & Clearing Corporation, which runs the central registry for swaps, has just begun publishing weekly data on the largest (but not broken down by counterparty).

A streamlining of back offices, which were swamped as trading surged, is also necessary. Only now is the industry discovering the joys of “compression”, which allows offsetting swaps to be torn up. A staggering $25 trillion-worth, almost half of the total, has been binned in recent months. Though this does little to cut the amount at risk, it reduces operational costs and strips away a layer of complexity that has obscured trading exposures. There are plans to extend this tidying-up exercise to other derivatives, including interest-rate swaps, whose gross value, $393 trillion at the end of 2007, dwarfs that of CDSs.

All this will strengthen market infrastructure. But it will also eat into the profits of big dealers, such as Goldman Sachs and JPMorgan, at a time when every dollar is precious. Estimates of their total revenue related to CDSs run as high as $30 billion a year. This will fall as central clearing brings more price transparency, and drop even further if the swaps end up being traded on exchanges. The dealers have long argued that bespoke swaps do not belong on bourses. But contracts, especially those tied to indices rather than single names, are steadily becoming more standardised. Most CDSs, thinks a bank regulator, will move to exchanges “within a few years”.

These quasi-voluntary efforts may or may not reassure those calling for more dramatic intervention. Buyers and sellers of swaps will probably be required to disclose more information. They will certainly have to stump up more capital to trade, making the market less attractive. Indeed, since September the typical margin demanded by dealers has more than doubled. Once reshaped, the CDS market will be a bit duller and a lot less lucrative. But it will also be much safer.

The Economist

200) The presidential election

2008-11-01T09:56:00.000-07:00

America should take a chance and make Barack Obama the next leader of the free world.

IT IS impossible to forecast how important any presidency will be. Back in 2000 America stood tall as the undisputed superpower, at peace with a generally admiring world. The main argument was over what to do with the federal government’s huge budget surplus. Nobody foresaw the seismic events of the next eight years. When Americans go to the polls next week the mood will be very different. The United States is unhappy, divided and foundering both at home and abroad. Its self-belief and values are under attack.

For all the shortcomings of the campaign, both John McCain and Barack Obama offer hope of national redemption. Now America has to choose between them. The Economist does not have a vote, but if it did, it would cast it for Mr Obama. We do so wholeheartedly: the Democratic candidate has clearly shown that he offers the better chance of restoring America’s self-confidence. But we acknowledge it is a gamble. Given Mr Obama’s inexperience, the lack of clarity about some of his beliefs and the prospect of a stridently Democratic Congress, voting for him is a risk. Yet it is one America should take, given the steep road ahead.

Thinking about 2009 and 2017

The immediate focus, which has dominated the campaign, looks daunting enough: repairing America’s economy and its international reputation. The financial crisis is far from finished. The United States is at the start of a painful recession. Some form of further fiscal stimulus is needed, though estimates of the budget deficit next year already spiral above $1 trillion. Some 50m Americans have negligible health-care cover. Abroad, even though troops are dying in two countries, the cack-handed way in which George Bush has prosecuted his war on terror has left America less feared by its enemies and less admired by its friends than it once was.

Yet there are also longer-term challenges, worth stressing if only because they have been so ignored on the campaign. Jump forward to 2017, when the next president will hope to relinquish office. A combination of demography and the rising costs of America’s huge entitlement programmes—Social Security, Medicare and Medicaid—will be starting to bankrupt the country. Abroad a greater task is already evident: welding the new emerging powers to the West. That is not just a matter of handling the rise of India and China, drawing them into global efforts, such as curbs on climate change; it means reselling economic and political freedom to a world that too quickly associates American capitalism with Lehman Brothers and American justice with Guantánamo Bay. This will take patience, fortitude, salesmanship and strategy.

At the beginning of this election year, there were strong arguments against putting another Republican in the White House. A spell in opposition seemed apt punishment for the incompetence, cronyism and extremism of the Bush presidency. Conservative America also needs to recover its vim. Somehow Ronald Reagan’s party of western individualism and limited government has ended up not just increasing the size of the state but turning it into a tool of southern-fried moralism.

The selection of Mr McCain as the Republicans’ candidate was a powerful reason to reconsider. Mr McCain has his faults: he is an instinctive politician, quick to judge and with a sharp temper. And his age has long been a concern (how many global companies in distress would bring in a new 72-year-old boss?). Yet he has bravely taken unpopular positions—for free trade, immigration reform, the surge in Iraq, tackling climate change and campaign-finance reform. A western Republican in the Reagan mould, he has a long record of working with both Democrats and America’s allies.

If only the real John McCain had been running

That, however, was Senator McCain; the Candidate McCain of the past six months has too often seemed the victim of political sorcery, his good features magically inverted, his bad ones exaggerated. The fiscal conservative who once tackled Mr Bush over his unaffordable tax cuts now proposes not just to keep the cuts, but to deepen them. The man who denounced the religious right as “agents of intolerance” now embraces theocratic culture warriors. The campaigner against ethanol subsidies (who had a better record on global warming than most Democrats) came out in favour of a petrol-tax holiday. It has not all disappeared: his support for free trade has never wavered. Yet rather than heading towards the centre after he won the nomination, Mr McCain moved to the right.

Meanwhile his temperament, always perhaps his weak spot, has been found wanting. Sometimes the seat-of-the-pants method still works: his gut reaction over Georgia—to warn Russia off immediately—was the right one. Yet on the great issue of the campaign, the financial crisis, he has seemed all at sea, emitting panic and indecision. Mr McCain has never been particularly interested in economics, but, unlike Mr Obama, he has made little effort to catch up or to bring in good advisers (Doug Holtz-Eakin being the impressive exception).

The choice of Sarah Palin epitomised the sloppiness. It is not just that she is an unconvincing stand-in, nor even that she seems to have been chosen partly for her views on divisive social issues, notably abortion. Mr McCain made his most important appointment having met her just twice.

Ironically, given that he first won over so many independents by speaking his mind, the case for Mr McCain comes down to a piece of artifice: vote for him on the assumption that he does not believe a word of what he has been saying. Once he reaches the White House, runs this argument, he will put Mrs Palin back in her box, throw away his unrealistic tax plan and begin negotiations with the Democratic Congress. That is plausible; but it is a long way from the convincing case that Mr McCain could have made. Had he become president in 2000 instead of Mr Bush, the world might have had fewer problems. But this time it is beset by problems, and Mr McCain has not proved that he knows how to deal with them.

Is Mr Obama any better? Most of the hoopla about him has been about what he is, rather than what he would do. His identity is not as irrelevant as it sounds. Merely by becoming president, he would dispel many of the myths built up about America: it would be far harder for the spreaders of hate in the Islamic world to denounce the Great Satan if it were led by a black man whose middle name is Hussein; and far harder for autocrats around the world to claim that American democracy is a sham. America’s allies would rally to him: the global electoral college on our website shows a landslide in his favour. At home he would salve, if not close, the ugly racial wound left by America’s history and lessen the tendency of American blacks to blame all their problems on racism.

So Mr Obama’s star quality will be useful to him as president. But that alone is not enough to earn him the job. Charisma will not fix Medicare nor deal with Iran. Can he govern well? Two doubts present themselves: his lack of executive experience; and the suspicion that he is too far to the left.

There is no getting around the fact that Mr Obama’s résumé is thin for the world’s biggest job. But the exceptionally assured way in which he has run his campaign is a considerable comfort. It is not just that he has more than held his own against Mr McCain in the debates. A man who started with no money and few supporters has out-thought, out-organised and outfought the two mightiest machines in American politics—the Clintons and the conservative right.

Political fire, far from rattling Mr Obama, seems to bring out the best in him: the furore about his (admittedly ghastly) preacher prompted one of the most thoughtful speeches of the campaign. On the financial crisis his performance has been as assured as Mr McCain’s has been febrile. He seems a quick learner and has built up an impressive team of advisers, drawing in seasoned hands like Paul Volcker, Robert Rubin and Larry Summers. Of course, Mr Obama will make mistakes; but this is a man who listens, learns and manages well.

It is hard too nowadays to depict him as soft when it comes to dealing with America’s enemies. Part of Mr Obama’s original appeal to the Democratic left was his keenness to get American troops out of Iraq; but since the primaries he has moved to the centre, pragmatically saying the troops will leave only when the conditions are right. His determination to focus American power on Afghanistan, Pakistan and proliferation was prescient. He is keener to talk to Iran than Mr McCain is— but that makes sense, providing certain conditions are met.

Our main doubts about Mr Obama have to do with the damage a muddle-headed Democratic Congress might try to do to the economy. Despite the protectionist rhetoric that still sometimes seeps into his speeches, Mr Obama would not sponsor a China-bashing bill. But what happens if one appears out of Congress? Worryingly, he has a poor record of defying his party’s baronies, especially the unions. His advisers insist that Mr Obama is too clever to usher in a new age of over-regulation, that he will stop such nonsense getting out of Congress, that he is a political chameleon who would move to the centre in Washington. But the risk remains that on economic matters the centre that Mr Obama moves to would be that of his party, not that of the country as a whole.

He has earned it

So Mr Obama in that respect is a gamble. But the same goes for Mr McCain on at least as many counts, not least the possibility of President Palin. And this cannot be another election where the choice is based merely on fear. In terms of painting a brighter future for America and the world, Mr Obama has produced the more compelling and detailed portrait. He has campaigned with more style, intelligence and discipline than his opponent. Whether he can fulfil his immense potential remains to be seen. But Mr Obama deserves the presidency.

The Eonomist

199) When consumers capitulate

2008-11-01T09:49:00.000-07:00

The long-feared capitulation of American consumers has arrived. According to Thursday's GDP report, real consumer spending fell at an annual rate of 3.1 percent in the third quarter; real spending on durable goods (stuff like cars and TVs) fell at an annual rate of 14 percent.

To appreciate the significance of these numbers, you need to know that American consumers almost never cut spending. Consumer demand kept rising right through the 2001 recession; the last time it fell even for a single quarter was in 1991, and there hasn't been a decline this steep since 1980, when the economy was suffering from a severe recession combined with double-digit inflation.

Also, these numbers are from the third quarter - the months of July, August, and September. So these data are basically telling us what happened before confidence collapsed after the fall of Lehman Brothers in mid-September, not to mention before the Dow plunged below 10,000. Nor do the data show the full effects of the sharp cutback in the availability of consumer credit, which is still under way.

So this looks like the beginning of a very big change in consumer behavior. And it couldn't have come at a worse time.

It's true that American consumers have long been living beyond their means. In the mid-1980s Americans saved about 10 percent of their income. Lately, however, the savings rate has generally been below 2 percent - sometimes it has even been negative - and consumer debt has risen to 98 percent of GDP, twice its level a quarter-century ago.

Some economists told us not to worry because Americans were offsetting their growing debt with the ever-rising values of their homes and stock portfolios. Somehow, though, we're not hearing that argument much lately.

Sooner or later, then, consumers were going to have to pull in their belts. But the timing of the new sobriety is deeply unfortunate. One is tempted to echo St. Augustine's plea: "Grant me chastity and continence, but not yet." For consumers are cutting back just as the U.S. economy has fallen into a liquidity trap - a situation in which the Federal Reserve has lost its grip on the economy.

