Monday, March 31, 2008
by Percy S. Mistry. [printable pdf]
Inevitable and so predictable! We are at it again. Another financial crisis. Another ritual orgy of breast-beating and ululatory lament: What went wrong? Why? Who is to blame? Why is private folly being bailed out at public expense? Don't we need tougher regulation to strangle banks, non-banks, exchanges, brokers, and financial firms? Isn't financial sophistication camouflage for pyramiding? Isn't financial capitalism fundamentally flawed? Should the Glass-Steagal Act separating commercial from investment banking have been repealed? More recently: Aren't financial derivatives dangerous instruments of mass financial destruction? And so on ad nauseam. These questions preoccupy journalists and commentators all over the world. But they are not worth answering in the way people seem to think. We've been there before.
Every crisis triggers its litany of retrospective recrimination, implosive introspection, elliptical expatiation, and perambular pontification -- indulged in to the nth degree. The current crisis is, alas, no different. These questions have been asked after all the crises of the last half-century. Each time the answers have failed to predict or prevent the next crisis.
Financial crises pre-date anno domini (AD). Finance was not as modern then. There were no CDOs or derivatives. But crises still occurred. Sophistication was not the issue. Failure of human judgement was. Ancient empires (Babylon, Egypt, Greece, Persia, Rome, India, China et al) had several such crises. So did European empires, not least, the British. The religious rant against Temples of Mammon had its origins in such crises. Its modern equivalent is peddled in financial journals. Often a crisis was triggered when a new gold or silver mine was found, and used to mint currency. When crises end, as they always do, the causes are forgotten. The financial columnists of the day come up with answers that lead to other problems.
The spectre of 1929-33 still haunts us. That financial crisis became the Great Depression. We want to void repeating that at any cost. But 1929 is now pre-history; as is Keynesianism. The modern era of global crises began with the breakdown of Bretton-Woods (BW) in 1971 when the US unilaterally abandoned the fixed redemption price of US$35 per ounce of gold. Subsequently, the carefully constructed post-war, global fixed exchange rate regime collapsed.
It seems like ``déjà vu all over again'' in 2008. Bretton-Woods cracked because the US overreached in financing the Great Society and the Vietnam War simultaneously. It over-borrowed to cover domestic public over-spending. That crisis was resolved by the US (the world's principal reserve currency issuer) expediently transferring the costs of adjustment to creditors that had accumulated its paper in reserves. It devalued those outstanding obligations at a stroke. Does that precedent ring any bells now? The 2007 crisis has the same macro-origins and roots. China, OPEC, Russia, et al are suffering the same loss of value of their USD reserve holdings that Japan and Germany did earlier on. So what - despite the angst and Q&A - is it that have we learnt over the last 40 years? Not much, apparently!
The demise of BW was followed by the oil and commodity price shocks of the 1970s (as is happening now). Global stagflation followed from 1973-87. It may recur now. The chronic incontinence of bad, profligate governments fuelled global demand for syndicated term loans (the complex instrument of its day). Such demand was manifest in developing countries anxious to grow rapidly through socialist, populist, public-spending to finance cradle-to-grave welfare states. Supply was provided by global banks. Flush with petrodollar liquidity, banks were more than willing to make inordinate profits by recycling these surpluses at a large spread. Unsurprisingly (though it was a shock at the time) that led to the debt crises of 1982-87. Justifying lending recklessly to emerging markets, Walt Wriston, head of Citibank in 1975, said: ``countries don't go bankrupt?'' With equal audacity, thirty-two years later, Chuck Prince (another Citi leader) said: ``You gotta keep dancing as long as the music is playing''. Neither thought about the systemic costs of their borrowers suddenly becoming illiquid! Must be something in the coffee served at Citi!
The same questions were asked and answered ad nauseam throughout the 1980s and 1990s. Everyone believed profound lessons had been learnt. By 1993 the world convinced itself that such debt crises could not recur. Then the Tequila crisis erupted in 1994. It was managed by corrective action in 1995-96. But did we learn anything? Not much. Immediately thereafter, inconsonant macro-policies in high-growth Asia (a fixed or appreciating exchange rate with higher domestic interest rates than USD rates -- i.e. India now) sent conflicting exchange and interest rate signals to global markets. In logical response, global banks took what they thought were `no-risk' arbitrage bets; leading to the Asian financial crises of 1997-99.
Again, the same banks made large short-term USD loans to dynamic, creditworthy Asian companies and governments from Thailand to Korea. These were not deadbeat Latin American or African dropouts who had disappointed before. Those loans covered domestic financing needs at lower nominal cost than local currency borrowing. People thought (as the RBI seems to now) that ``the impossible trinity was not invincible'' -- whatever that means! The risk-adjusted cost proved much higher. In between these major tectonic financial market disruptions every decade, a plethora of smaller national financial crises have occurred annually -- one after another (e.g. in Argentina twice, Turkey, Russia, Ecuador, etc.)
What is different this time? Well: size, shape, geography and impact. Starting out as a sub-prime crisis in the mortgage market of the US in late 2007, we now have a global financial debacle in 2008, and beyond. We do not know its full dimensions yet. We have no idea how long it will last. Underlying macro-meso-micro causes are similar to previous crises. But they are not exactly the same. They include: (a) suspect governments overreaching themselves; (b) lax monetary authorities/regulators permitting them to; (c) bankers operating under perverse systemic and compensation incentives; (d) excessive risks being made non-transparent and obscured by sophisticated instruments; and (e) sub-prime risk borrowers overstretching themselves to procure what they can't afford from their income streams. Sound familiar?
