Financial Bubbles

Before I begin, I have a serious suggestion for all those who read my blog and have an interest in economics and finance. Make sure, you read all the speeches of Ben Bernanke. He is simply superb and explains all the topics with rich references and literature survey. I may go overboard, but one Bernanke Speech a day keeps the fat books/papers away!! 

Now with the main topic. Generally, analysts are divided in two groups. First says, times are good and asset prices/sectors/economy would go up and Second says, not all is good and there is a bubble around the corner and this is about to burst.

From this stimulating post on WSJ Blog, I got this speech from Ben which he gave in 2002. In this he talks about the bubbles in asset markets and whether monetary policy should be used to prick the bubbles? Read Stephen Ceccheti’s superb views as well on this subject; I do cover it in the end as well.

To cut the story short, Ben’s answer is Mon Pol should only be used to monitor inflation, nothing more nothing less. Instead of Mon Pol use 

…..micro-level policies including supervisory action to ensure capital adequacy in the banking system, stress-testing of portfolios, increased transparency in accounting and disclosure practices, improved financial literacy, greater care in the process of financial liberalization, and a willingness to play the role of lender of last resort when needed.

Why shouldn’t we use Mon Pol for the same?

1. Identifying a bubble: Calculating fundamental values of assets is difficult. To say it is a bubble, Fed needs a better pricing model than that adopted by finance professionals whose collective information is reflected in asset-market prices.

Ben believes prices are better determined in the financial markets and any belief that Fed has a better model would lead to analysts focusing more on rumours’ and Fed talk than economics.

He also says various indicators available to find stock prices are not perfect hence one cannot say whether there is a bubble at all he cites an example by saying that Shiller and Campbell had made a presentation to Fed Board using dividend-price ratios saying that markets were overvalued (precisely 3 times the fundamental value). But the desired correction did not happen.

Then he cites a study by Borio and Lowe where they use bank credit as a measure of bubble. Ben superbly points out that what is needed is regulatory supervision that ensures financial institutions are lending prudentially (KYC norms are followed etc). With deposit insurance present financial institutions (mainly banks) may not look at KYC and lend leading to crisis later. He adds:

When this moral hazard is present, credit flows rapidly into inelastically supplied assets, such as real estate. Rapid appreciation is the result, until the inevitable albeit belated regulatory crackdown stops the flow of credit and leads to an asset-price crash. Bubbles of this type may be identifiable to some extent after they have begun, but the right policy is to do the financial deregulation correctly–that is, in a way that does not allow speculative misuse of the safety net–in the first place. Or failing that, to intervene and fix the problem when it is recognized

2. Mon Pol is not the right tool: BB says:

If a bubble–a speculative mania, in the more colorful language of the past–is actually in progress, then investors are presumably expecting outsized returns: 10, 15, 20 percent or more annually. Is it plausible that an increase of ½ percentage point in short-term interest rates, unaccompanied by any significant slowdown in the broader economy, will induce speculators to think twice about their equity investments? All we can conclude with much confidence is that the rate hike will tend to weaken the macroeconomic fundamentals through the usual channels, while the asset bubble, if there is one, may well proceed unchecked.

So, if a Central Bank does raise interest rates to check bubbles at best it would lead to slowdown in economy and he gives a very good example of this via the Great Depression in 1929.…..

The correct interpretation of the 1920s, then, is not the popular one–that the stock market got overvalued, crashed, and caused a Great Depression. The true story is that monetary policy tried overzealously to stop the rise in stock prices. But the main effect of the tight monetary policy, as Benjamin Strong had predicted, was to slow the economy–both domestically and, through the workings of the gold standard, abroad. The slowing economy, together with rising interest rates, was in turn a major factor in precipitating the stock market crash. 

Wow! Reading Bernanke really helps. How do you explain so many things in so few pages?Bernanke however does not include the kinds of asset bubbles one needs to look at.

Primarily there are two assets, which pose trouble, equity and real estate. (Commodities would be included in research now) And there is a difference as Ceccheti points out:

In thinking about the impact of bubbles, it is important to distinguish equity from property prices. While they affect the economy through similar channels, the magnitudes tend to be different. Booms and busts in equity prices are much less damaging to an economy than soaring property prices. There are two reasons for this. First, individual consumption decisions are much more sensitive to changes in housing prices than to fluctuations in equity prices. Second, in countries where housing purchases are financed by borrowing (as in the US, the UK, and a number of other countries), bank balance sheets are exposed to the impact of the crash.

How much more damage by real estate? Again from Ceccheti,

…..in the April 2003 World Economic Outlook, the IMF reported that the average equity price bust lasts for 2½ years and is associated with a 4% GDP loss that affects both consumption and investment. While less frequent, housing price busts last nearly twice as long and have been associated with output losses that are twice as large because of what happens to banks.