Some background: One of the high points of the semester, if you're a teacher of introductory macroeconomics, comes when you explain how individual virtue can be public vice, how attempts by consumers to do the right thing by saving more can leave everyone worse off. The point is that if consumers cut their spending, and nothing else takes the place of that spending, the economy will slide into a recession, reducing everyone's income.

In fact, consumers' income may actually fall more than their spending, so that their attempt to save more backfires - a possibility known as the paradox of thrift.

At this point, however, the instructor hastens to explain that virtue isn't really vice: In practice, if consumers were to cut back, the Fed would respond by slashing interest rates, which would help the economy avoid recession and lead to a rise in investment. So virtue is virtue after all, unless for some reason the Fed can't offset the fall in consumer spending.

I'll bet you can guess what's coming next.

For the fact is that we are in a liquidity trap right now: Fed policy has lost most of its traction. It's true that Ben Bernanke hasn't yet reduced interest rates all the way to zero, as the Japanese did in the 1990s. But it's hard to believe that cutting the federal funds rate from 1 percent to nothing would have much positive effect on the economy. In particular, the financial crisis has made Fed policy largely irrelevant for much of the private sector: The Fed has been steadily cutting away, yet mortgage rates and the interest rates many businesses pay are higher than they were early this year.

The capitulation of the American consumer, then, is coming at a particularly bad time. But it's no use whining. What we need is a policy response.

The ongoing efforts to bail out the financial system, even if they work, won't do more than slightly mitigate the problem. Maybe some consumers will be able to keep their credit cards, but as we've seen, Americans were overextended even before banks started cutting them off.

No, what the economy needs now is something to take the place of retrenching consumers. That means a major fiscal stimulus. And this time the stimulus should take the form of actual government spending rather than rebate checks that consumers probably wouldn't spend.

Let's hope, then, that Congress gets to work on a package to rescue the economy as soon as the election is behind us. And let's also hope that the lame-duck Bush administration doesn't get in the way.

Paul Krugman

198) Arbitrage funds: Low risk alternative for investors

2008-10-26T11:03:00.000-07:00

Investors are increasingly scouting for exposures that can provide relatively stable returns. Arbitrage funds offer one such exposure. This article discusses why such funds carry alpha-like exposure and how they generate arbitrage gains.

The sharp drawdown in portfolio values since this January has seen a paradigm shift in investor behaviour. Even portfolios with equity bias now seem to prefer exposure to assets with stable returns.

Some investors, for instance, have taken exposure to arbitrage funds (arb funds) as they have generated positive returns even during market downturns. Do such funds provide optimal gains?

Risky arbitrage?

Academic arbitrage is riskless. It involves buying an asset in one market and selling it in another for a higher price without initial investment.

Financial markets do not provide such opportunities. Some risk is involved because an initial capital outlay is often required. But the strategies that arb funds engage in are the closest an investor can get to riskless arbitrage.

The concept is based on capturing the “cost of carry” in the futures price.

Take Reliance Industries. Suppose the current spot price is Rs 1,200 and the near-month futures contract trades at Rs 1,215. The portfolio manager will buy, say, 7,500 shares of Reliance and sell 100 contracts (underlying 75 shares) of near-month futures.

The trading strategy is built on the fact that futures price converges to the spot price on expiry. What if Reliance spot price is at Rs 1,350 on expiry? The portfolio will gain Rs 11.25 lakh in the spot market but lose Rs 10.12 lakh in the futures market.

The net gain on the spot-futures arbitrage will be Rs 1.125 lakh.

What if Reliance closes at Rs 1,100 in the spot market? The portfolio will lose Rs 7.5 lakh in the spot market but gain Rs 8.625 lakh in the futures market.

The net gain will be Rs 1.125 lakh. The gain is the difference between the futures and the spot price at the time the trade is initiated.

It is, however, not necessary for the portfolio manager to hold the position till expiry. If she finds that the difference has narrowed since initiating the trade, she can close the position and capture arbitrage gains.

The portfolio will, however, gain most if the position is held till expiry. The reason is that the difference between futures and spot price will then be zero and the initial difference turns into arbitrage gains.

Investment optimality

Arb funds generated between 7 and 8 per cent return in the last one year. The benchmark for such funds is typically a liquid index.

Money market funds have generated higher returns this year because of the tight liquidity in the credit market.

Such funds invest in short-term instruments such as treasury bills and commercial papers.

Liquid funds are somewhat different in that they also invest in short-term bonds.

The point is that upside is capped in money market funds as returns comprise only of interest income.

Liquid funds generate marginally higher returns but are exposed to price risk due to bond price declines.

Arb funds carry the potential to generate higher returns if there is large mispricing in assets, which is often the case in volatile markets. Besides, such funds neutralise market risk as long as the portfolio manager follows the fund’s mandate.

This gives the fund an alpha-like characteristic which fits well in the satellite portfolio within the core-satellite framework. Alpha returns refer to excess returns that the fund manager generates which has low correlation with market returns.

Investors have to consider two factors before choosing an arb fund- management expense ratio (MER) and exposure to the bond market. Most arb funds have MER between one and 1.65 per cent. This is high but not unreasonable, considering that even index funds carry an MER of one per cent.

The problem then is with the arb fund’s bond exposure. Arb funds take such exposure to earn above cash-returns when the portfolio manager does not find arbitrage opportunities.

Investors should prefer funds instead that take exposure in money market instruments. The reason is that bonds carry higher price risk that may not be necessarily compensated by the higher yield.

Besides, such exposure could bring down the stability of alpha returns, as exposure to bond market will increase correlation with market returns.

Conclusion

The continual decline in asset prices has led many investors to look for exposure that provide relatively stable returns. This article shows why arb funds could be one such exposure. At present, there are just over 10 funds exploiting the spot-futures arbitrage.

As more funds engage in such strategies, arbitrage gains may become increasingly difficult but not impossible. Till then, MERs and bond exposure will play a significant role in selecting an arb fund.

B. Venkatesh

(The author is an investment strategist. He can be reached at enhancek@gmail.com)

197) Who murdered the financial system?

2008-10-22T19:42:00.000-07:00

Leftists claim that the global financial crisis was caused by reckless deregulation and greed. Rightists blame half-baked financial regulations and perverse incentives. Actually, the financial sector is deeply regulated, with major roles for both the state and markets. It was not one or the other that failed but the combination.

The best metaphor for the mess comes from Jack and Suzy Welch, who recall Agatha Christie’s Murder on the Orient Express. In this novel, 12 people are suspects in a murder. And 12 turn out to be guilty. What starts as a whodunit concludes as an everybody-dun-it. In the same spirit, allow me to present the 12 murderers of the US financial system.

1) The Federal Reserve Board

Alan Greenspan, Fed Governor in 1987-2006, was once hailed as a genius for keeping the US booming, but is now called a serial bubble-maker. He presided over bubbles in housing, credit, and stock markets. He said it was difficult to identify asset bubbles in advance, so anti-bubble policies might be anti-growth. It was better to let bubbles build, and sweep up after they burst. Bernanke, like Greenspan, ignored the US housing bubble till it burst.

2) US politicians

Envisioning a home for every American, regardless of income, they provided excess implicit and explicit housing subsidies. One law forced banks to lend to subprime poor borrowers. Legislators created Fannie Mae and Freddie Mac, government-sponsored entities that bought or underwrote 80% of all US mortgages, and enjoyed exemption from normal regulations. Politicians ignored Greenspan’s warning that such a dominant role for two under-regulated giants posed a huge financial risk.

3) Fannie Mae and Freddie Mac

They resisted regulation, and spent over $2 million lobbying legislators against any tightening of rules. As mortgagers of last resort they should have been especially prudent. But they bought stacks of toxic mortgage paper — collateralised debt obligations (CDOs) — seeking short-term profits that ultimately led to bankruptcy.

4) Financial innovators

Their ideas provided cheap, easy credit, and helped stoke the global economic boom of 2003-08. Securitisation of mortgages provided an avalanche of capital for banks and mortgage companies to lend afresh. Unfortunately the new instruments were so complex that not even bankers realised their full risks.

CDOs smuggled BBB mortgages into AAA securities, leaving investors with huge quantities of down-rated paper when the housing bubble burst. Financial innovators created credit default swaps (CDSs), which insured bonds against default. CDS issues swelled to a mind-boggling $60 trillion. When markets fell and defaults widened, those holding CDSs faced disaster.

5) Regulators

All major countries had regulators for banking, insurance and financial/ stock markets. These were asleep at the wheel. No insurance regulator sought to check the runaway growth of the CDS market, or impose normal regulatory checks like capital adequacy. No financial regulator saw or checked the inherent risks in complex derivatives. Leftists today demand more regulations, but these will not thwart the next crisis if regulators stay asleep.

6) Banks and mortgage lenders

Instead of keeping mortgages on their own books, lenders packaged these into securities and sold them. So, they no longer had incentives to thoroughly check the creditworthiness of borrowers. Lending norms were constantly eased. Ultimately, banks were giving loans to people with no verification of income, jobs or assets. Some banks offered teaser loans — low starting interest rates, which reset at much higher levels in later years — to lure unsuspecting borrowers.

7) Investment banks

Once, these institutions provided financial services such as underwriting, wealth management, and assistance with IPOs and mergers and acquisition. But more recently they began using borrowed money — with leverage of up to 30 times — to trade on their own account. Deservedly, all five top investment banks have disappeared. Lehman Brothers is bust, Bear Stearns and Merrill Lynch have been acquired by banks, and Morgan Stanley and Goldman Sachs have been converted into regular banks.

8) Rating agencies

Moody’s and Standard and Poor’s were not tough or alert enough to spot the rise in risk as leverage skyrocketed. They allowed BBB mortgages to be laundered into AAA mortgages through CDOs.

9) The Basel rules for banks

These international negotiated norms provided harmonised regulatory checks on financial excesses across countries. The first set of norms, Basel-I, was widely criticised as too rigid and blunt. So countries agreed on Basel-II, which allowed banks to use credit ratings and models based on historical record to lower the risk-ratings of many securities. This dilution of norms led to excesses everywhere. Iceland’s banks went bust holding loans/securities totalling 10 times its GDP. The dilution of risk-rating in Basel-II helped inflate the financial bubble.

10) US Consumers

Their savings used to be 6% of disposable income some time ago, but more recently has been zero or even negative. They have gone on a huge borrowing spree to spend far more than they earn. This excess is reflected in huge, unsustainable US trade deficits.

11) Asian and OPEC countries

They undervalued their currencies to stimulate exports and create large trade surpluses with the US. They accumulated trillions in forex reserves, and put these mostly into dollar securities. This depressed US interest rates, and further fuelled borrowing there.

12) Everybody

Consumers, corporations, banks, politicians, the media — indeed everybody — was happy when housing prices boomed, stock markets boomed, and credit became cheap and easily available. Bubbles in all these areas grew in full public view. They were highlighted by analysts, but nobody wanted to stop the lovely party. Everybody liked easy money and rising asset prices. This trumped prudence across countries.

So, forget the Left-versus-Right or regulations-versus-markets debate on the financial crisis. States, institutions, markets and everybody else was guilty.

These actors will for some years don sackcloth and ashes, adopt stiffer regulations, and listen to lectures on the virtues of prudence and restraint. But after seven-to-ten years of the next business upswing, I predict that we will once again have a new generation of bubbles, evading whatever new checks have been put in place. When everybody loves bubbles, they are both irresistible and inevitable.