The 2007 crisis is an unholy combination of government failure, regulatory failure, market failure, and induced institutional failure in the financial services industry. It has also been a case of across-the-board management and risk-management failure; compounded by a compensation culture in the financial world that generates strong perverse incentives and is now past its sell-by date. Yet the debacle is represented only as a combination of financial market failure, bank failure, and institutional/personal greed; an odd way of interpreting the facts. All these failures have occurred in the world's most sophisticated countries and markets. But because they did, does it mean that modern finance is all wrong and to blame for this mess? That would be an otiose conclusion to reach when there are so many other variables operating.
Failure of personal judgement should not be confused with design faults in checks and balances, systemic paradigmatic flaws, or fundamental structural flaws in regulatory architecture or practice. Of course, the probability of so many judgements, failing simultaneously at so many levels, all at the same time, raises interesting statistical questions. But improbable events do occur. And we err in dismissing the fact that they do. Because a policeman or soldier fails in his duty, does not mean we should immediately redesign the whole concept of a police force or army, or decide to do away with both. And, in times of duress, police and military judgements do fail right through the chain of command. That does not require the whole world to be up-ended! But that is precisely what many pundits seem to be saying now for finance.
Excess dollar liquidity -- created since 2000 by the US Administration (running a large fiscal deficit that exacerbated a galloping current account deficit) and the Federal Reserve (through monetary accommodation to offset the impact of the technology bubble collapse and that of 9/11 thereafter) -- has inflated global property, asset and commodity prices from 2002 to 2007. The Fed's bubble-blowing capacity raises fundamental questions for the rest of the world. Might we all have been better off if it had only an `inflation-fighting cum financial stability' mandate like the BoE? If it was not responsible for ensuring growth and employment in the US, would the Fed have primed the pump to this degree? But that key question is being obscured; especially in India, which must ask the same question of the RBI.
The Bush-Greenspan dollar bubble created systemic pressures to increase speculative, risky lending; partly in response to perverse incentives and erroneous signals -- created/sent by governments and regulators. When one maintains a 1-2% prime rate regime for a prolonged period to combat growth and deflation risk, yet one has pension pay-out obligations, insurance obligations, and asset management obligations, requiring 5-6% returns to meet committed actuarial liabilities, what is the financial system supposed to do? Sit on its hands and keep reserves at the Fed? A financial system that takes no risks is not a financial system at all. It is simply a pass-through utility. Is that what we want? That is the kind of financial system Japan has contrived. The result has been two decades of stagnation and deflation with no end in sight.
Obviously we do not want national or global financial systems to take excessive risks. What are excessive risks? How do we measure them before they materialise? Are we implying that financial systems should take no risks at all when they intermediate between savers and borrowers? Responding to the perverse incentives created by the excess liquidity generated by the Treasury and Fed, the US financial system started out taking what it thought were calculated risks. They proved to be excessive as 20-20 hindsight has revealed. This time, dubious lending was not to developing countries or Asian companies. It was directed to low-income, uncreditworthy US home-buyers. They were persuaded by unscrupulous, poorly regulated intermediaries to buy cheap homes they could not afford through aggressive mortgage pricing made possible by a 1.25% Fed rate regime. But is the Fed blameless for the fiasco that has occurred?
First, the Fed reduced rates to ridiculously low levels between 2000 and 2005. Second, it jacked them up mechanically to five times the low rate over 21 months. It did not wait to see what the cumulative effect of these monthly/quarterly rises would be. That sharp reversal of tack by the Fed heightened risks across the financial system without banks doing anything. Mortgages that were affordable and sustainable when Fed rates went from 1.25% to 3.5% became unsustainable when they were jacked up too quickly to 5.5%. The sub-prime credit risk taken in 2000-05 was transferred to supposedly professional institutional buyers (like pension funds) that demanded these instruments. They should have known what they were buying. But they blamed the banks instead for opacity; thus absolving themselves of any responsibility. It was done through the sale of bundled CDO and ABSO instruments with high-coupon returns; with the collusion of rating agencies paid by the sellers of such instruments to rate them. How's that for a conflict-of-interest?
Now the sub-prime crisis has unfolded with a vengeance. It is spilling over into prime credits as well. The whole US property market is imploding with devastating implications. Value-loss is now spiralling well beyond limits that any properly functioning market should be signalling. Confidence is collapsing across the board in: (a) the quality, content and probity of national, regional and global financial regulation;(b) the monetary and academic judgements of central bankers whose concerns seem to be at odds with what their priorities should be; (c) the reactions of OECD treasuries which seem to be too knee-jerk to be thoughtful; (d) mark-to-market valuations of financial securities, with stressed-out asset markets emitting price signals that are not worth relying on at all for the time being; (e) the credibility and probity of ratings and rating agencies; (f) a seeming inability on the part of financial operators, authorities and commentators, to differentiate systemic problems and effects of aggregation, from firm-level problems and consequences; and (g) the collective impact this is having on perceptions about the fundamental creditworthiness, solvency and liquidity of all borrowers, especially banks. That is resulting in situations like HSBC not lending to Citibank in national or global interbank markets, because neither knows what the other is worth, or whether it has any free net capital at all! Traders are being asked at a moment's notice not to do business with any outfit about which a rumour is circulating. And now there is financial trade in rumours!