Well why do bubbles actually happen? Well the root cause is leverage as people borrow against an asset (which they expect to rise in future). So you need to tone down the leverage via policies.

With equities some correction still happens as short-selling mechanism is possible but with that options not easily doable with houses the prices would continue to rise. Well this is tremendous insight.

Ceccheti also says Mon Pol may not be the right tool to take care of bubbles, and does suggest measures like higher margins for checking equity bubbles and increasing net worth margins for the borrower etc for correcting housing bubbles. But says there efficacy has to be evaluated and till then Mon Pol remains the only tool.

As both the article and speech were written some years back what do we see now? In India, RBI keeps a tab on housing prices not via interest rates but through other policies. It looks at how much of the loans go towards housing, tinkers with the risk weightage associated with housing loans etc.

So a consensus is building on alternative measures for checking asset prices.

Before I close, the idea that Mon Pol should be used for asset prices is gaining ground. This recent article by Leijonhufvud and latest BIS annual report all talk about accommodative monetary policies being responsible for the recent asset price rise.

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Assorted Links

1. As was expected, Fed leaves rates unchanged at 5.25%. In yet another excellent pointer from WSJ Blog, see how the FOMC statement has changed from the previous ones. This is super stuff.

2. Wall Street vs Silicon Valley. Google rules on US campuses. Thanks to WSJ Blog once again. Another pointer is the article by Hal Varian on how ipods are made…It is a global ipod with components coming from all over the world.

3. Montek Singh Ahluwalia’s interview in BS is a nice read.  He says inclusiveness is not just about poverty reduction. Unlike most (including me) he says reforms haven’t slowed down.

We have restructured policies to induct public-private partnership (PPP) into infrastructure, to re-energise agriculture and also to improve health and education. Tax reform has continued and yielded excellent results. The near universal adoption of VAT by states and the spread of the service tax net are particularly important.

I recognise that the financial press often complains that reforms have slowed down. I think this it is partly because they focus on one or two areas like labour reforms, where we have not made progress, because we simply do not have the political consensus to move forward.

Assorted Links

1. WSJ Blog asks how often should we revise GDP Estimates?

2. I had read about impossible trinity. Dani Rodrik has a new impossible trinity of world economy. He says democracy, national sovereignty and global economic integration are mutually incompatible. Where does he get these thoughts from?

3. Finance Professor points to a nice article on hedge funds run by Bear Stearns.   

4. Apurv has an excellent post on Internet speed enjoyed by locals in their countries. He says 256 kbps is a decent speed which most of us use in India but in Japan the median download speed is hold your breath….61 mbps….USA average is 1.97 mbps…. 

5. Good Blogs on Liberia. By two Harvard students who are doiong their internships in Liberia Here and Here . Thanks to Rodrik for the pointer.

6. World Bank PSD Blog points to a super article written by Easterly criticising Sachs’ “Aid is Good” model of development.

Concerns over World Economy

After some postings on concerns over Indian economy, it is time to look at the world economy. BIS Annual Report for 2006-07 has been released.

Unlike most Annual Reports this one is a good review on World Economy and Financial Markets. The summary is here. As it is a pretty long report, it would take time to read and comment.

I read Malcolm Knight’s (General Manager of BIS) speech on the same, which provides a neat summary. His speeches are quite good and the focus on risk in his speeches is exceptional.

• See Table 1 (page 1 of the speech) for sure. Most economists have underestimated the growth levels in world economy and the consensus predictions have been lower than actual for most of the years. Infact, it is quite amusing that when growth is falling analyst expectations are higher than actual and vice versa. 🙂 So analysts don’t get it wrong just with India but also with World Economy in general.
• On Inflation front, the actual has been marginally higher than estimates but overall low inflation.
• Knight says the trend this year further confirms that this is the era of Great Moderation, the period of low volatility of inflation and output.  

What lies ahead? Or in Knight’s words “potential fault lines”. He says  there are 3 :

1. Inflation outlook: Core inflation (excluding food and energy) has been higher than the comfort levels for much of 2006-07. Globalization effects seemed to be fading away as wages have been increasing in China and this could lead to high inflation.
2. Features of Financial cycle: The risk premiums have been really low and most asset prices have increased to all time highs leading to concerns that we might have already gone too far and a correction is on the anvil.
3. Global configuration of country’s external balances: Current account deficits of developed countries continue to be financed and capital continues to flow in emerging markets. Plus there has been a huge increase in foreign exchange reserves of some Asian countries. Knight remarks:

   In current account deficit countries, the positions have largely tended to reflect buoyant consumer spending and associated declines in household saving as opposed to the accumulation of productive capital that could raise future incomes. As regards current account surplus countries, in those economies that have been building up reserves it has proven increasingly difficult to forestall rapid monetary and credit expansion and asset price rises, which could be aggravating vulnerabilities to financial strains and future inflationary pressures.