Swaminathan Iyer
Economist

196) For a few dollars more

2008-10-17T09:16:00.000-07:00

Is it worthwhile for developing countries to pursue policies which increase integration of their financial markets?

Financial globalisation by increasing cross-border capital flows can increase systemic risk in financial systems around the globe. That is, when markets become closely integrated, instability generated in one market rapidly spreads to other markets. The current market turmoil, seen as a consequence of financial globalisation, has revived the debate about the pros and cons of financial globalisation. The key question is: is it worthwhile for developing countries to purse policies which increase integration of their financial markets with those of the other countries. In other words, do the benefits from financial globalisation outweigh the risks?

A recent paper from Her Majesty’s Treasury* argues that financial globalisation can deliver significant benefits to countries in terms of economic growth and macroeconomic stability. Specifically, the paper claims that the main channel through which financial globalisation contributes to economic growth is by improving allocative efficiency of capital. In open financial markets, capital would tend to flow into economies where it can be put to its most productive use, thereby increasing its efficiency. Moreover, increased availability of capital lowers the cost of raising capital. This in turn encourages firms to take on more investment, thereby enhancing growth.

Furthermore, financial globalisation can enhance growth by spreading technology and managerial expertise, promoting development of secondary markets and aiding productivity growth because of increased competition. In addition, financial globalisation is likely to provide impetus to financial sector development, help promote institutions and contribute to total factor productivity growth by improving economy-wide efficiency. The paper argues that it is for these reasons a return to financial protectionism would damage global economic prospects.

In contrast, in a recent paper Dani Rodrik and Arvind Subramanian** argue that in the case of developing economies it is difficult to empirically establish a robust causal relationship between financial integration and economic growth. The paper goes on to argue that the presumed benefits of financial globalisation, such as, increased investment and better consumption smoothing opportunities have simply not materialised for emerging markets. It turns out that countries that have grown most rapidly have been those that rely less on foreign capital.

Rodrik and Subramanian argue that whether financial liberalisation and globalisation is beneficial or not depends on country specific factors. For example, in a country where the return on investment is low, additional foreign capital will not increase growth, but instead will drive up the value of the domestic currency. This might hinder exports and hence growth. This argument raises an interesting question. Why would there be an influx of foreign capital in the first place if return on investment is low? The paper fails to shed light on this issue.

The treasury paper also acknowledges that there are significant risks from financial globalisation. For example, increased cross-border transactions can increase systemic risk by increasing the correlation of asset prices across countries. Furthermore, it makes emerging economies vulnerable to the sudden reversal in international capital flows, which can cause exchange rate volatility and asset price bubbles. It is for this reason that both papers acknowledge that capital controls may be necessary for emerging countries at certain times.

In sum, both papers argue that the benefits from financial globalisation depend on a country meeting certain pre-requisites, although Rodrik and Subramanian appear to be more pessimistic about its potential benefits. Good institutions, appropriate regulatory and supervisory framework, responsible macroeconomic policies, financial sector development and trade integration determine the extent to which a country benefits from financial globalisation.

The current financial meltdown is bound to intensify scepticism about markets and globalisation. Neither of the papers reviewed here argue in favour of financial protectionism, but rather the message is, countries should accelerate reforms to strengthen their regulatory and supervisory systems, and should satisfy the pre-conditions for opening up of their financial markets before embarking on financial globalisation. Or else the risk-return trade off associated with financial globalisation would turn unfavourable.

Vidya Mahambare

*Embracing financial globalisation, HM Treasury, UK, May 2008
**Why did the financial globalisation disappoint? Dani Rodrik and Arvind Subramanian, Harvard, March 2008. The author is senior economist, CRISIL

195) Deregulate and perish?

2008-10-17T09:08:00.000-07:00

Deregulation cannot be blamed since it decreased costs through increased competition and raised efficiency.

In the last few years commentators often pointed out that the persistent global economic imbalances were unsustainable. However, few would have predicted that the Western financial sector and global stock markets would be close to a meltdown by October 2008. Governments have been forced into taking action to prevent the financial system from shutting down. Therefore, taxpayers have ended up recapitalising wayward financial firms. In this context, it would be useful to review recent events with a historical perspective to better understand how some of the best-known names in banking and insurance descended into bankruptcy so abruptly.

In the 1840s several US states defaulted on loans received from European creditors and the Eleventh Amendment to the US Constitution prevented foreign creditors from obtaining repayment by petitioning US courts. Over time some of these loans were repaid since US borrowers did not want to lose their access to European credit. It was around the late 19th century that financiers such as John Piermont Morgan garnered sufficient capital to act as financial intermediaries between Europe and the US. The two World Wars devastated Europe and US-based firms were able to establish themselves as the dominant international financial houses. As capital was scarce at that time, financial firms had a stranglehold over the corporate sector.

Till about the 1970s bankers in Western countries continued to have exclusive relationships with corporate clients, and investment banks underwrote debt and equity issuance at highly profitable terms for themselves. US companies grew, along with the economic ascendancy of the US, and were able to set up triple A-rated financial subsidiaries. Consequently, in the 1980s, as underwriting margins decreased, firms such as Salomon Brothers moved away from traditional investment banking to focus on proprietary trading of stocks, bonds and later options. Salomon Brothers was perhaps the first to create mortgage-backed securities (MBS). Michael Lewis documents in Liar’s Poker that as deregulation continued in the 1980s, and savings and loans managers were allowed to sell mortgages as bonds, unscrupulous Wall Street traders made huge fortunes. Michael Milken emerged as the junk bond king and finally went to jail in 1989 for “racketeering and securities fraud”. In 1990, Drexel Burnham Lambert was driven to bankruptcy for its involvement in junk bonds.

The 1933 Glass-Steagall Act, which set up the Federal Deposit Insurance Corporation and separated commercial from investment banking since the Great Depression in the US, was repealed in 1999. This meant that deposit-taking commercial banks like Citibank could underwrite and trade instruments such as MBS and collateralised debt obligations (CDOs), and set up structured investment vehicles (SIVs). In 2000, the elite investment bank J P Morgan which was reeling from an erosion of its traditional high margin investment banking business consolidated with Chase Bank.

Hedge funds are relatively lightly-regulated on the grounds that these special investment vehicles cater only to high net worth individuals or institutions. These funds have proliferated since the late 1960s when they were first set up. They engage in complex trading strategies including algorithmic or automated trading and are usually highly-leveraged. However, it is not just hedge funds which have high leverage ratios and use automated trading, banks engage in similar practices. It is estimated that in G7 countries, at least half of all stock trades are executed per automated instructions.

It is amusing that hedge funds and asset management firms advertise themselves as having consistently beaten the market rate of return. To do this, they have to adopt higher-risk strategies. And, riskier asset portfolios face sharp corrections in value from time to time. Hedge fund managers and institutional investors profess that they can time their investment decisions optimally. This is seductive logic. However, since hedge funds take varied positions, their collective investments are a sub-set of the market and it is not credible that they can regularly outperform the average market return.

The US housing mortgage market is valued at about $14 trillion and the sub-prime component is around 10 per cent of that amount. The recent financial firm bankruptcies and credit freeze were clearly triggered by housing loan defaults. However, the root causes of the current crisis are more varied than just the repackaging and selling of “toxic” sub-prime mortgage securities by getting the rating agencies to classify them as triple A. For example, AIG was inadequately capitalised to sell high volumes of credit default swaps (CDSs) on CDOs linked to MBS. At a more fundamental level, elementary principles of risk management were abandoned by regulators. For instance, in 2004 five US investment banks, namely Goldman, Lehman, Merrill, Bear-Stearns and Morgan Stanley prevailed upon the Securities and Exchange Commission (SEC) to allow them to increase their leverage. The SEC relaxed its three-decade-old rule, which restricted debt to net capital ratios to 12:1 and allowed these five banks to increase their leverage ratios to 30 and even 40:1. If leverage is around 30:1, a reduction in the value of a bank’s assets by a little over 3 per cent will wipe out its entire equity capital.

The US has invariably been at the forefront of financial sector deregulation and innovation. At the same time, in the last ten years or so, any weakening of consumer confidence or stock market sentiment was met by increased federal spending and interest rate cuts. This was possible because some Asian and fossil fuel-exporting countries had accumulated large trade surpluses and lent back the dollars to the US through investments in US government paper. Excessively generous housing loans to non-creditworthy borrowers led to a sharp increase in demand which, in turn, resulted in a housing market bubble. MBS were repackaged such that the underlying risk was less obvious and for a time the rise in real estate prices fuelled consumer spending. Less nimble financial institutions were left holding the risk on their books and some of the firms which provided CDS cover did not have adequate risk capital.

To summarise, is it deregulation which is at the root of the financial sector’s current problems? Deregulation cannot be blamed since it decreased costs through increased competition and also raised efficiency levels. The financial meltdown was due to an abdication of regulatory responsibility, conflicts of interest leading to irresponsible behaviour on the part of rating agencies, and excessively leveraged bets taken by financial institutions combined with loose monetary policy, the last of which was made possible by global trade imbalances.

Jaimini Bhagwati

The writer is the Ambassador of India to Belgium, Luxembourg and the European Union. Views expressed are personal. Contact: j.bhagwati@gmail.com.

194) Insurance cos learning lessons hard way

2008-10-15T10:47:00.000-07:00

For all of the last two years, capital has never been an issue for private life insurance companies. To get promoters to loosen purse strings, the management of a life insurance company had to only mention that they were growing faster than the market. Even mid-sized corporates with life insurance subsidiaries were willing to bring in a few hundred crores into the business every six months.

What drew in the capital was not the return on equity. Although it has been eight years since the industry was opened, most companies are far from break-even. The reason why capital was so freely available was the huge valuations that the market was placing on these life companies.

The valuations, in turn, were driven by 100%-plus growth recorded two years ago. Although private life insurers continued to pile up losses, these losses were explained away as notional since most of the capital continued to remain on their books in the form of provisions for solvency margins. The real surge in investments came in 2007-08 when the stock market took off, pushing up valuations of private life companies even further.

Corporates were also flush with cash and rising stocks pushed up the net asset value of various unit-linked insurance plans leading to further optimism in the business. In this one year, the private life insurance industry doubled its branch network to close to 8,000 branches and also grew their agency force 100% to 1.5 million agents. A host of new companies joined the fray, increasing the demand for managerial talent and pushing up the salary bill for the industry.

The tide began to turn earlier this year when the markets crashed in January. However, unlike the mutual fund industry, the life business held its own and saw its income rise during this period. What helped was that new Irda norms blocked exit routes for policyholders for three years. Also the new distribution capacities created earlier in 2007-08 started coming into play.

As a result, even as stocks tumbled, fresh money continued pouring into Ulips.
The outlook has, however, changed for the life insurance industry with the subprime storm gaining strength in October and bringing down with it giant institutions like AIG and Lehman Brothers. The decline in stocks has exposed the weaknesses of the life insurance industry.

For the first time, it looks likely that policyholder confidence in Ulips could get shaken. Insurance companies are already talking about a slowdown in new business in September & October. There is also the lurking fear that existing policyholders, who bought when the markets were at its peak, might be reluctant to put in renewal money, seeing how much their capital has shrunk. The negative equity returns have also brought into focus the cost structure of Ulips.