Northern Rock (NR) made good money for years, financing long-term mortgages by sourcing from cheap wholesale short-term interbank credit markets. That is also happening in India; where it would be foolish to assume that 25-year mortgages are financed by 25-year deposits, bonds or loans. No one thought that lending long by borrowing short was odd or risky at the time. Term transformation is the bread-and-butter business of banks and other financial intermediaries. Many (including regulators) thought that the NR business model was fine; it made sense given the way markets were functioning. But the interbank market froze overnight when the sub-prime crisis broke. That compromised the viability of the entire collateralised debt market. The Rock could no longer find the liabilities to fund high-quality assets already on its books. That outcome was unpredictable and unprecedented. Instead of rectifying that short-term market seizure by stepping in boldly and acting sensibly, the Bank of England timorously gave vent to academic concerns about moral hazard, when the stability of the financial system was at stake. Talk about priorities!
The Chancellor of the Exchequer went on TV to reassure depositors of Northern Rock that their funds were safe. But he was non-credible. Brits don't trust someone with eyebrows a different colour to their hair. After his broadcast the public (which had not been bothered before) panicked. Queues formed to remove their funds thus causing a run on the Rock. Had he handled the situation differently, there might have been no run. The crisis could have been resolved with a 30-year multi-currency bond issue to global pension funds. It might have required a temporary public guarantee. But it would have been eminently more sensible. In the US, five months on, Bear Stearns was hair today and Dimoned tomorrow.
With all this happening, a number of commentators (e.g. in the FT) are indulging in heavy-duty, sanctimonious huffing and puffing about how rotten things are in the land of Nod. They are going overboard with criticisms of financial markets and eliciting applause for striking a chord with Joe-Public. They are attempting erroneously to (again) answer age-old questions definitively, and with finality. These `legends-in-their-own-mind' are relying on their mighty cerebrums, cerebellums and egos. But they have no experience of finance at any time, nor do they have any practical idea of financial decision-making in firms, banks, central banks or treasuries. Their knowledge of theoretical economics is (hopefully, but I am never sure about this) sound, but their knowledge of finance is suspect. And, like all economists with a PPE tripos (we have too many in India) they are inherently sceptical about finance. They do not understand it. The maths are probably too tough. They believe it is not `real' and mostly tosh; stuff dreamt up by barrow boys in the City and on Wall Street with the only innovations being nomenclatural rather than substantive.
Such commentators seem sagacious. They write so well that they obscure flaws in what they say. But they can, on occasions like these, be eccentrically off-the-mark: i.e. by proverbially hitting their thumbs, rather than the intended nail on the head, with their verbal sledgehammers. And, because they have a wide audience, they run the risk of destabilising the situation even more, with ill-considered, ill-timed remarks, when everyone who was anyone, is too nervous, stressed and broke (their stock options are now worthless) to think straight, and lacking in confidence in their own judgements. The worst time to kick someone is when they are down; unless your agenda is to make sure they never get up again. But that is what our brave commentators and regulators in India are also now doing, imitating the FT's columnists. The crisis has made clear that the $100 million dollar a year masters-of-the-universe (Motu's), seem not to be worth 10 cents when the crunch comes. What John Mitchell said was true: ``When the going gets tough, the tough get going''. He should have added: ``And the babblers babble too much''. But we knew that from before.
As in the past, when the dust has settled, the cost has been counted, and the global financial system ``picks itself up, dusts itself off and starts all over again'' all this angst, blame, and recrimination we are over-indulging in now, will recede to the dimmer mists of fading memory. We will learn some lessons to be sure; but not all that can be learnt even from past mistakes.
For example, despite serial crises in its savings and loan system which is regulated at state level, the US has still not found a way to regulate origination quality in a market as elementary as home mortgages. The Fed and SEC failed in not highlighting risks that non-transparently bundled CDOs with hidden sub-prime risk entailed. So did the FSA and BoE. Nor has the US found a way of curbing its own systemic macro-excesses. None of these are financial firm or market failures. They are failures of governments and regulators. They need to be looked at with even greater scrutiny than should the behaviour of financial markets and firms responding to the signals sent. But since governments and regulators are also the investigators, egged on by journalists, they are hardly likely to criticise themselves in the way that they should. And India, which is congratulating itself and RBI for the wrong reasons, is not exempt from that observation.
Worse, the world has not yet found a way of disciplining the economic behaviour of the US in the same way as the US has, in the past, disciplined other countries (including the UK and Italy in the late 1970s); bilaterally and through multilateral institutions. Instead, since 1945, the US has always portrayed itself, and been regarded by the world, as being above and beyond economic law. But circumstances have changed dramatically sixty years on. The US has escaped harsh scrutiny from the international community although it has twice brought the world to the edge of financial Armageddon since 1970. Three times would be one too many. The US must now be brought into the same ambit of collective multilateral surveillance that other countries have accepted. Yet, the world is reacting in the opposite way. It is now extending the same courtesy of according `untouchable' status (not in the Indian caste sense but in the Elliot Ness sense) to China which, through its intransigently inflexible (until too late) exchange regime, has contributed to the current debacle. Can adjustments occur, in correcting large imbalances automatically through markets, if we perpetuate the loaded asymmetry of having free and open global markets for goods and services but managed and closed markets for some of the currencies in which they are valued?