   The efficiency of domestic financial systems could also be compromised by these developments. Other distortions pertain more to the global financial system. The management of unprecedented volumes of foreign exchange reserves by the public sector, concentrated in a handful of countries, is bound to raise major challenges of an economic and even a political nature. More broadly, the threat of economic protectionism should not be underestimated.

Hmmm… So this is what BIS thinks.

Knight further says, if he has to point out one concern it is the “unusually low level of inflation adjusted interest rates”. He adds that this factor either lurks behind or is a symptom of the above concerns. Very well put Sir.

What are the policy measures to correct?

1. A need to adjust the fiscal policy by bringing reforms in labour and product markets. There is a need to gradually reduce the costs of healthcare and pensions on the fiscal and make it more market oriented. As times are good, these reforms would be easier to implement now.

2. The monetary policy should try and normalize interest rate levels to contain inflationary risks and this would also help in pricing the risks in the financial markets better.

3. Keep strengthening the financial system. After all, in these good times, financial markets can often play the spoilsport by allocating/channelizing resources to not so prudent deficit unit. When times are good, the probability of risks due to moral hazard/adverse selection increases.

Nice stuff. 

Downside factors in Indian growth story

We have been witnessing a lot of literature, media releases, and blogging on Indian economy. They are generally divided into 2 camps- optimistic/hopeful and pessimistic/cautious.

I just came across this paper that falls into pessimistic/cautious category. It is by Shankar Acharya (SA) and is a highly referred paper so one needs to look into it. It is written in 2004 but is still pretty relevant.He lists all the factors that have been cited by the first camp and criticizes them one by one:

1.  Demographic Dividend (Labour): Most analysis just look at broad India numbers and suggest that India would gain from the huge working population and falling dependency ratio.But Acharya does a state-wise analysis and finds states that have the highest fertility rate are laggards (Bimaru States – Bihar, MP, Rajasthan and UP)  and those with lowest fertility are leaders. So is the demographic dividend happening?And when one looks at fertility rates and per capita incomes the disparity grows further as population has grown higher in Bimaru states.

2.  Demographic Dividend (Capital): The conventional thinking is, as people in working age (15-64) group grow so would the savings and the investment or capital in the country. This would mean more capital would be deployed leading to higher GDP growth.The hypothesis is that as the demographic trend cited has begun almost 15 years ago, we should be seeing some effects by now. But Gross Domestic Savings has increased by just 20.4% ( average of 1985-90) to 24.2% in 2002-03  largely because of negative savings of Public Sector.

Before I go on, this point needs to be revisited and revised by  Acharya. As per latest CSO estimates, India’s savings and investment rate has improved quite a bit. The average gross savings and investment rate as a % of GDP (at market prices, as he also takes the same) between 2003-06 is 31% for each.  (And if you look at the respective data as a % of GDP at Factor Cost then it is 34% for each. He criticises a Rodrik paper which says India’s savings rate could increase  to 39%. Well if you look at estimates based on Factor cost, we are getting nearer to the Rodrik guesstimate.)

3. Productivity Growth: SA rightly says that to calculate productivity growth via a metric called Total Factor Productivity Growth is difficult because if output growth is high, TFPG would be high and vice-versa.

4. Others: SA then comments on the well-known problems-  falling standards of  institutions in India (particularly the Indian bureaucracy), the deplorable infrastructure, the slowing down of reform process, agriculture, fiscal stress and increasing inter-regional disparities.

In the whole paper he criticises two pieces, one a paper by Rodrik and Subramanian (RS) and a speech by Kelkar. I have already pointed out above one criticism needs to be re-looked.  

SA also criticises the Planning Commission for assuming 7% plus growth rates in Bimaru States during 10th plan where as they grew by only 4% during 9th plan (1997-02). On checking the growth rates for these states for 10th plan period,                   
                   Net State Domestic Product (2002-05)
Bihar –        9%
MP-             5 %
Rajasthan – 6% 
UP-             4.6%So, we do witness high growth rates in Bimaru States. But these growth rates need to be taken with a pinch of salt, as the variation (measured by standard deviation) in growth is pretty high. All Bihar, MP and Raj have high variation of almost 15. Only UP has a low variation of just 0.85.  So, a bit of a mixed evidence really.