While high front-ending of costs does not matter much when stocks rise 40%, it is a different story in a bear market. Falling markets could also hit the persistency of life insurance agents, which in turn could impact policy persistency. When an agent drops out, all the money that has been invested in training the agent is lost. This pushes up the average cost of getting an agent on the street.

Companies spend anywhere between Rs 7,000 and Rs 10,000 in getting an agent trained and certified. If only one out of five agents sticks to the profession long-term, the average cost of recruiting a professional agent goes up to Rs 50,000. Similarly, when more-than-expected policies lapse, the assumptions made by insurers on new business profits go for a toss.

The other concern is that promoters may not be as willing as in the past to open their purses, particularly when the break-even date is being constantly pushed away. Unlike banking, insurance is a highly capital-intensive industry and insurance companies cannot substitute equity with tier II capital as in the case of banks.

But it is not all doom and gloom. Over the years, the life industry has built some inherent strengths that could help create strong financial institutions. With over Rs 12,000 crore invested in the industry, the life business is among the most resilient in the financial sector. Life companies have overtaken mutual funds in retail penetration because of their nationwide distribution network. Life companies also have built up immense brand value over the years because of which retail investors are willing to entrust them with their retirement savings.

What is needed for the industry is to recognise the change in approach that is required post subprime crisis. Unlike mutual funds life companies have the ability to provide guaranteed return products. Guaranteed return products coupled with trusted conventional plans could help life insurers capture some of the ‘flight to safety’ that is now being witnessed in the savings markets.

Secondly, this crisis provides insurers with the opportunity to get back to basics. In the last eight years, the life business has moved away completely from protection to investment-led products. Demand for protection is expected to rise as individual liabilities rise. This provides insurers with an opportunity to build relationships with new customers.

The other issue that has to be addressed is that of professionalising the insurance agency force. Private life companies came with the promise of bringing in financial advisors who do ’need-based’ selling rather than agents who push. But this has not happened. On the contrary, fly-by-night agents have mis-sold policies with their eye on first year commissions. Quality controls can check misselling and reduce lapsations.

Finally, like in all financial services, insurers need to bring down their margins to remain competitive. The recent case of mutual funds selling systematic investment plans with life covers shows how much the boundaries have faded. From next year, there will be pension companies which will offer to manage retirement funds with wafer-thin margins. Life companies may have carved out a new market in the last eight years but they will need to bring down costs if they wish to retain their market.

193) Paul Krugman: Gordon does good

2008-10-14T08:45:00.000-07:00

Has Gordon Brown, the British prime minister, saved the world financial system?

OK, the question is premature — we still don’t know the exact shape of the planned financial rescues in Europe or for that matter the United States, let alone whether they’ll really work. What we do know, however, is that Brown and Alistair Darling, the chancellor of the Exchequer (equivalent to our Treasury secretary), have defined the character of the worldwide rescue effort, with other wealthy nations playing catch-up.

This is an unexpected turn of events. The British government is, after all, very much a junior partner when it comes to world economic affairs. It’s true that London is one of the world’s great financial centres, but the British economy is far smaller than the US economy, and the Bank of England doesn’t have anything like the influence either of the Federal Reserve or of the European Central Bank. So you don’t expect to see Britain playing a leadership role.

But the Brown government has shown itself willing to think clearly about the financial crisis, and act quickly on its conclusions. And this combination of clarity and decisiveness hasn’t been matched by any other Western government, least of all our own. What is the nature of the crisis? The details can be insanely complex, but the basics are fairly simple. The bursting of the housing bubble has led to large losses for anyone who bought assets backed by mortgage payments; these losses have left many financial institutions with too much debt and too little capital to provide the credit the economy needs; troubled financial institutions have tried to meet their debts and increase their capital by selling assets, but this has driven asset prices down, reducing their capital even further.

What can be done to stem the crisis? Aid to homeowners, though desirable, can’t prevent large losses on bad loans, and in any case will take effect too slowly to help in the current panic. The natural thing to do, then — and the solution adopted in many previous financial crises — is to deal with the problem of inadequate financial capital by having governments provide financial institutions with more capital in return for a share of ownership. This sort of temporary part-nationalisation, which is often referred to as an “equity injection,” is the crisis solution advocated by many economists — and sources told The Times that it was also the solution privately favored by Ben Bernanke, the Federal Reserve chairman.

But when Henry Paulson, the US Treasury secretary, announced his plan for a $700 billion financial bailout, he rejected this obvious path, saying, “That’s what you do when you have failure.” Instead, he called for government purchases of toxic mortgage-backed securities, based on the theory that ... actually, it never was clear what his theory was.

Meanwhile, the British government went straight to the heart of the problem — and moved to address it with stunning speed. On Wednesday, Brown’s officials announced a plan for major equity injections into British banks, backed up by guarantees on bank debt that should get lending among banks, a crucial part of the financial mechanism, running again. And the first major commitment of funds will come on Monday — five days after the plan’s announcement.

At a special European summit meeting on Sunday, the major economies of continental Europe in effect declared themselves ready to follow Britain’s lead, injecting hundreds of billions of dollars into banks while guaranteeing their debts. And whaddya know, Paulson — after arguably wasting several precious weeks — has also reversed course, and now plans to buy equity stakes rather than bad mortgage securities (although he still seems to be moving with painful slowness).

As I said, we still don’t know whether these moves will work. But policy is, finally, being driven by a clear view of what needs to be done. Which raises the question, why did that clear view have to come from London rather than Washington? It’s hard to avoid the sense that Paulson’s initial response was distorted by ideology. Remember, he works for an administration whose philosophy of government can be summed up as “private good, public bad,” which must have made it hard to face up to the need for partial government ownership of the financial sector.

I also wonder how much the Femafication of government under President Bush contributed to Paulson’s fumble. All across the executive branch, knowledgeable professionals have been driven out; there may not have been anyone left at Treasury with the stature and background to tell Paulson that he wasn’t making sense.
Luckily for the world economy, however, Gordon Brown and his officials are making sense. And they may have shown us the way through this crisis.

Paul Krugman
(The writer is this year’s winner of the Nobel Economics Prize for his analysis of trade patterns)

192) Not Learning From History

2008-10-12T00:30:00.000-07:00

As the world struggles in the throes of a credit crisis, it seems appropriate to recount some (un)forgettable meltdowns of the twentieth century, the economics behind them and the panic that they created. Each of these major crises had features that have parallels in the current one. Yet, history repeats itself. Could investors have drawn a lesson or two from each of these and been more prudent? Read on.

The Japanese property bubble

The fall in property prices and defaults by sub-prime borrowers flagged off the now famous credit crisis. Will this crisis tip the world into recession? Let us hark back to the Japanese property bubble in the early 1980s.

At that time, Japan had huge trade surpluses (excess of exports over imports) with the US. Alarmed at its unfavourable Balance of Trade position, the US, through the Plaza Accord of 1985, allowed the yen to appreciate against the dollar. In two years’ time, the yen was up by almost 50 per cent.

The country’s export-dependent economy stumbled. Capital investments slowed. To avoid a recession, Japan eased restrictions on borrowings and progressively lowered interest rates. But low inflation (due to cheap imports and the fall in international oil prices), coupled with cheap money, enabled cash-flows into the property and stock markets as well.

Over the next few years, as demand for land increased, property prices soared. In the latter part of 1989, the Nikkei too raced towards its all-time high of 38,957 points but inflation had started to rear its head.

As the New Year dawned, the stock market nose-dived. The Bank of Japan sharply increased lending rates and placed restrictions on lending to the real estate sector. Property prices plummeted. Loans given with land as collateral went bad.

Soon, slowing investment and consumption led to deflation. Following the crash, the 1990s came to be known as ‘the lost decade’ in Japan. With the Asian financial crisis further rubbing salt into the wounds, Japan’s central bank adopted an extremely easy money policy that kept interest rates at virtually zero. Even today, at half a per cent, Japan has one of the lowest lending rates in the world. Little wonder that its central bank couldn’t cut rates earlier this week, alongside several other countries, in response to the US credit crisis!

Great Depression

The current credit crisis is increasingly being compared to the Great Depression in the US in the 1930s. The 1920s witnessed a huge increase in manufacturing output in the US. But the wages didn’t keep pace. Instead, the bulk of the profits was pocketed by corporates, creating a wide gap between the rich and the blue-collared.

At the same time, capacity expansions by companies (signalling higher profits), rising dividends and speculation drew surplus into the stock market. The upward spiral helped the Dow Jones Industrial Average hit a peak of 381 in September 1929.

When volatility rose, speculation gave way to fear and the party wound up quickly. The rich stopped spending. The poor, who were earlier financing their purchases mostly on credit, cut back. As demand declined, so did production. As a result, unemployment rose. Borrowers defaulted.

Ironically, it was the onset of World War II that boosted spending and bailed out the economy .

Asian crisis

If the Great Depression was born out of the unequal fruits of industrial prosperity, the Asian currency crisis of 1997-98 exposed the harm that volatile capital flows and highly leveraged positions can cause to entire economies. The years preceding the crisis saw South-east Asian economies such as Thailand, Malaysia and Indonesia open up their economies to foreign direct investments and capital flows.

Full capital mobility was allowed, with these Asian economies aligning their exchange rates closely with the dollar.

A sharp appreciation in the dollar in 1995 caused South-east Asian currencies to appreciate against other currencies as well. This resulted in significant losses on the export front — which was a key blow to these externally dependent economies.

A widening current account deficit (financed with overseas borrowings) coupled with basic differences in the economies of the US and these countries aroused speculation as to the ‘real’ exchange rate — the fixed exchange rate regime collapsed. As a result, the currencies of countries such as Thailand, Malaysia, Indonesia, Korea and Philippines were sharply devalued.

Interest rates were steeply raised to protect the local currencies. This set off a vicious spiral of rising cost of financing for companies and a squeeze on debt servicing capabilities. Earlier, the fixed exchange rates and the free flow of foreign funds had prompted domestic banks and corporates to borrow heavily from abroad.

Once disaster struck, the high leverage choked borrowers. Banks which resorted to borrowing from abroad for lending domestically too felt the heat. The excessive inflows had also found their way into asset classes such as the stock market and real estate.

When foreign investors began to pull money out, both stock market and real estate prices slumped. In the latter half of 1997, the IMF, along with the World Bank and the Asian Development Bank, provided aid to these countries as they were in danger of defaulting on their debt repayments.

These countries also agreed to undertake structural reforms by tightening their fiscal and monetary policies.

Latin American debt crisis

A similar story had already been enacted in Latin America in the 1980s. In the context of massive inflows of foreign capital and subsequent flight, the Asian crisis was, in fact, Latin America Part II.

The substantial increase in oil prices in 1973-74 by the OPEC nations resulted in massive inflows of surplus money into the oil-exporting countries. With the availability of funds far exceeding domestic requirements, these countries parked surplus funds in international commercial banks.

This happened at a time when countries such as Chile, Uruguay and Argentina had just liberalised trade and needed money to implement economic reforms.

Besides, oil-importing countries in this area also needed money to finance their deficits. So Latin America resorted to borrowing these surplus ‘petro-dollars’ from commercial banks whose loans were short-term and carried variable rates.