That is simply not a tenable argument to sustain for any length of time. India and China now risk reversing the benefits of globalisation they have gained so much from. They risk triggering a global backlash, if they insist on adhering to fundamentally misconceived philosophies and a heterodox stance on capital account convertibility and managed exchange rates. Their posture is self-serving in the short-term but self-defeating in the medium and long term. It defies theory and logic. Those are the real issues that need to be addressed as the 21st century unfolds. If we cannot resolve them, but focus attention on the supposed failures and risks of modern finance, we risk deluding ourselves and lynching the wrong mob.
But, coming back to the current crisis: The problem arose with the lack of regulation of the base mortgage market to prevent its criminal abuse. Why did that happen? The sub-prime problem was one of origination through NINJA loans i.e. loans being made by unscrupulous realtors, mortgage brokers and local mortgage institutions and small banks to people with No Incomes, No Jobs or Assets. Immigrant gardeners were classified as landscape architects. They were induced to borrow 120%-of-value to buy four properties at a time and rent them out with mortgages that involved virtually no costs for the first three years. Mortgage originators were incentivised to churn out as many of these mortgages as they could so that the bundlers and packagers of these dubious assets had grist for their mill.
But though all that happened, the sub-prime problem was not simply a case of unscrupulous investment banks, and bonus-obsessed operators stripping, re-packaging, and selling mixed bulk assets with unsound risk profiles, to unwitting innocent buyers of synthetic debt obligations. Institutional investors who bought CDOs by the barrel are not widows and orphans. Also, let's not forget that regulators at several levels failed to identify or express concern about the transparency-deficit in bundling these CDO packages; nor the failure of rating agencies that rated many of them AAA.
There is nothing wrong with the basic principle or mechanism of collateralised debt obligations (CDO) or asset-backed securitisation and the sale of repackaged debt stocks. In fact the reverse is true. The principles and mechanisms of packaging different strips of debt stocks are sound. They can be incredibly useful devices for transforming maturities and durations. They help to liquefy otherwise stagnant but productive assets. Constructed and used properly, the risks of firm-level, and systemic, illiquidity can be reduced by CDOs and ABSOs. The same is true of maligned derivatives both simple/traded and complex/tailored.
Yet both are now condemned (especially in India) as inherently flawed and evil; in particular, derivatives,. Constructed and traded without proper knowledge and transparency, the risks they are intended to ameliorate can be amplified by uncertainty and ignorance. Credit risks can be managed through credit default derivatives; but the counterparties have to remain viable. Interest rate risk, currency risk, political risk can be managed with derivatives as well; but these instruments can be abused if the objective is to speculate without knowledge rather than hedge within limits.
In India such mindless vilification is reaching insane proportions with the losses recently suffered on currency derivative transactions. Witness the loud screams of Indian corporates who made the wrong bets on currency hedges incurring collective losses alleged to be INR 200 billion (or USD 5 billion). They are now crying foul and blaming their bankers for tailoring these hedges to their specified needs. They are pleading ignorance and lack of understanding. The RBI is joining in the chorus. But is it blameless for not having permitted a market to develop in exchange traded currency derivatives in the first place? Had such a market been permitted to develop, corporates could have traded on that market directly, using their own treasury judgements and not gone to their banks.
Talk of these instruments being inherently deadly and dangerous is just plain wrong. Even my wise friend T.N. Ninan has been infected by the retroactive `modern finance-is-wrong-RBI-is right' strain of virus. It is being propagated by the Indian media (abetted by FT commentators) and by a Left that hates capitalism. Such criticism is often motivated by superficial interpretation of the evidence, by ignorance, and by a failure (or unwillingness to make the effort) to understand the mathematics involved. Since no one (especially a senior central banker) wants to admit to being slow on the uptake, it's so much easier to cast aspersions and make the case that these instruments are too dangerous for public use. Properly used, with broad, deep and liquid markets in them, derivatives and synthetics are indispensable in a modern financial system. They are its traffic signals, its price discovery mechanisms, as well as its trading nuts and bolts; grist for the financial mill that would otherwise be confined to only four plain vanilla functions: i.e. buy, sell, borrow, lend. And if that was all finance could offer we would be back in pre-historic times.
A kitchen knife can be used to murder someone. It is more usually used to cut onions, vegetables, bread and meat. Murders often involve kitchen knives. Does that mean knives are inherently dangerous and should be banned? Or should their possession be restricted only to certain types of consenting adults with Ph.Ds and an intensive 4-year training course in knife-use? The same is true of cars, planes, trains, ships and buses. Accidents happen. They are part of the game of life. Should we ban all transport and traffic to avoid any accident happening at any time? Should we stop issuing driving licenses altogether? Should we introduce bicycle-riding tests that take a day or car driving tests that take a week? And yet this is what command-control freak regulators, and supposedly wise commentators, seem to be suggesting when it comes to correcting all that ails finance. It is at times like these that common sense, especially on the part of supposedly intelligent people, escapes and becomes unusually uncommon.
What went wrong with the sub-prime crisis is a question that has multiple answers at different levels: macro, meso and micro. Some of them we will always disagree about and never get to the bottom of. We have to accept that reality. Views of public choice economists, who always want to put sand in the wheels of finance at one end, and market-friendly, tax-unfriendly economists at the other, will never be reconciled. Their philosophical and technical differences are too profound.
But let's make an attempt at a plausible explanation. At the macro-level, as explained above, Bush and Greenspan printed about US$10-12 trillion more in 2000-05 than was needed to finance US or world growth. Where did that excess liquidity go? It's estimated that about $4-5 trillion was absorbed in unusual property price increases in the US property market. Of that about US$1-2 trillion has already been written down over the last year or so. It may be that a similar amount will be written down in the coming year.