Overall, a good analysis and helps us know more factors we need to be cautious about while analysing India’s growth story. But then he needs to revisit some facts and revise the paper.  

Assorted Links

1. Dani Rodrik divides the development thought process into two schools.

2. Jeff Sachs advises Zoellick on how to fix the World Bank. Thanks to Rodrik for the pointer.

3. Econbrowser has a nice post on Inflation and globalisation.

First Financial Crisis of 21st century

This is a nice paper on economic history. The paper/case-study is nicely titled “Northwest of Suez: The 1956 Crisis and the IMF” and is available here.

The author James Boughton is an IMF Historian. IMF Chief Michel Camdessus commented post crisis in Mexico in 1995 that it is the ” first financial crisis of the 21st century”. The author differs and says the Suez Crisis ion 1956 had all the elements of the financial crisis seen in 1995 and IMF had already been through the experience.

First the abstract:

Egypt’s nationalization of the Suez Canal in 1956 and the failed attempt by France, Israel, and the United Kingdom to retake it by force constituted a serious political crisis with significant economic consequences. For the United Kingdom, it engendered a financial crisis as well. That all four of the combatants sought and obtained IMF financial assistance was highly unusual for the time and had profound effect on the development of the IMF. This case study illustrates the complexities in isolating the current account as the basis for determining balance of payments “need” and shows that the speculative attack on sterling—and the IMF’s response to it—were remarkably similar to financial crises in the 1990s.  

The sequence of events can be read in the case study. It is nicely done with detailed explanation of the political scenario behind the first IMF bail-out. I would like to point out how the crisis was similar to the ones we see now: (abridged version)

• United Kingdom faced in 1956 was almost purely a speculative attack on a stable currency against a backdrop of reasonably sound economic policies. That is, it was a financial and not an economic crisis, and its primary effect was on the capital account of the balance of payments. Similarly, Mexico in 1995 had a current account deficit and faced speculative pressures to maintain its fixed exchange rate.
  
• In both cases the crisis was precipitated by a clash of policy goals, between maintaining a stable exchange rate and simultaneously establishing open markets for the currency.

(Readers may ask, why was there a clash of policy goals? Well, as most Central Banks are formed with the objective of managing inflation, I assume that Central Banks would be managing it even then. Hence, we have a case of Impossible Trinity.)

• In both cases, a rapid response was essential. Despite the limited convertibility of sterling in 1956, Britain began losing reserves rapidly after the United Nations condemned its invasion of Egypt in early November. The IMF had to respond by early December if Britain was to avoid floating the pound. The length of time between the onset of the attack and approval of the financial package was almost the same as in the peso crisis of 1995.
  
• The key in both cases was to post a large enough number to impress financial markets, convince speculators that a bet against the currency could not be won, and persuade investors to keep their money in the country. 
  
• The IMF’s involvement in both cases was necessitated by the unwillingness of the United States to provide sufficient resources bilaterally, despite its acknowledged self-interest in a successful resolution of the crisis.

A nice case study for finance professionals/scholars.  

Assorted Links

1. Lots of reference material is provided by New Economist on the fall-outs of globalisation. The main concern is that inequality has increased.

2. Lawrence Summers says inequality is rising. Thnaks to Greg Mankiw for the pointer.

3. Wall Street likes Bernanke but Washington doesn’t. Thanks to WSJ Blog for the pointer.

4, WSJ Blog also has an excellent post on revival of Austrian School of Economic Thought. I liked this para:

In the 1930s adherents of the “Austrian school,” named for its Austrian-born proponents Ludwig von Mises, Joseph Schumpeter and Friedrich Hayek, argued the Great Depression represented the unavoidable remediation of misallocated credit and overinvestment in the 1920s. The Austrian school largely failed to become orthodoxy as first Keynesian demand management appeared to end the Depression and later monetarism blamed the Depression on inadequate attention to the money supply.

5. Private Equity boom ending.

6. Finance Professor has some superb links from various sources on a new report (press release) by Senate on Amaranth downfall.  The full report is here. Should be a good read.