As the 1970s drew to a close, oil prices spiked again, fuelling inflation and, hence, higher interest rates. Money was needed to finance both the trade imbalance and the higher interest. For this, these countries resorted to fresh borrowings, and were thus pulled into a debt trap.

A year or two later, oil prices fell, but not interest rates. In Mexico, an oil-exporting country there was a flight of capital abroad. The peso depreciated by about 80 per cent; Mexico was unable to service its debt and was on the verge of defaulting on loan repayments.

Other Latin American countries followed suit. Further lending to these countries was refused and they could not get out of the debt trap. These nations were later forced to renegotiate their debt and the IMF stepped in to co-ordinate.

Parvatha Vardhini C.

191) Rescue the Rescue

2008-10-02T08:51:00.000-07:00

I was channel surfing on Monday, following the stock market’s nearly 800-point collapse, when a commentator on CNBC caught my attention. He was being asked to give advice to viewers as to what were the best positions to be in to ride out the market storm. Without missing a beat, he answered: “Cash and fetal.”

I’m in both — because I know an unprecedented moment when I see one. I’ve been frightened for my country only a few times in my life: In 1962, when, even as a boy of 9, I followed the tension of the Cuban missile crisis; in 1963, with the assassination of J.F.K.; on Sept. 11, 2001; and on Monday, when the House Republicans brought down the bipartisan rescue package.
But this moment is the scariest of all for me because the previous three were all driven by real or potential attacks on the U.S. system by outsiders. This time, we are doing it to ourselves. This time, it’s our own failure to regulate our own financial system and to legislate the proper remedy that is doing us in.
I’ve always believed that America’s government was a unique political system — one designed by geniuses so that it could be run by idiots. I was wrong. No system can be smart enough to survive this level of incompetence and recklessness by the people charged to run it.
This is dangerous. We have House members, many of whom I suspect can’t balance their own checkbooks, rejecting a complex rescue package because some voters, whom I fear also don’t understand, swamped them with phone calls. I appreciate the popular anger against Wall Street, but you can’t deal with this crisis this way.
This is a credit crisis. It’s all about confidence. What you can’t see is how bank A will no longer lend to good company B or mortgage company C. Because no one is sure the other guy’s assets and collateral are worth anything, which is why the government needs to come in and put a floor under them. Otherwise, the system will be choked of credit, like a body being choked of oxygen and turning blue.
Well, you say, “I don’t own any stocks — let those greedy monsters on Wall Street suffer.” You may not own any stocks, but your pension fund owned some Lehman Brothers commercial paper and your regional bank held subprime mortgage bonds, which is why you were able refinance your house two years ago. And your local airport was insured by A.I.G., and your local municipality sold municipal bonds on Wall Street to finance your street’s new sewer system, and your local car company depended on the credit markets to finance your auto loan — and now that the credit market has dried up, Wachovia bank went bust and your neighbor lost her secretarial job there.
We’re all connected. As others have pointed out, you can’t save Main Street and punish Wall Street anymore than you can be in a rowboat with someone you hate and think that the leak in the bottom of the boat at his end is not going to sink you, too. The world really is flat. We’re all connected. “Decoupling” is pure fantasy.
I totally understand the resentment against Wall Street titans bringing home $60 million bonuses. But when the credit system is imperiled, as it is now, you have to focus on saving the system, even if it means bailing out people who don’t deserve it. Otherwise, you’re saying: I’m going to hold my breath until that Wall Street fat cat turns blue. But he’s not going to turn blue; you are, or we all are. We have to get this right.
My rabbi told this story at Rosh Hashana services on Tuesday: A frail 80-year-old mother is celebrating her birthday and her three sons each give her a present. Harry gives her a new house. Harvey gives her a new car and driver. And Bernie gives her a huge parrot that can recite the entire Torah. A week later, she calls her three sons together and says: “Harry, thanks for the nice house, but I only live in one room. Harvey, thanks for the nice car, but I can’t stand the driver. Bernie, thanks for giving your mother something she could really enjoy. That chicken was delicious.”
Message to Congress: Don’t get cute. Don’t give us something we don’t need. Don’t give us something designed to solve your political problems. Yes, Hank Paulson and Ben Bernanke need to accept strict oversights and the taxpayer must be guaranteed a share in the upside profits from all rescued banks. But other than that, give them the capital and the flexibility to put out this fire.
I always said to myself: Our government is so broken that it can only work in response to a huge crisis. But now we’ve had a huge crisis, and the system still doesn’t seem to work. Our leaders, Republicans and Democrats, have gotten so out of practice of working together that even in the face of this system-threatening meltdown they could not agree on a rescue package, as if they lived on Mars and were just visiting us for the week, with no stake in the outcome.
The story cannot end here. If it does, assume the fetal position.

THOMAS L. FRIEDMAN

New York Times News Service

190) Greenspan: Revered to reviled?

2008-10-02T08:37:00.000-07:00

Warned about the after effects of a house price collapse, Mr Greenspan’s response was that asset bubbles were not the business of central banks.

He was hailed as the greatest central banker of all time (This writer thought so too). But former US Fed Chairman Mr Alan Greenspan’s reputation is heading towards tatters.

Never in history or hereafter will a central banker have as sharp or quick a fall.

The problem was the phenomenon of an asset price boom — specifically the boom in house prices.

This took place in the environment of sharp falls in US interest rates engineered by the Greenspan Fed, following the collapse of the dot com bubble and 9/11. From 5.5 per cent, as we entered 2000, the Fed cut to 1 per cent and kept it there for as long as three years.

In the meanwhile and as a result, housing prospered as did the stock market. Economic growth was tepid compared to the Clinton years (and might have been far worse but for the housing investment stimulant). Early warning

Sane advice was not in short supply. Mr Greenspan was warned — not once but several times, not by an odd economist, but many — about the after effects of a house price collapse.

His response was that asset bubbles were not the business of central banks and they should not influence monetary policy.

The most he would concede was that central banks might have a lot of cleaning up to do if asset prices crashed — in essence, no action on the way up but rate cuts and adequate liquidity provisioning on the way down.

Mr Greenspan did not see a housing collapse in his tenure but did successfully tackle the 1987 stock market fall, the Mexican and Asian crises and hedge fund LTCM’s implosion with his recommended medicine.

In fact, he was busy fighting a different war — one against deflation, strange as it sounds today. In this, he was on the same wavelength as the present Fed Chairman, Mr Ben Bernanke, who too missed the significance of asset bubbles. By the time Mr Greenspan decided to start raising interest rates, it was too late to check the boom, which, sooner or later, was bound to end in tears.Regulation laxity

More than failure to recognise the risk of asset bubbles, Mr Greenspan must be faulted for the laxity in bank regulation, which enabled the financial system to create millions of (now) worthless mortgages and Collateral Debt Obligations backed by these weak assets.

The crowning glory was the rush to insure them with Credit Default Swaps, which were written for trillions of dollars by institutions like the late unlamented AIG on the strength of dubious credit ratings awarded by conniving rating agencies.

It will remain a tragedy that the first rate mind of Mr Alan Greenspan did not see all this coming.

S. Balakrishnan

189) Global financial crisis: A slippery slope

2008-10-01T09:21:00.000-07:00

We are going through the most serious global financial crisis since the Great Depression. It is centred in the United States, but its implications are worldwide.The nationalisation of Bradford & Bingley in the UK and financial support for Fortis in Europe highlight the dangers of contagion.

Only concerted action by governments and monetary authorities, particularly those of the US, can prevent a global disaster. The crisis is as much real as it is based on the fear in the minds of participants in the financial system. That is why the $700 billion Troubled Asset Recovery Plan proposed by US treasury secretary Paulson and rejected by US House of Representatives is so important. The US government must commit large amounts of taxpayer funds and show firm determination to solve the problem.

There were four main factors behind this crisis. One, the US had long and continuous economic expansion with low inflation over the last 15 years, making financial markets and regulators complacent. They forgot that there is a “business cycle”. Only 18 months ago, regulators, particularly the US Federal Reserve, were focused on dealing with the so-called ‘liquidity glut’. In the process, they missed noticing the emerging risk due to asset price inflation, particularly in real estate.

Two, during these good times financial institutions (FIs), particularly investment banks, grew very large. They took big risks and made huge profits. In recent years, FIs contributed nearly 40%, as against the normal 10%, of total US corporate profits. They paid huge salaries to recruit the best and the brightest from top business schools, who, in turn, helped create and sell complex financial products, credit derivatives and other securities whose risks were not understood by either investors or the top managements of investment banks.

Three: The good times encouraged banks to take higher risks. Highly leveraged transactions with “life covenants” became the norm. Investment banks themselves, became highly leveraged: 32:1 for Lehman Brothers before it failed, as against 8:1 for a conservative bank. Investment banks did not have sufficient capital to support the risks on their balance sheets.

Four, there was major failure of leadership at most FIs. Dealmakers took charge and risk managers were completely sidelined. Credit was mispriced so much that there was only small difference in the yield between junk bonds and US treasuries.

The very first inkling of the crisis came in February 2007 when Bobby Mehta, chief executive of HSBC, North America and another executive of HSBC, USA were sacked for catastrophic forays into high-risk US mortgage securities. These two bankers had received $40 million in bonuses the previous two years. The bank was forced to issue the first profit warning in its 142 years history but the timely action to recognise and deal with this problem has served HSBC well. Few market participants picked up the implications of this market signal.

Since early 2008, treasury secretary Henry Paulson and Federal Reserve chairman Ben Bernanke have been spearheading the fight against the financial crisis. Their challenge is to prevent systemic failure and recession, without creating a moral hazard, which would encourage people to act irresponsibly in the future.

They orchestrated Bear Stearns’ merger with JP Morgan to stabilise the markets in March. Last month, they took over Fannie Mae and Freddie Mac, virtually government enterprises believed to have “the full faith and credit of the US government” behind them. They let Lehman Brothers file for bankruptcy as it did not represent a systemic risk. By this action, they also gave a salutary warning to shareholders and creditors of FIs that the US government would not always bail them out.

Merrill Lynch’s merger with Bank of America, nudged on by the regulators, was a smart move. It addressed a problem before it became serious. AIG had to be rescued. Its normal insurance business continues to be sound, but it has assembled a huge portfolio of structured securities and credit default swaps that posed a risk to the entire financial system. Washington Mutual’s takeover by JP Morgan, and Wachovia’s acquisition by Citigroup underline the current fragility of US banking system.

Depending upon how effective the US government and other monetary authorities are in dealing with the current crisis, it would take at least a year, possibly more, for the credit markets to get back to normal. In the medium term, we will see US lawmakers impose fresh, perhaps, too many, regulations, on the financial system. The structure of the financial industry will undergo a major change. After the Great Depression, the Glass-Steagall Act separated commercial banks and securities firms. Ironically, the current financial crisis has led to combination of the two.

There will be other changes. Insurers will have to stick to their basic business and not take on huge risks on unrelated ventures. There is likely to be more regulations on hedge funds and other unregulated financial entities. Capital requirements for most FIs will be further enhanced. There would be an overhaul of executive compensation, and strengthening of risk management. Most derivatives such as Credit Default Swaps would become exchange-traded to eliminate counter party risk. Rating agencies will completely revise their approach to rating of mortgage and other complex securities.