Another US$2-3 trillion went in inflating commodity prices, especially oil, gold and precious metals. That is now reflected in the ballooning reserves of hydrocarbon and commodity producing countries. Much of the remainder has gone into inflating the price of financial assets, especially in emerging markets, where valuations at the end of 2007 reached stratospheric levels based on fantasies about future growth prospects. These valuations too have seen sharp corrections in recent months. They have returned to more sensible levels that can be justified by a reasonable discounted value of future earnings based on more realistic growth trajectories. But, some selective overvaluation of particular assets in these markets (like India's property market) continues and requires further correction.
At the meso level, the financial industry's traditional herd instincts (that Avinash Persaud has so eloquently and persuasively written about several moons ago) took over. The Motu's of Wall Street (joined rapidly by their brothers in the City) decided to jump on the bandwagon of packaging and aggressively selling CDOs. These contained mixed mortgage debt obligations that ranged from sub-prime to super-prime (which has now also become sub-prime). The buyers of these instruments (who run your pension and mutual funds and mine) obliged by demonstrating an unusual appetite for them. Wouldn't you buy paper (however complicated in its construction) that gave you a yield of 5-7% and was rated AAA, when the alternative was to park your funds at returns of 0-2%? That sell-buy tendency was difficult to restrain in a property market where prices were rising by 5% a month for a considerable number of months, thus increasing the underlying collateral value of the debt obligation it supported. And then the Fed reversed itself!
At the micro-level, the unusual pressure on Motu's to keep flashing extraordinary quarterly profits, in order to justify even more extraordinary personal bonuses, actually increased. That perverse incentive launched trading markets -- for sophisticated CDOs and a range of affiliated derivatives -- into overdrive. Almost everyone with a sense of history knew from mid-2006 onwards that valuations and trading volumes were going haywire. Many (including moi) expressed grave concern in our writings about another bout of market access and the certainty of another crisis. But none of us were aware of how large and debilitating or contagious it might be. It was openly discussed in official and private circles. But the `Prince Principle' -- continue dancing while the music plays -- ruled with a vengeance. No one wanted to stop dancing though the band was running out of puff. Is that a systemic flaw or human nature?
Of course, in the domestic context, with India having (for the third time since 1982) avoided global contagion (have we really?) another question has been highlighted implicitly and explicitly: Hasn't the RBI been wise in deliberately retarding: financial system liberalisation; innovation and competition to protect antediluvian state-owned banks (SOBs); development of the derivatives, corporate bond and currency markets; and employing draconian regulatory practices over congenitally non-compliant banks and financial operators? In other words, hasn't India been fortunate in having financial authorities who operate with the conviction that modern finance is quintessentially un-Indian, thus emphasising primitivism over modernity, simply to continue exercising familiar command-control options with greater facility?
These questions of course obscure the reality that, irrespective of what has happened globally, India has had its own series of home-grown financial scams, scandals and failures. They have involved massive losses in value. And they have recurred with alarming regularity, despite our supposedly terrific regulation! But, in India, the peculiar view has taken hold that regulators are always right. They are naturally cautious and conservative. And they have the public's interest at heart. Conversely operators are always wrong. They are thieves who take risks with other people's money and create crises which then require public bailouts.
No one pays enough attention to the perverse incentives and the contradictory macroeconomic, monetary and exchange rate signals that are emitted by the authorities in ways that often heighten uncertainty and risk before a crisis erupts? When people like Ajay Shah and Ila Patnaik do that, they are branded either as heretics or as people who have temporarily lost control of their senses or as people simply against the RBI.
No one believes that strangulating financial systems artificially in the name of conservatism, caution and (false) security, also involves massive costs. If the financial sector were permitted to breathe naturally, if currency markets were opened and freed, India's financial sector would generate additional value added and export revenues amounting to 1-2% of GDP. The efficiency gains of further financial liberalisation and financial market development would result in another 1-2% of GDP growth.
Non-pre-emption by the fiscus of scarce resources (always unproductively deployed by government), and privatisation of SOBs/SOEs, would dramatically reduce India's public debt and its annual debt service obligations. That would result in further growth gains of another 2-3% of GDP. So we are implicitly surrendering potential gains of 4-7% of GDP annually just to maintain command-control in the name of financial safety (which has often proven illusory).
If we chose the alternative path of financial liberalisation and sophistication, we could afford a financial crisis every decade that costs us 3% of GDP, and still come out well ahead. That may be seen as an excessively cynical view. It is not. It is in the nature of markets to work well most of the time, overreach egregiously at the end of cycles, and fail occasionally with disruptive effects, followed by cleansing that is entirely healthy and natural. If we believe in market economics, we have to accept the intrinsic nature and cycles of market functioning. We should do everything we can to learn more about stretching out period of proper market functioning and to anticipate/mitigate the effects of potential failures. But we cannot make markets socialist and planned to behave in ways we like and not behave in ways we don't.
What is also obscured in the Indian debate is an awkward but very real asymmetry. No one complains when they are making easy money in stock or property markets quickly (because they are brilliant) but wail, ululate, and demand revenge and redress when they lose it (because it is someone else's fault). It goes unnoticed that a financial system is in distress when asset prices are rising too rapidly; and is actually emitting sound corrective signals when such prices correct downwards sharply. But aam aadmi never sees it that way. In fact he sees it in exactly the opposite way: i.e. that the financial market is great and healthy when his portfolio is increasing in value at 10% a month, but that all financial operators are thieves and crooks, and regulators are corrupt and stupid, when that momentum reverses.