Transforming India

That is the title of the paper written by Arvind Panagriya (AP) and the paper is very well written. The solutions are the same, it is the presentation of the paper which makes it stand out.He starts off the paper by dividing India’s growth pattern in 4 phases:

1951-65 :  4.1% 
1965-81: 3.2%
1981-88: 4.8%
1988-04: 6.1%

And during the last three years i.e. from Apr 2003 to Mar 2006 the average growth is 8.1% ( if you add the latest CSO estimate of 9.4% then in last 4 years the average has been 8.75%). The question is whether this increase in growth rate is a business cycle phenomenon (means temporary) or a shift in the long term growth rate (means permanent)? AP says he is more convinced that it is the latter. His reasons are:

• Trade and foreign investment expansion and therefore integration into the world economy in the current phase has been much more rapid and deeper.
• The exchange rate in the current phase has been either stable or has appreciated. This has meant a very rapid growth in the GDP in dollar terms when converted at the market exchange rate. Given very large stock of foreign exchange reserves of $165 billion on August 11, 2006, prospects of a large depreciation are extremely low. What this means is that the expansion in the dollar value of the GDP achieved will sustain itself.
• After three consecutive years of 7 percent plus growth, the previous phase (1993-97) saw growth rate plummet to 4.8 percent in 1997- 98. The current phase has so far shown no sign of slowing down. According to all available projections, despite natural calamities and therefore very low agricultural growth, the GDP growth in 2006-07 is expected to hit the 8 percent mark.

I do not find the reasons very conclusive. Need to look at additional literature.Anyways, the growth story’s salient features are:

• Despite the shift most of the employment is still in agriculture. In 1999-00, 
                               Share in GDP        Share in Employment
  Agriculture                 25.3                              60.3
  Industrial                    19.5                              11.9
  Services                      65 .2                              27.8

Industrial includes Mfg., Mining and Electricity Sector. Mfg contributes 15% of GDP & 11.0% of employment. Services include Construction, Hotels, Transport, Financial Services and Social Services. In Services, Financial services contributes 13% to GDP but its share in employment is just 1.2%

• So, the transition from agriculture to other sectors has been very low.
   
• The most interesting table is on Page 20, which divides the employment % into organised and unorganised labour. It says that outside of agriculture, as much as 88 percent of the labor force continued to be in the informal sector in 1999-00 though the output generated there was only 44 percent. Within manufacturing, 94 the informal sector though only 39 percent of the manufacturing output originated there.

And then AP revisits (albeit in brief) India- China debate and says China liberalized much more than India did and hence has a different growth pattern. The reason why China grew faster was that it allowed manufacturing of unskilled labour-intensive products on a large scale and India limited their production by reserving these items for small-scale industry.

As most would know, India moved from agriculture led growth to services one where as most countries first move to manufacturing sector and then to services. The large-scale firms in India had a preference for capital intensive goods and did not want to move into unskilled labour-intensive sectors.  

Now, both services and industries require educated/skilled workforce and India lacks way behind on this front. Hence, initially, there is a need to move the surplus labour in agriculture to these low skilled jobs which the former can adapt to in a much more easy manner. The reforms so far have not been very friendly for such kind of production.

This is the basis of AP’s idea, which he very neatly summarizes as:  

Therefore, the challenge of transformation facing India is that of creating an environment that allows unskilled-labor-intensive manufacturing to grow rapidly and rise as a proportion of the GDP. On one hand, such growth would pull workers from agriculture into gainful employment more rapidly than is the case currently while on the other it will reduce the burden of labor on the land. Wage in agriculture would also rise faster than in the absence of rapid expansion of unskilled-labor-intensive manufacturing. Some have argued that the transformation to the modern economy need not require a switch to manufacturing. After all, according to the traditional growth pattern, once manufacturing reaches a certain stage, its share does decline and that of services rises. India could simply skip the transitional stage and directly jump to the final stage of specialization in the services sector.

The flaw in this argument, however, is that if the workers are to be employed in the formal-sector services, they must be given college education. But the vast majority of the farm workers that need to be moved into the formal sector of the economy lack even high school level education. Moreover, given the countrywide gross college enrollment ratio (the number of individuals in college as a proportion of the population in the 18 to 24 years age group) of 14 percent and relatively poor prospects for further expansion of higher education, prospects that a large proportion of the population can be imparted college education in the next two decades are extremely poor.

It makes some sense in another way. With increasing liberalisation, the sectors/industries that are out of favour would have large number of idle labour. Without jobs, this already constrained section would face enormous difficulties and hence resentment against government etc. Now, it is difficult for these people to move to high-specialised jobs right away and would need to earn a living first. These kinds of low skilled jobs would definitely help relocate this section of population. It looks like a good policy suggestion.

However, what would be needed to achieve growth in this sector- labour market reforms and infrastructure. 😦 Things never seem to end. 

Nevertheless, a very good paper with a very fresh perspective. A must read for new insights on Indian economy.

Assorted Links

1. Robert Barro says Bill Gates has done more for business world than he can do for philanthropy. Thanks to Greg Mankiw for the pointer.

2. Doha Round has collapsed. Comments from Dani Rodrik , New Economist 

3. Myron Scholes (of Black-Scholes fame), seeking a licence  to advice Japanese Pension Funds. Thanks to Finance Professor for pointer.