This crisis will have some impact on India as well — we are not decoupled from the global financial systems. We have already seen the Indian stock market move in tandem with global markets. Capital flows into India will, the in short term, slow down. The rupee will depreciate.

On the other hand, our domestic financial system is robust and well capitalised. The Reserve Bank has already initiated sound measures to control inflation and excesses in the property sector.

There is an additional concern and an opportunity. Indian corporates who made large acquisitions overseas in recent years, with significant leverage, will be challenged. At the same time, asset prices are very depressed, particularly in the US and Europe, presenting Indian companies with interesting acquisition opportunities.

(The author is former India CEO of Bank of America)

188) Monetary policy - Following the Fed or not?

2008-09-26T09:33:00.000-07:00

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

2008-09-22T11:25:00.000-07:00

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

2008-09-20T09:53:00.000-07:00

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?

2008-09-19T12:51:00.001-07:00

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

2008-09-19T12:51:00.000-07:00

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?

2008-09-17T19:07:00.000-07:00

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)

182) Securities Lending and Borrowing System(SLBS)

2008-08-11T13:17:00.000-07:00

It has been almost four months since the Securities Lending and Borrowing (SLB) system was launched amid great fanfare. But there has not been a single trade in this window for over three months now.

And unless capital market regulator the Securities and Exchange Board of India (Sebi) overhauls some of the “user unfriendly norms”, that will continue to be the case, warn market watchers.

Custodians and institutional players have already made representations to SEBI, suggesting some amendments that could revive interest in this segment. These include extending the tenure of contracts, providing a longer duration for placing trades, and relaxing margin requirements.

While the SLB segment has failed to take off, foreign institutional investors (FIIs) continue to actively lend and borrow Indian equities in the over-the-counter (OTC) market.

FIIs authorised to issue participatory notes (PNs) are lending shares in their inventories to overseas investors for a fee, say sources at foreign broking houses. One of the reasons for the active OTC market is the lacunae in the domestic lending and borrowing mechanism, they claim.

“Why would FIIs want to play the over-regulated SLB market, when the offshore market is far more efficient and a lot quicker,” says an official at the Indian arm of a US-based brokerage.
At present, the tenure of a borrowing/

lending contract is seven days. This means that the borrowed shares have to be returned on the eighth day from transaction, to the lender.

Market participants say this time frame is too short. In the OTC market, players have the flexibility to borrow shares for up to a month or more. But the bigger problem is that of margins.

There are five types of margins levied on trades in the SLB segment. These include value at risk (VaR) margins, extreme loss margins, mark-to-market (MTM) margins, fixed percentage of lending price (to be paid by both the borrower and lender), fixed percentage of lending fee to be paid by the borrower.

The margins for the last two categories have been set at 25% and 100% by the National Stock Clearing Corporation - the clearing arm of the National Stock Exchange.

If all these margins are added, it works out to be as high as 100% or sometimes even more, say market participants. This means that to borrow Rs 100 worth of shares, you need to pay Rs 100 worth of margins, which then makes the trade unviable.

Such high margins make little sense, considering that the list of securities eligible for lending and borrowing is that same as that eligible for futures and options (F&O) trading. In such a scenario, a prospective borrower could as well go short on single stock futures by paying a margin of 25-30%.

“In the offshore lending market, the margin requirement is just about 20%,” says an official from an institutional brokerage house.

A group of custodians and officials from foreign brokerage houses is already said to have met the NSE, seeking easier margin norms.

These players are also seeking extension of the duration for which the trades can be placed in the SLBS window. At present, this window is open for only hours between 10 am to 11 am on trading days. Then comes the matter of transparency - how much is good enough?

The Sebi guidelines mandate the authorised intermediaries publicly disseminate the details of SLB transactions executed on the platform provided by them and the outstanding positions on a weekly basis.

Some players feel this could lead to front-running or other forms of market manipulation, as the market would be aware which player is short in which stock.

“Like in the offshore market, SLB has to exist in a dark pool of liquidity, or there could be attempts to distort prices,” says the official from the institutional brokerage.

181) Don`t worry about the Balance of Payments

2008-08-09T23:03:00.000-07:00

The merchandise deficit is rising and FII inflows are falling, but higher FDI and stable ECB flows will ensure there's no forex crisis.

The recent sharp rise in the Current Account Deficit has brought attention back to the Balance of Payments accounts. Like many emerging markets, India has seen significant increase in capital inflows over the past few years as consistently above-8 per cent domestic growth attracted global investors. But, it has also seen a rising import bill on account of escalating oil prices and accelerating domestic demand for capital goods and metals. As India relies on oil imports to meet much of its oil needs, it remains vulnerable to volatile and uncertain oil prices. Moreover, relatively lesser liquidity in the global economy and an expected slower domestic growth this fiscal are also likely to generate smaller net capital inflows. But do these risks translate into a serious threat to the balance in external accounts?

Since the beginning of the decade, external transactions have resulted in an addition to the foreign exchange reserves as Capital Account Surplus and this has continually offset the Current Account Deficit. But the Balance of Payments composition and magnitude has changed significantly over the period. Acceleration in economic growth since 2002-2003 not only created increased thrust for imports of both oil and non-oil goods but also attracted large capital inflows. Thus the gap between Current Account Deficit and Capital Account Surplus has continued to widen every subsequent year. In 2007-08, where Capital Account Surplus jumped to record $108.3 billion, the Current Account Deficit soared to a record deficit of $17.4 billion.

The merchandise deficit has been the dominant component influencing the Current Account Deficit, with its contribution increasing sharply. Even though exports grew at a compound annual growth rate of about 20 per cent, imports grew at a much faster 24 per cent over the last seven years. Exports were driven primarily by demand for engineering goods, gems and jewellery, chemicals, and more recently petroleum products. But imports have been driven by demand for crude oil, electronic machinery and electronic goods, gold, machinery and iron and steel in accordance with rising demand for production.

Thus, the surging international price of most of these commodities in the last few years resulted in a much higher payments outflow on account of a higher import bill. Oil imports which constitute one-third of total imports have shot up 5.5 times since 2000-01 to $77 billion and meanwhile non-oil imports have ballooned four times to $171.5 billion. Consistently rising net invisibles balance (sum of net transfer payments, net incomes received from abroad and net services trade) has only partially offset the merchandise deficit. Even as net software services grew at a 26.2 per cent compound annual growth rate in the period, it offset only 40 per cent of the merchandise deficit every year. In 2007-08 specifically, invisibles surplus surged at 36 per cent to $31.7 billion but the merchandise deficit grew a further 42 per cent to $90.9 billion, bringing the Current Account Deficit to 1.5 per cent of the nominal GDP.

In contrast, the Capital Account Surplus has been driven by large inflows on account of portfolio inflows (FII), which have been virtually doubling every year over the past three years whilst the stock market rallied to record highs. Over the decade, these flows have increased 15-fold to $29.3 billion. While robust domestic economic growth and corporate performance attracted FIIs, easing investment regulations across sectors and greater interest rate arbitrage opportunities facilitated inflows of the other two significant constituents — external commercial borrowings (ECBs) and foreign direct investment (FDI). Both components have grown 5-fold to $22.2 billion and $15.5 billion respectively over the decade.

Significant increase in foreign acquisition of Indian companies and widening participation of global private equity players in India raised FDI flows to $9.2 billion in 2005-06 and further to $34.9 billion in 2007-08. The rapidly growing service sector and computer hardware etc. sector have been the largest recipients of these inflows. In 2007-08, housing and real estate and not surprisingly the petroleum and natural gas sector emerged as the other two important sectors attracting FDI.

Meanwhile, as the interest rate differential widened, ECBs became more attractive and easier to obtain as impressive corporate financial performance over the last few years reduced their risk perceptions.

But, de facto capital account convertibility over the last few years has provided resident individuals and companies greater opportunities to diversify their portfolios. This is reflected in the manifold rise in portfolio outflows, to $206.4 billion last fiscal. Importantly, rising global aspirations of Indian firms led to the emergence and growth of Indian multinationals encouraged by the steady rise in limit on their outward acquisition to 300 per cent of their net worth. From an average of about $2 billion for years, FDI outflow jumped to $6.4 billion in 2005-06 and further to $19.4 billion in 2007-08.

But these trends are set to change this fiscal as slowing domestic economic activity, tight global liquidity conditions, and more recently, slowing corporate profit growth point to moderating momentum of FII inflows this year. Yet, the long-term attractiveness of the Indian market will sustain FDI interest in the market and relatively high domestic interest rates are likely to prevent a sharp decline in ECB inflows. Moreover, volatility in equity markets across the world and relative strength in domestic growth vis-à-vis in other emerging countries will deter high capital outflows. The last two trends will cushion the impact of lower FII inflows this fiscal. Thus, the Capital Account Surplus is expected to drop to $ 70 billion or 5.3 per cent of GDP.

This would offset the Current Account Deficit completely. Even as high prices of oil, fertilizers and some commodities persist into fiscal 2008-09, a depreciating exchange rate (Rs 41.5-42/$ by year-end) will accelerate exports and encourage a fall in imports at the same time. While, demand for goods exports from the Asian neighbourhood and the Middle East will bolster growth, diversification of markets for software service exports will propel overall growth. This would partly offset the impact of high oil import bill. The oil import bill is likely to grow at 45 per cent to $111.7 billion in 2008-09, but the already evident fall in non-oil imports will take the total imports bill to $311.1 billion. The merchandise deficit is expected to rise to $123.8 billion as exports clock a 19 per cent growth. Moderation in invisibles surplus growth will result in a Current Account Deficit of $33 billion or 2.5 per cent of GDP.

Thus, while the gap between the Current Account Deficit and the Capital Account Surplus, will narrow in 2008-09, the Balance of Payments situation is still stable. Oil prices are the single-largest factor exhibiting considerable stress on the Current Account Deficit, but they have already begun to moderate, taking off some of the pressure. As of the end of March 2008, the merchandise imports cover of foreign exchange reserves was 15.6 months. By the end of 2008-09, the import cover is expected to reduce by a month and half by our calculations. Thus, while there is some stress, an overall healthy economy will prevent any crisis situation.

Radhika Anand & Parul Bhardwaj

The authors are economists at Crisil. ranand@crisil.com, pbhardwaj@crisil.com

180) Will dear money policy pay off?

2008-08-09T22:55:00.000-07:00

The RBI seems to have accorded highest priority to liquidity management to tackle inflation. While it remains to be seen whether this will work or not, such tightened monetary policy does have a bearing on the other sectors of the economy.

The RBI’s move to raise the repo rate and cash reserve ratio (CRR) sharply upwards has raised a lot of eyebrows with some feeling that it may be an overreaction to the inflation threat. This is especially so given that it follows a hike in repo rate by 75 bps (25 bps on June 11 and 50 bps on June 24) and CRR by 50 bps on June 24, which took effect in two tranches in July.

The fact is that an adjustment of aggregate demand through monetary policy was warranted to anchor the heightened inflationary expectations, which were engendered by global commodity price pressures.

The apex bank seems to have accorded highest priority to liquidity management. It apparently seeks to achieve price stability by ‘taming’, and not merely moderating, inflation. To meet the pressures of rising inflation, slowing growth and higher deficits, the RBI has frontloaded the monetary policy.