Of all the screams heard, the loudest are those of empty wallets: just go to the racecourse and talk to a losing punter! It's never the punter who was stupid and made the wrong choice: it is always the fault of the owner, trainer, jockey or syce, who hooked the horse, or of stewards who are ignorant and blind.
And that is the way it is with financial systems and the periodic crises they generate! So let's stop pointless breast-beating and making the wrong arguments for the wrong reasons. Let's not give credit where it is not due (i.e. to the RBI) and let's not thank the authorities for keeping our financial system unsophisticated and primitive. That does not suit the image of India of the 21st century -- an image we are trying to convey of being at the cutting edge, and not at the thicker end, of human intelligence and progress.
An editorial in Indian Express:
The sharp rise in wholesale price index based inflation to 6.68 per cent, no doubt, calls for a response from the government. A high level cabinet committee is to meet today to decide its response. It is important that the government analyse the causes of inflation before proposing a response. Last year too, about the same time, inflation had risen sharply. This was brought down by an increase in interest rates. But last year, inflation was demand driven and the rate hike helped in cooling down the overheated Indian economy. Growth slowed down, as expected, and price rise was contained. This year’s inflation is different. It is coming at a time when the economy is slowing down. The strategy to reduce inflation cannot be based on reducing growth further. This year’s inflation is primarily the result of a supply shock coming from rising world commodity, food and oil prices. It would be a mistake to raise interest rates to deal with this kind of inflation. Growth would slow down further and, given that inflation is due to higher global prices, it may not be significantly contained.
The best way to deal with international price inflation affecting the Indian economy would be a strong rupee. The exchange rate pass-through from a change in the rupee-dollar rate to domestic inflation is positive. In other words, when the rupee appreciates it reduces the price of imported goods or import parity priced goods, that is, goods whose prices are determined by world prices. This will help in pulling down prices. Instead of quantitative restrictions such as a ban on exports of food products whose world price is high, a strong rupee will ensure that it is less profitable to export these items. This will help make more food available domestically. Also, it will make it cheaper to import food and food products. The government should, in addition, eliminate import duties on edible oil, for example, to make it more affordable. The combination of a strong rupee and the removal of duty will make food products cheaper. It will also eliminate incentives to hoard.
One of the most serious policy mistakes made by the UPA government over the last year was to prevent the Indian consumer from benefiting from a strong rupee. The political power of exporters appears to have forced the government to resist rupee appreciation. Since rupee appreciation comes at the cost of higher domestic prices, today, the government is paying this price. Hopefully, now that we are closer to an election, the interest of the larger mass of the population may rule over the interest of a concentrated group of exporters.
Sunday, March 30, 2008
The New York Times has an interesting article by Elan Greenberg about how a bunch of activists invented and propagated the `genocide olympics' idea. How far have they come? A google search for "genocide olympics" shows 46,100 hits.
The 1936 Olympics, held in Nazi Germany, were an astonishing propaganda coup for Hitler. It's true that the star performance of Jesse Owens, the black American track-and-field great, did shoot some holes in the Nazi theory of Aryan racial superiority. But Hitler still got what he wanted out of the Games. With the help of American newspapers such as the New York Times, which opined that the Games put Germany "back in the family of nations again," he convinced many Germans, and many foreigners, to accept Nazism as "normal." The Nuremburg laws were in force, German troops had marched into the Rhineland, Dachau was full of prisoners, but the world cheered its athletes in Berlin. As a result, many people, both in and out of Germany, reckoned that everything was just fine and that Hitler could be tolerated a bit longer.
Yes, ubiquitous information and communications technologies imply that the game is changing. But would live video footage from the Night of the Broken Glass have made a difference? The situation is easier for China than it was for Nazi Germany to the extent that the Fortune 500 firms are long China, while they weren't that invested in Germany of 1936.
Friday, March 28, 2008
Thursday, March 27, 2008
Monday, March 24, 2008
I just wrote a post about the 6th pay commission report, and found the timeline to be interesting:
- The report came out in the afternoon.
- I had skimmed it by roughly 7 PM, and found a spot of free time to write a blog entry at 10:30 PM.
- Now it is 11 PM IST. I wandered over to google news to see what others are saying on the subject. I was surprised to see nothing written by a person who's skimmed the entire report.
- I suspect the newspapers will only get opinion pieces written tomorrow (Tuesday) and these will only appear on the web at deep night Tuesday.
Blogging lets a person respond to events much faster than the traditional media is able to match.
Decompression of wages
Broadly speaking, wages of government employees in India are too high at the junior levels and too low at the senior levels. Before the 6th pay commission, the wage ratio of the top to the bottom was 10.7. My rough thumb rule is that by comparison with the labour market at large, wages at the bottom are 2x to 3x too high, and wages at the top are 3x to 10x too low. If such adjustments are made, the top to bottom ratio would rise to something like 45.
How do I know so clearly that at junior levels, salaries in government are 2x to 3x too high? Some time after I left the Ministry of Finance, one day, I encountered a chap who had once been my driver while I was there. I asked him how he was faring and he said things were not good at all. He had been assigned to a certain JS who was not nice to him. So he outsourced his job. The government pays a driver perhaps 3x higher than the public market price of a driver. So my ex-driver recruited a driver from the public market, sent him in to work every day in his place, and pocketed a neat profit off the wage differential (even after some money was paid to people in the payroll department to keep them quiet).