4. Finance Professor points out to various links that talk about Bear Sterns bailing out its hedge funds.

5. A nice debate looking at reasons behind rise is US bond yields. Thanks to WSJ Blog

Comparing India and China

Both get some encouragement from Bob Fogel in his recent paper. His conclusions are similar to the ones in various research reports that India and China are going to be the most powerful economies in future. But as this one is by Fogel, a nobel laureate and a very respected economist, one better take note.  

And he says:

The population forecasts are those of the United Nations. The economic forecasts are mine but were influenced by the forecasts of the C.I.A. and The Economist.

He puts forward some very strong viewpoints. As he has focused his research on health and population, this paper provides another insights as well.  The tables 1 & 2 in particular (page 17 & 18) provide a stark picture of economic outlook. We all knew about India and China but look how other nations are doing? EU clearly is a problem. Its share in World GDP decreases from 21% in 2000 to just 5% in 2040!

Fogel cites reasons:….

rapid aging of many EU15 countries means that their dependency ratios (the ratio of economically inactive to economically active persons) will soar. These demographic factors will, by themselves, significantly curtail the capacity for economic growth. However, political and cultural factors appear to be reinforcing the impediments to economic growth. These include limitations on the length of the workweek and increasingly heavy taxes on businesses to support large social welfare programs (that are nevertheless facing bankruptcy) and are threatening to make EU15 firms uncompetitive in the global market.

He adds that it is nit as if EU would not grow but its growth rates are going to be much lower than India, China and SE Asian nations.

The European market will be about 60 percent larger in 2040 than it was in 2000. But the U.S.’s market will be over 400 percent larger, India’s will be over 1,500 percent larger, and China’s will be 2,500 percent larger. Indeed, the Chinese market in 2040 by itself will probably be larger than the combined markets of the U.S., the EU15, India, and Japan.

He then analyses the forecasts for India and China.He says most think political system is a constraint for China and could hinder growth in China. He doesn’t agree and says leaders recognize the problem and are gradually working towards it. The policies are oriented towards stability and he cites number of references, which show things are improving in China. 

I however, take this analysis with a pinch of salt. They may be making policies for stability, but I guess more is to be done.Infact, unlike most research work he says constraints are more for India than China. The summary is:

• Economic constraints: India has low education standards (which means services and industry would not be able to grow in future) and agriculture sector is in a mess (low productivity and still 75% of population in agriculture)
• Political Stability: He says comes from 3 sources- unresolved religious tensions, especially between Hindus and Muslims; unresolved ethnic disputes; and unresolved pressures created by the caste system.

Overall a nice short analysis.  Discusses those areas which most economists/research reports do not mention and leave it to assumptions (provided there are no constraints, India will grow at so and so rate etc) . But more insights were needed and expected from likes of Fogel. 

Assorted Links

1. List of Cognitive Biases. Useful to understand behavioural aspects in decision making. They form the basis for Behaviour Economics/Finance.

2. Rajrishi Singhal in ET, offers Contract Farming as a more viable solution.

3. Andy Mukherjee offers a politically unacceptable solution for Mumbai.

4. A nice interview of Dr. Rangarajan in BS. But I don’t really quite agree to this:

Do you believe a trade off exists between inflation and growth?
This is a false dichotomy. In my view, over the medium term there is no conflict between lower inflation and higher economic growth. In fact, higher economic growth can be sustained only in an atmosphere of reasonable price stability. Price stability is required for promotion of savings and investment. Sometimes there could be a conflict in the short run. But, that should not be utilised as an excuse for letting inflation go out of hand.

All he is saying is there is indeed a trade-off. Well, you need to maintain price stability to have sustained growth. The moment inflation hurts, growth also falls.

5. T Thomas says India needs elite universities. I think he is way off the mark. India already has its share of elite universities and needs to improve the levels at other colleges and universities. On comparing India with UK is like comparing apples with oranges. We have a huge population and need places where people can get right education, not elitist education.  And why build more? Improve on the existing ones first.

Difference between trade in goods and trade in finance

The best ideas on any topic in economics come when we have criticisms/critiques of an academic paper/ thought/article etc.

I just came across this piece written by Jagdish Bhagwati and critique by Maurice Obstfeld. And let me tell you it is super-stuff. This is what makes the field of economics so interesting.

I have often wondered what is the difference between trading in goods and trading in finance (assets)?  The latter has been distinguished from the former in wake of number of financial crisis. The initial idea was that trading in finance would also have similar benefits as trade in goods does (developing countries would need to fiannce their investments they would need additional finance apart from domestic savings) , hence it was advocated by a number of economists. Then came number of crisis in 1994 where finance (mainly short-term capital flows) was held largely responsible for the crisis. So now, we have 2 seperate topics and financial globalisation is a different topic altogether.