The money supply or M3 (broad money) continues to be a relevant target and indicator. It was 20.5 per cent on July 4 against 21.8 per cent a year ago, reflecting the deceleration in time deposits. However, it is higher than the 16.5-17 per cent indicative trajectory of the RBI.

Similarly, bank credit to the commercial sector has been 24 per cent, above the 20 per cent indicated in the Annual Policy statement. These factors necessitate ‘continuous vigilance and appropriate and timely policy responses’ such as a rate hike in order to temper demand for money and thus, the velocity of money. The WPI inflation has been high when the inflation-stoking money supply was high (see Table)

The spread between the repo and reverse repo rates has increased from one to three percentage points over the last three years (see Chart). This signifies the heightened uncertainties in the financial markets. There is a positive correlation between the levels of uncertainties and the spread between the rates.

The spread was one percentage point when the level of uncertainties was relatively low in the markets. The increasing spread between repo and reverse repo rates now captures the myriad uncertainties. Recently, the RBI called upon banks to share some of the costs of uncertainties.

Effect on economy

The GDP growth over the past three years has been close to 9 per cent and has been fuelled by robust domestic demand and availability of credit at competitive rates. But the consumption and investment demand are likely to shrink in the current situation of hardening interest rates, thus reducing the aggregate demand.

Recently, the RBI revised the GDP forecast for 2008-09 to around 8 per cent from 8-8.5 per cent as the fundamentals of the economy continue to be strong. However, the fiscal deficit is likely to increase on account of the huge under-recoveries on oil account. The decelerating growth coupled with higher inflation gives the semblance of a stagflationary scenario in India.

With an increase in the repo rate, it is inevitable that the lending and deposit rates of banks would also go up.

In recent years, the reverse repo has been more frequently used than the repo window, which has also witnessed relatively greater number of fluctuations than the former. During the last one year, the repo window has been used in only 25 per cent of the days.

The frequency of resorting to the repo bids has been low as the call money rates have been hovering at less than the repo rate. On a similar note, bankers may increasingly resort to the call money market, as the call rate has been higher than the reverse repo rate.

Notwithstanding the frequency of using the repo window, the cost of funding increases following a rate hike and there is a pressure on net interest margins. Furthermore, the repayment schedule of bank loans gets affected in view of the increase in interest rates and there is a greater tendency for borrowers to default, thereby enhancing the scope of NPAs.

This creates the need for greater provisioning under prudential norms, as the quality of some assets turns suspect, thus having an impact on the balance-sheets of banks.

The RBI stated that banks should now lay greater emphasis on stricter credit appraisals on a sectoral basis, monitor loan-to-value ratios and ensure the health of credit portfolios on a durable basis, without encountering undue asset-liability mismatches.

It has been urging banks regarding the containment of credit growth and may even take a supervisory review of the banks, indicating that the financial sector has to be in sync with the monetary policy.

Banks that depend more on bulk deposits, which come with higher interest rates, are likely to be affected more on account of hike in CRR, rather than the ones that have low-cost deposits (current and savings deposits) from retail savers.

Corporate sector IMPACT

An increase in repo rate has a ripple effect on industry, as some of the projects that were hitherto viable owing to the low interest rate regime may be rendered unviable in the face of higher interest rates.

Despite fluctuations in the Index of Industrial Production (IIP), the capital goods sector has been growing at a steady pace and the investment demand up to April has been strong. This was because of the availability of funds and relatively lower interest rates.

However, both the IIP and capital goods growth figures declined significantly in May, indicating the state of things to come. Moreover, there has been a downward revision in the April data from 7 per cent to 6.2 per cent. There is a time lag between rising costs and rising prices. The costs of inputs are going up and this invariably gets translated into higher prices for the consumers. The slowdown in the capital goods sector would have an impact on the consumer goods sector as well. Given the current inflationary situation, companies that have a higher component of debt in their capital structure are going to face the brunt of hardening interest rates. The capex plans of these companies may be put on hold.

There is likely to be a slowdown in the manufacturing sector as corporates face the double jeopardy of drying liquidity and higher debt burden, on the one hand, and rising input costs, on the other. The impact of curtailed demand and sluggish investment are likely to be seen with a lag in FY10.

The economy has to brace with a higher level of structural inflation and it cannot be conclusively stated that the current correction in oil prices is a trend reversal. Though the double-digit inflation in India has been a harbinger of a tightened monetary policy, the quantum and the deployment of both the instruments in the Quarterly Review, were not expected in many a quarter.

While inflation is largely imported, attributable to the rising global commodity prices, factors such as incomplete pass-through of oil prices on the domestic front and rising fiscal and trade deficits continue to be irritants in the domestic economic milieu.

C. N. M. Lavanya

179) When numbers don’t meet expectations

2008-08-09T22:53:00.000-07:00

If a stock falls, post-results, only because the quarterly numbers did not match ‘expectations’, it may be best to avoid selling the stock.

As we put the June earnings season behind us, one question that is likely to linger in investor minds is about how stock prices react to results announcements. Sometimes, a lot of hype is generated before the declaration of the results and the stock is on an upward march, only to be hammered once the numbers are out!

The numbers not being up to ‘expectations’ is often the reason cited for such events. If the numbers don’t meet street expectations, does it automatically mean that the company is not doing well and that you should sell that particular stock? Not necessarily. To understand a company’s performance, you must know how to read and evaluate quarterly numbers.

Trends in input costs: High costs of input can affect a company’s profit margins to a considerable extent and input costs (mostly commodity prices) can be cyclical as well as seasonal.

Therefore, price trends in a particular quarter may not sustain in the next one. For instance, airlines have been affected by the high cost of aviation turbine fuel last quarter, but if prices fall, that could improve profits next quarter. The high cost of steel has dented the profitability of automobile companies and any correction in steel prices can help in the next quarter.

Seasonal business: Some businesses are seasonal in nature, with much of the revenues or profits being made over one period of the year. Hotels register their peak performance in the winter season, when tourist arrivals are at a high. Cement sales and construction activity are usually down in the monsoon months.

Launch or project expenses: Some businesses may have to incur huge initial expenditure while launching a product, commencing a business or floating a project. This can also be on research and development cost or those associated with acquiring or merging entities. Though such expenses, in the short run, can affect profits, in the long run, they may aid the company’s growth. The investor should carefully evaluate if project-related expenditure is on account of delay in implementation or cost-overruns, which may be negative.

One-time expenditure: Employee VRS expenses, one-time settlement charges for any legal dispute, charges payable on account of statutory dues may drag down a quarter’s profits on a one-off basis, but may actually have positive implications for the long term. Corporates such as Century Textiles, Phoenix Mils, Bombay Dyeing have incurred high expenses on account of VRS in the past.

However, the resources such as land and building that were released as a result of the closure of units have resulted in windfall gains or opened up business opportunities for them.

Non recurring income: The sale of a division/asset or a stake in subsidiary company can provide a one-time boost to income in one quarter and artificially depress growth rates, if calculated on this base.

For instance, HDFC had booked a sizeable profit from sale of its stake in Intelnet BPO in the recent past. Such income is not likely to be of recurring nature and should not be considered for the purpose of stock evaluation.

Provisioning requirement: Provisions made towards losses on derivative contracts, decline in the price of debt securities, doubtful debts, etc may impact earnings one quarter, but may not necessarily sustain. The important point to note is that these provisions may be reversed in future in case there is any change in the asset price of security or recovery of debt.

Quarterly numbers is not the key parameter to judge a company. The same should be read along with the sustainability of earnings and general business conditions. A quarterly analysis should be used to find out if there is a systemic decline in the business or profitability. Only that is a case for an exit. If a stock falls, post-results, only because the quarterly numbers did not match “expectations”, it may be best to avoid selling the stock. Wealth maximisation requires you to stick with a business for the long term. This may require riding over short-term blips in stock prices and earnings as well.

A. V. Pai
(The author is a free lance writer.)

178) How much cover do I need?

2008-08-09T22:50:00.000-07:00

Do you need Life Insurance? In the Financial Planning that I do for my clients, this is usually my first question. The right question that we need to ask ourselves is — Do I need to protect my family even if I am not around? The answer is ‘Yes’.

The next question that I ask my clients is: How much of life insurance do you need on yourself to protect your family’s lifestyle, if you are not there?

The answer that usually comes back to me is — “I have lots of insurance policies – I am sure I have enough”. Yes, most of us have a number of life insurance plans. But do we have enough life cover to protect our families? How do we find whether we have enough life cover in our insurance plans?

Methods to Find Insurance Requirement

There are a number of methods to calculate the need for insurance. All these are based on finding an economic value (called Human Life Value) of the bread-winner of the family. Then insurance should be equal to Human Life Value.

The first method is the Income Replacement Method. Technically, this method defines human life value as the present value of all future incomes. The logic is that the family of the deceased should have the benefit of getting all the salaries/incomes that the deceased would have brought home otherwise. The other method is the Need-Based Approach. Here the present value of different milestones/goals/dreams in life, that the bread winner has planned for the family are added. To this the present liabilities are also added to calculate the insurance requirement. In other words, the present value of all milestones planned and liabilities held is calculated.

Let us illustrate these concepts with some examples:

Income Replacement Method

Mr Amar, 30, plans to retire by 58. His current salary is Rs 10,000 per month. He expects his salary to increase by 15 per cent annually. Inflation decreases his earnings by 6 per cent on an average.

The insurance need for Mr Amar based on the above calculation is nearly Rs 97 lakh, even though he earns only Rs 10,000 per month today.

Calculation Insurance requirement based on Needs Approach

Mr Akbar, 30, lives in a rented house with wife and son. He plans to buy a car worth Rs 3 lakh after two years. His dream house is to be ready at an expense of Rs 20 lakh after seven years. He plans to educate his son, who is 10 years old, with an engineering degree which today costs a total of Rs 4 lakh for the four years. He plans to gift his wife a diamond necklace worth Rs 5 lakh on their Silver Jubilee Marriage Anniversary in 15 years’ time. He plans to retire at 58 with Rs 1 crore in his bank account.

The average expected inflation is 6 per cent and average investment returns is 12 per cent. His dream car would be worth Rs 3.37 lakh after two years, factoring inflation.

Similarly, the house will cost Rs 30 lakh, the college education would cost Rs 16 lakh, the diamond necklace would cost Rs 12 lakh and the retirement fund would need to be Rs 5 crore, after we factor in inflation. Next, we can calculate the present value of each of his goals and sum them up. To protect his dreams and goals of his family, Mr Akbar should have about Rs 46.5 lakh as his life insurance.

Simplified Income Replacement Method

The above illustrations are highly mathematical and will require a good calculator or a spread sheet on computer to calculate. Is there a simplified way to find my life insurance need? Yes, help is on the way.

A simplified and uncomplicated way is to use what I call the Simplified Income Replacement Method. This gives the bare minimum of the life insurance that anyone should have. The limitation is that this method does not consider the effects of inflation. Here is our example:

Mr Anthony, 30, earns a salary of Rs 10, 000. He earns Rs 1,000 every month from tuitions. His personal expenses Rs 2,000 per month. He is currently saving Rs 500 in a mutual fund. The balance of the money he gives to his wife for running the household.

Thus, for a person earning a salary of Rs 10,000, and without any lavish expenses, a minimum life insurance of Rs 12 lakh is required.