The 6th pay commission has made progress on increasing inequality by getting the ratio up to 12. But this is tiny progress when compared with the scale of the problem. From 10.7 to 12 is progress, but is just not enough when compared with a normative goal like 45.
Under their proposal, the salary of a Secretary goes to Rs.80,000 a month. This is small progress. In my mind, a number like Rs.300,000 a month would have been about right.
Treatment of regulators such as SEBI
The 6th pay commission has made genuine progress on delinking wages of the chairman and members of independent regulators, such as SEBI, from government wages. Their proposals (page 632) envisage a CTC for the chairman of Rs.300,000 a month and Rs.250,000 a month for the member. I think this is about right. This could be a breakthrough for addressing the HR problems of independent regulators in India.
In 2005, I had done a presentation at Centre for Policy Research where I had said that the price at which it was not hard to recruit good quality EDs at SEBI was Rs.100,000 a month plus house plus car. With the above revision of wages for the chairman and members, we're about there in terms of getting the price of the ED right.
As far as I could see, RBI is not listed in this special treatment.
There is a certain sense of entitlement about civil service wages having to go up through time. I think this is the wrong way to think about it.
When a government buys (say) steel, it sets an objective technical benchmark of what kind of steel is required, and then sources it at the lowest possible price from the open market. The government is willing to pay market price - and no more than market price - when buying steel of the required technical attributes.
This is exactly how the private sector labour market works. The price of a driver of acceptable quality in Delhi is probably Rs.4,000 a month, and a private employer would not pay more than Rs.4,000 a month to get a driver.
When the State is engaged in the production of public goods, there is no reason why the same style of procurement should not be applied for labour. Civil service HR policy needs to recruit the required technical capability at all levels, and pay the L1 price in order to get there. As an example, large corporations use salary surveys by HR companies in judging (say) the price of a personal assistant in Bhopal. Similar methods can be used by the State.
If this strategy is encoded into the civil service HR process, then the periodic resetting of wages by a pay commission would not be required. Instead, benchmarking to wages in the overall labour market would be an ordinary part of the year-by-year wage adjustments, as is the case with the private sector, and as is the case with steel.
Implications for NPS
The New Pension System was excluded from the terms of reference of the 6th pay commission. With a 20% contribution rate from civil servants into NPS, the flow of contributions will rise considerably owing to the wage hike.
I don't think anyone understands the impact of this on the consolidated expenditure of centre, states, local government, autonomous bodies, grant-in-aid institutions, etc.
Thursday, March 20, 2008
Tuesday, March 18, 2008
I've long been worried about how the US economy will shape up, and about the consequences of a downturn in the US for India. But writing in Business Standard today, I disagree with some of the more extreme doomsday scenarios about the US. We're all well schooled on emerging markets crises, and I think we're inappropriately extrapolating too much to the US. I think there's a good chance that the US will hit 0% GDP growth for a few quarters. But I don't see things getting much worse than that.
Update (19th morning). I wrote this article at 2 PM yesterday (18th, Tuesday). This morning, when I woke up, I saw the S&P 500 was up 4.24% and VIX is down sharply from 32% to 26%. These are massive moves. The standard deviation of a one-day change of the S&P 500 over the last 1000 days was 0.81%, so this is a 5.3 standard deviation move.
This blog entry is by Vijay Mahajan of BASIX.
Iraq was attacked by the US and the UK on the basis of a fictional threat - WMD - weapons of mass destruction. We have seen the results of that lie, with shock and awe. India's WMD is less costly - Rs 60,000 crore, or only $15 billion - but is based on similar half-baked analysis of half-truths, and well designed to benefit those behind it - in our case Pawar-ful large commercial farmers.
As per the National Sample Survey, 59th Round, 2004-05, over half, or 51.4% of the farmer households in the country did not access credit, either from institutional or non-institutional sources. Further, despite the vast network of bank branches, only 27% of total farm households had any loans from formal sources (of which one-third also borrow from informal sources), while 73% did not. Among the marginal farmer category, as many as 80% did not have any borrowing from formal sources.
So the FM and the Agriculture Minister must have known in advance that their generosity will only cover the upper quartile of farmers. Yet, if we go by the details, only those whose bank loans were overdue on Dec 31, would get a waiver. So a big grape farmer in Nasik who had a bumper crop but was politically aware, so did not repay his loan, will get a waiver of Rs 1 lakh while a poor rainfed farmer in Vidarbha who has sold his less than normal yield cotton crop to the state monopoly cotton federation, at a lower than market price, will be deemed to have repaid his Rs 15000 loan from the proceeds that he has yet to receive, and will not get the waiver.
There is no fig leaf to this pro big farmer loan waiver, as can be seen by RBI's clarification that not only crop loans but also term loans for tractors, poultry farms etc will be covered by the waiver. To minimize backlash from those who did not get the waiver, in AP, the Chief Minister has additionally declared a 10% bonus payment to all farmers who sell their produce through regulated market yards - once again, the larger farmers.
Apart from the gross inequity in the name of small farmers, the loan waiver is particularly inept as it completely fails to address the underlying causes of the Indian agrarian crisis, including -
- Dwindling size of land holdings;
- Low percentage of irrigation, even protective irrigation; and where there was irrigation, tapering yields due to long years of mis-fertilisation and increasing level of pesticide resistance.