JB says in this famous and often cited piece that trade in widgets isn’t the same as trade in dollars. He says:

Each time a crisis related to capital inflows hits a country, it  typically goes through the wringer. The debt crisis of the 1980s cost South America a decade of growth. The Mexicans, who were vastly overexposed through short-term inflows, were devastated in 1994. The Asian economies of Thailand, Indonesia, and South Korea, all heavily burdened with short-term debt, went into a tailspin nearly a year ago, drastically lowering their growth rates.

The difficult part is the policies followed after the financial crisis. It basically leads to further opening of the capital markets which caused the crisis in the first place:

When a crisis hits, the downside of free capital mobility arises. To ensure that capital returns, the country must do everything it can to restore the confidence of those who have taken their money out. This typically means raising interest rates, as the IMF has required of Indonesia. Across Asia this has decimated firms with large amounts of debt. It also means having to sell domestic assets, which are greatly undervalued because of the credit crunch, in a fire sale to foreign buyers with better access to funds……. Thus, Thailand and South Korea have been forced to further open their capital markets, even though the short-term capital inflow played a principal role in their troubles in the first place.

He in the article then goes onto point out the Wall Street -Treasury Complex where both combine to always promote capital openness:

Wall Street’s financial firms have obvious selfinterest in a world of free capital mobility since it only enlarges the arena in which to make money. It is not surprising, therefore, that Wall Street has put its powerful oar into the turbulent waters of Washington political lobbying to steer in this direction……Wall Street has exceptional clout with Washington for the simple reason that there is, in the sense of a power elite a la C. Wright Mills, a definite networking of like-minded luminaries among the powerful institutions-Wall Street, the Treasury Department, the State Department, the IMF, and the World Bank most prominent among them……

So he provides a basic framework on which Obstfeld builds his thoughts. He says the difference between trade in goods and dollars is:

The basic differences relate to the intertemporal nature of financial trades and to the potential for asymmetric information to eliminate trade gains. Asset trade inherently involves commitment – the commitment to pay on a later date. Payment in reality is therefore always contingent, and the circumstances of contingency can depend on information known to only one party to the deal. Thus, financial transactions inherently must allow for the asymmetric-information distortions that we call moral hazard and adverse selection. These distortions reduce the gains from asset trade that would otherwise be available – even with an efficient and impartial judicial enforcement system.

As is well appreciated, government guarantees aimed at mitigating the redistributive effects of financial crises can, in fact, worsen moral hazard and raise the probaility of eventual crises.

Again, the difference compared to goods markets is a matter of degree. A consumer durable yields returns over time, it may be known to the seller to be a “lemon,” yet an unconditional service contract may leave the owner with insufficient incentives to operate the durable good appropriately. But there is no doubt that commitment and informational problems are by far most severe, and have the widest systemic ramifications, in the financial market setting.

Obstfeld then says domestic financial markets also pose problems as the above i.e. intertemporal nature and assymetric information are a problem in domestic markets as well. What makes international capital flows a bigger problem is addition of 3 more risks:

1.  Sovereignty: The potential involvement of two (or more) governments as implicit parties to international contracts.
2. Regulatory end-run:  International transactions can sometimes be used to evade domestic supervision.
3. Currency mismatch: The potential for unbalanced positions creates a significant additional systemic risk.

This is basic stuff and very well said. For a survey on whether financial globalization (or trade in finance) is helpful or not, I have put findings of the most exhaustive paper on the subject here and here. And in nut-shell the evidence so far has been mixed.

State of WI Cricket and innovation at Wimbledon

First read this good story on Wimbledon….The Centre Court is being revamped, it would be without its roof this year. They would also be using hawk-eye technology at Wimbledon this year.

Now for some Cricket. Here is another great discussion on what ails WI cricket. Sanjay Manjrekar has done a great job as a moderator. He discusses it with Michael Holding (MH) and David Lloyd (DL).

MH nails the root cause at its head. When asked what the real problem is he says:

You don’t have that as many people playing the game in the Caribbean now, it’s as simple as that. Years ago you had a lot of people playing cricket. Football was also a very popular sport and is still a very popular sport as far as participation is concerned. But the amount of people who would play cricket 30-40 years ago is probably 3-4 times the number who play now.