Are we Sufficiently Insured?

Based on the calculations above, please calculate the life insurance you would need. Are you sufficiently insured? Most of us do not have enough life insurance. What prevents us from having enough life insurance? The Cost of Insurance This is the answer I get from practically all of my clients. “How can I afford to pay premiums if I were to have Rs 12 lakh as insurance at a salary of Rs 10,000 per month?

“One of my insurance agents says it will cost me Rs 25,000 per year for Rs 5 lakh insurance. The other one says that if I pay Rs 10,000 per year I can, at the maximum, get Rs 4 lakh as insurance. How can I insure myself for Rs 12 lakh,” — This is what one of my clients asked. The problem here is with the choice of insurance plans. In the above two types, one is an endowment plan and the other is a ULIP. The issue with the above plans is that they combine savings and investment respectively, with insurance. Hence they are bound to be costly.

The most elementary and basic of all insurance plans is the Term Insurance Plan, which is least costly. This is also the reason most insurance agents do not sell these plans — their income is also going to be lesser.

Life Insurance is not costly!

For Mr Anthony the cost of a term plan will be only Rs 3,600 per year for Rs 12, 00,000. Now is that affordable? Yes it is.

In fact the cost of the term insurance, is many fold lesser than most of the comparative vehicle insurance. For example the insurance for a car worth Rs 12 lakh will be Rs 36,000.

In fact, since insurance is basically to preserve the life style of our family and not for ourselves, then we can infer that we don’t need any insurance other than term Insurance. All the other plans are optional, for specific purposes which can be taken up only if we have a surplus.

Karthikeyan Jawahar
(The author is Director – Research & Consulting, Finerva Financial Solutions Pvt Ltd.)

177) Covered calls – here is how to use it

2008-08-09T22:46:00.000-07:00

Derivatives by the virtue of their nature are perceived as instruments best put to use only by traders.

That, however, is not entirely correct for even long-term investors can use a few derivatives tricks to improve their return on investments. Using covered calls is one such way you can boost your equity returns.

How to set it?

This strategy involves selling ‘out of the money’ call options in a stock, against the purchase of an equivalent number of shares of that stock. Covered calls can also be written if you already hold an equivalent position in the underlying.

Since the strategy is almost always backed by equity holding, it is considered less risky.

When to use it?

Covered calls can be used when you are bullish on the underlying stock over the long-term but feel that the stock price will trade in a tight range over the lifetime of the contract.

Investors sitting on idle long-term holdings, looking to exit it in the near-term can also consider this strategy.

To better understand how this strategy can be used and what its limitations are, let us suppose you are bullish on the long-term prospects of TCS (trading at Rs 845).

But over the near-term, you feel that the share price would trade sideways, weighed down by the waning appetite for IT stocks in the market.

Depending on what you foresee as the upper trading range of the stock (say, Rs 900), you can consider selling calls at that strike price.

So, if you have bought, say 500 stocks of TCS at Rs 850 each, you will need to sell two lots of TCS August month

Call option at strike price Rs 900 (trading at Rs 23 per share) to cover the purchase completely.

This is so because TCS stock options have a lot size of 250 shares.

Alternately, you can also chose to partly cover your equity purchase by selling just one lot of TCS call options.

The profitability of your strategy would depend on the share price movement of TCS.

If TCS trades flat and ends the month at about the same price at which you purchased the stocks, then your sold call option will expire worthless.

This means, you will get to pocket the premium (Rs 23 per share).

But, if the stock price falls from your purchase price, while you would still get to pocket the premium, you may have to bear some notional loss on your equity investment, as its value would have also gone down by as much.

However, you can take heart from the fact that the premium pocketed from selling the options would bring down your net cost of purchase of the stock.

So, in both these cases, where the stock price fails to trend upwards you would have, in essence, outperformed the stock returns in the cash market, courtesy premium received on selling the calls.

However, if the stock price of TCS were to rise beyond Rs 900, then you may be required to part with your shares, since your sold call option would then stand the risk of being exercised.

In such a case, your upside would be capped at Rs 900, regardless of the extent of gains in the underlying’s share price.

Caveats

Since the strategy involves selling call options on a stock, note that it would limit the near-term upside potential of your stock.

So, even if the stock’s price zooms significantly above your purchase price, your returns would be limited to the difference between its purchase price in the cash market and the strike price of the sold option.

Further, writing covered calls may not be possible for all the stocks, even if they are traded in the derivatives segment, as not all stock options enjoy adequate liquidity.

This means, that you may also stand the risk of not finding any takers for your calls.

Srividhya Sivakumar

176) Benchmarks: Do multi-style managers justify alpha fees?

2008-08-09T22:45:00.000-07:00

Last week, this column discussed about how to identify closet indexers — those that claim to be active funds but essentially hug the benchmark index. The problem with closet indexers is that they charge a high fee for beta exposure. In response to that article, readers posed several interesting questions. One such question was how to choose benchmarks for diversified funds.

We address the issue of choosing an appropriate benchmark for diversified equity funds. We discuss the importance of benchmarks and the constraints a benchmark poses on truly active managers.

Need for benchmarks

It is both fortunate and unfortunate that most equity funds in India follow multi-style investing. It is fortunate because multi-style funds can generate higher alpha (market outperformance). It is unfortunate because performance evaluation of such fund managers becomes difficult.

Alpha is the excess returns that a portfolio (adjusted for beta) generates over the benchmark index. This excess returns is due to the manager’s skill at security selection and/or market timing.

Suppose a large-cap styled active fund generates 40 per cent returns during a certain period. Suppose the S&P CNX Nifty, the appropriate benchmark, generates 25 per cent return during the same period. If the portfolio beta is 1.5, the beta-adjusted return on the fund should be 37.5 per cent (25 per cent times 1.5). The excess return or alpha is, hence, only 2.5 per cent. Investors usually pay high management fee for alpha returns. Take Reliance Equity Fund. This fund has an expense ratio of 1.81 per cent. The fund’s stated benchmark is the S&P CNX Nifty. If this fund does not generate sizable excess returns, an investor can just as well switch to an index fund that has expense ratio of one per cent or lower.

Benchmarks, therefore, enable investors to ascertain whether fund managers justify the high ‘alpha’ fees that they charge. But choosing benchmarks is not easy. For one, using a narrow-style index as a benchmark for a multi-style fund is not suitable. For another, most diversified equity funds do not provide clear investment objectives so as to enable analysts to apply suitable benchmarks.

Benchmark for multi-style managers?

Truly active managers do not like benchmarks. The reason is that, in order to beat the benchmark, an active manager is forced to select stocks within the benchmark universe. And that acts as a constraint in generating alpha. Small wonder that Peter Bernstein argues that “traditional benchmarking for active portfolio managers is contrary to the client’s best interest.”

Peter Bernstein’s argument will be more practical for institutional investors. Such investors follow liability-driven investments. That is, they match their investment with their liability structure. The benchmark is the required return on the liability structure. Importantly, the benchmark return varies between one institutional investor and the other. This does not pose any problem as institutional portfolios are typically separately-managed accounts.

Mutual funds are collective investment vehicles. Pooling the required returns of various unit-holders into one useful benchmark becomes difficult. So, required return cannot be used as a performance evaluation benchmark for mutual funds. A benchmark index, thus, becomes the preferred alternative.

To ensure that truly active multi-style managers are not constrained by narrow benchmarks, a broad-based benchmark such as the S&P CNX 500 can be considered. This serves two objectives. First, such a broad-based index encompasses all investment styles ranging from large-cap growth to mid-cap. And second, because this index is stuffed with all kinds of stocks, generating alpha returns becomes difficult. This will weed out funds that invest in large caps and mid caps but use S&P CNX Nifty as the benchmark index to show some alpha returns.

Peer Universe?

There is a tendency among analysts to use peer universe as a benchmark for performance evaluation. If an analyst wants to evaluate a multi-style fund, the peer universe would be all funds following multi-style investing.

There are several problems in using such peer-group evaluation. The most important characteristic of a good benchmark index is that it should be investible. That is, an investor should be able to replicate the benchmark portfolio either by taking exposure to such shares directly or through an index fund.

A peer group of all diversified equity funds, for instance, fails on this count. The benchmark portfolio is only known at the end of each month, not before. How can this benchmark be replicated?

Conclusion

Appropriate benchmarks enable investors gauge if active funds justify alpha fees. It is equally important to ascertain if such managers consistently generate alpha to justify the higher fee structure.

B. Venkatesh

(The author is an investment strategist. He can be reached at enhancek@gmail.com)

175) If crude falls further, equities may follow suit

2008-08-09T22:42:00.000-07:00

Stocks, bonds, gold and every other financial asset have been dancing to global gyrations in crude oil prices. In 2008, Indian stocks have moved exactly in the opposite direction to crude prices. The BSE Sensex dropped to its low of 12576 points on July 16, shortly after crude hit a record of $147.27 a barrel on July 11. And the recent recovery to 15000 has been triggered by tumbling oil, which is now below the psychological $120 mark.

If rising oil triggered a flight of investments from Asia, the recent correction in oil prices has injected fresh life into Asian stocks.

Net importers of oil, such as India, are no longer pariahs and are suddenly back on the “buy” list of institutional investors. Oil exporting economies are being hastily downgraded. But is there another side to the relationship between crude oil and Indian stocks? Will stocks continue to rise if crude continues to fall?

Point: Declining crude prices should directly tame inflation, the biggest worry for emerging markets such as India. If inflation subsides, the RBI may turn dovish on interest rates, which is good for the companies and stocks.

CounterPoint: Oil prices may have to dip below $100 levels and stay low for the RBI to review interest rates. That appears unlikely for now. Even if oil prices do stay low and inflation drops, the RBI may take its time to cut rates, given that the inflation rate it is targeting is still much below current levels.

Point: With crude oil becoming unattractive from an investment perspective, ‘smart’ money may come back to equity investments, especially in the emerging markets. With India among the worst affected markets in 2008, our markets are now attractively placed and might attract a huge share of those funds.

CounterPoint: Rising crude prices helped wealth creation in the oil producing countries, especially the Gulf nations. A lot of investments from this “oil money” has entered emerging markets such as India. A sharp correction in crude oil prices would lead to a dwindling of fund flows from those countries. Second, with every asset from real-estate, bond prices and equities all witnessing a sharp fall, crude oil was the last bastion to earn returns. If that gives way, investor wealth can only be further eroded.

Point: Falling crude oil is good for the earnings of India Inc, which was facing pressure from rising input prices.

CounterPoint: Index heavyweights such as ONGC (to some extent), Reliance Industries and Reliance Petroleum stand to benefit from firm crude oil prices. The weakening of prices could put pressure on them. Moreover, prices of other industrial inputs such as steel, non-ferrous metals and agri-commodities were also responsible for margin pressures on companies. These too need to cool off to help margins.

Point: A major worry with rising crude oil was that it widened India’s current account deficit, weakening the rupee against major currencies. If this deficit narrows, the rupee may gain strength. That may prompt foreign investors to view India more favourably, as their returns from India investments could improve.

CounterPoint: Though the rupee is influenced by the current account deficit, it can stage an appreciation only if capital inflows into Indian markets pick up substantially. That, in turn, depends on how FIIs view Indian stocks.

K. S. BADRI NARAYANAN