- In rainfed areas, no measures for coping with recurrent drought, no significant varietal improvements, nor any agricultural guidance to farmers.
- Increases in input costs, coupled with lower relative prices for produce, and price fluctuation, has meant that agriculture is not very profitable even for commercial farmers. For small farmers, with imputed wages for family labour, farming does not even break even.
The same Rs 60,000 crore could have been used to drought-proof 60 million ha of dryland @ Rs 10000 per ha, which would permanently secure the livelihoods of at least 3 crore of our poorer, farmers in rainfed areas. Dozens of successful examples exist, of the rehabilitation of natural watersheds and traditional water storage structures, by NGOs and government agencies. Part of the funds could also be used to rehabilitate the dilapidated canal irrigation systems, conditional on the states switching to participatory irrigation management (PIM).
Even if one were to accept that the loan waiver was aimed at gaining electoral advantage, it could have been done much more equitably and would have fetched more votes.
Recognising that the debt burden of small and marginal farmers is more from moneylenders and traders, a waiver should have been given for both bank and moneylender/trader loans. Given the difficulty of verifying these, the waiver could have been limited to Rs 5000 per ha for farmers with irrigation, and Rs 2500 per ha to rainfed farmers, with a cap of Rs 10,000 per farmer in both cases. Additional amounts from informal lenders could have been swapped for much lower cost bank loans, as has been tried in Andhra Pradesh by the "total financial inclusion" program of the Indira Kranti Patham project.
Further, to prevent leakage, the money could be credited to the bank accounts of farmers. This would also have incentivised banks to open "no-frills" accounts for 5 crore farmers who don't have bank accounts, as per the recently adopted national financial inclusion plan.
Rough calculations show that this alternate method would have benefited 10 crore farmers, about thrice the number likely to be covered at the moment.
The one mystery is - why did not the Left argue in favour of a more equitable waiver? Have they lost interest in the agrarian vote bank after Nandigram? Or is it a deal which we will understand many years later?
Sunday, March 16, 2008
Thursday, March 13, 2008
New data has come out which validates this analysis. In January, the INR was basically unchanged: starting at 39.41 on 2 January and ending at 39.3 on 31st January. How did this come about? It required an unprecedented scale of purchase by RBI, both on the spot and the forward market. They purchased $13.6 billion on the spot, and the forward position grew by $8.4 billion!
In January, net FII flows were negative. Why, then, did it take $22 billion of USD purchase to maintain a flat exchange rate, even after capital controls have been brought back on ECBs and PNs in 2007, thus drastically curtailing these? The answer lies in India's deepening de facto convertibility. Capital controls that target any one element of capital flows might seem to work, but money will come through by other channels.
This links up to the case for a rate cut. The deep case for a rate cut is that India's 500 basis point interest rate differential against the US cannot be supported when India pegs the rupee to the US dollar. RBI is in an extremely uncomfortable position with the implementation of the pegged exchange rate, as long as this large interest rate differential is in place. The only way to reduce the discomfort of pegging is to lower interest rates. This is all about the loss of monetary policy autonomy that pegging induces, and has nothing to do with whether or not there is a business cycle slowdown.
This data about January trading by RBI was released today, i.e. 13 March. This big lag is part of the larger problem of RBI transparency; the delay helps to impede thinking and policy discussion about the difficulties of implementation of the exchange rate regime. Play the thought experiment in your mind: Suppose this shocker of January data was in the newspapers on 1 February. Or even better, suppose RBI was as transparent as FIIs are: suppose that RBI trading is disclosed every day. The process of policy analysis, policy discussion, and the external constraints that would come upon decision making at RBI would kick in much faster. Instead, with the present environment of non-transparency, information comes out with a huge lag, by which time the decisions are already made, and public policy discussion is stifled.
Wednesday, March 12, 2008
We know that credit risk can be inferred using stock prices (through the Merton / KMV style models) and the credit default swaps (CDS) are of course all credit risk. So there should be a strong link between the two. The CDS market is all offshore, and I believe it is quite illiquid. Still, Pravin describes a fascinating relationship between the two. He has a striking picture in his article, where the red line is the CDS and the blue line is the stock price:
The stock price and the CDS time-series are both I(1). If I shift them to returns, and thus make them I(0), using the full dataset, I see a relationship where the stock price leads the CDS over a one-two day horizon. In my mind, this emphasises the interlinkages between markets: corporate bonds are tightly linked to the government bond yield curve, but when you focus on the credit risk of a corporate bond, it's tightly linked to equity risk. A position which is long corporate bond and short government bond is pure credit risk: this is what the credit derivatives are about and this is what the stock market is about.
What would be great is to have trading on all these instruments - interest rate derivatives, government bonds, corporate bonds, credit derivatives, equity, equity derivatives - by a unified set of participants with a unified system of markets. That's the `BCD Nexus' idea of the MIFC report, and it's very different from the silo system that we have in India today.
Wednesday, March 05, 2008
Tuesday, March 04, 2008
Sunday, March 02, 2008
Greg Mankiw shows this remarkable graph, about the tax payments made by households in five quintiles of income categories in the US:
Unfortunately, information systems in India are so weak, one just doesn't know what a comparable picture in India might look like.
A lot of people believe that income tax rates should be `progressive' - i.e. that richer people should pay higher tax rates. A belief that progressivity of income tax is a `good' thing is one of the instinctive reflexes from the decades of socialism. However, the logic in favour of this from first principles is not apparent, as David Friedman recently reminded us.