It is important for the administrators to put in the infrastructure and the facilities so that the people who want to play the game can easily access all the required facilities. There are so many other games that are easily accessible plus we are in the modern age of computers – kids just do what is easiest for them. There are basketball courts with lights all over the Caribbean. So the kids don’t have to worry about playing just during the days – they can come home from school or work and start playing. They don’t have to worry about preparing surfaces, making pitches, wearing special uniforms or buying any expensive equipment – it’s all ready for them. What the cricket administrators need to do is make cricket just as readily available as the other sports and distractions.

He also raises questions about lack of domestic cricket etc but I think most important is the one that people do not play cricket at all.

Then DL says not all is lost and there is a lot of hope:

I think you have to be radical. Infrastructure is always important, you need top administrators, it needs to be an attractive game, it needs to be accessible and yes, you certainly need icons for the youngsters to emulate. I am miles away from what goes on in West Indies cricket but I do know of a man who is passionate about West Indies cricket called Mr. [Allen]Stanford – and he has the money. I think if the administrators and the ex-players could put forward a plan from the West Indies Cricket Board stating where they are looking to be in 5 or 10 years time and present that to Mr. Stanford and say, ‘please, help us out,’ he may just get involved; because from what I can see he is really passionate about West Indies cricket ….

Who is Alen Stanford? He is the chairman of a Financial Services Powerhouse called Stanford Group. He is immensely interested as MH also points out but has been goven a cold shoulder from WI cricket board.

So the basic issue is you need to develop more interest towards cricket amongst local population. Why doesn’t that happen? Two things, one other sports have better facilities and two higher incentives present at other sports.

Now, both are equally important. In India for instance, cricket is hugely popular but because of poor infrastructure that cannot identify right players becomes a problem. How do you reconcile the fact that Chiarman of Selection committee says there is not enough talent and on the other side there are young players who are committing suicides for not getting a chance?

For better facilities you need more finance (Finance is important) and this Mr. Stanford can provide and then the incentives have to be altered so that the public becomes interested and the game becomes popular. And in teh meantime other institutional changes like having a better board, more local cricket etc need to be brought about.

For Mr. Stanford WI cricket is like a distressed asset but has immense potential. So like a private equity player he would go about making changes in the entire structure and clean up the slate and eventually make a gain.

It is akin to a growth and development problem which economists face and have to tackle with most of the time.

Assorted Links

1.  TK Arun in ET says we should not worry about Rupee getting stronger. His summary is:

The short point is that a stronger rupee right now would help the economy consume and invest more and to enhance Indian ownership of assets in India and abroad.

I don’t really agree to his viewpoint. Firstly, we do not really know what is the right level of rupee. As India has current a/c deficit, the rupee should depreciate but because of capital flows the new effect is appreciation of the rupee. This means worsening of the deficit as imports become cheaper. And then we have RBI intervention which is done in an opaque manner and it is only of Friday we come to know how much RBI intrevened in the markets. More clarity is needed.

2. Super economics blog from WSJ. Thanks to Marginal Revolution for the pointer.

3. Mutual Funds business is a mess. SEBI Chairman says the growth is mostly in liquid funds and that too from corporates. It is hightime something is done about the Mutual Fund business- lot of schemes by one AMC with similar objectives, mostly used by corporates, high expenses, no idea about number of individual investors etc are some very important issues which have to be answered.

4. SEBI takes out a consultative paper for listing and trading securitised paper. Here is ET’s view . Here is the paper. I am a bit confused after reading ET’s view. SEBI should do something about its website.

Indian Banking sector – a simple analysis

I have made a mention of this report from RBI in my previous posts. I have commented some important findings from the report covering Financial Market Integration, G-Sec Markets and Equity and Corporate Debt Markets. 

This post covers the Banking structure in the country and credit markets.

The first question which often comes to mind is what are the different kinds of banks in India? The report says:

There are wide range of financial institutions exist in the country to provide credit to various sectors of the economy. These include commercial banks, regional rural banks (RRBs), cooperatives [comprising urban cooperative banks (UCBs), State co-operative banks (STCBs), district central co-operative banks (DCCBs), primary agricultural credit societies (PACS), state co-operative and agricultural rural development banks (SCARDBs) and primary co-operative and agricultural rural development banks (PCARDBs)], financial institutions (FI) (term-lending institutions, both at the Centre and State level, and refinance institutions) and non-banking financial companies (NBFCs) 

Thankfully, the report gives a very good picture of India’s Credit System here 🙂 And it also explains each institutions role as well.

How large is the credit market in India? Almost 54% of GDP and is increasing. Indian society is getting friendlier to credit.

Total Outstanding Credit by all Credit Institutions
1991	1,94,654	–	34.2
1995	3,47,125	22.7	34.3
2000	7,25,074	17.1	37.1
2001	7,94,125	9.5	37.8
2002	8,93,384	12.5	39.2
2003	10,77,409	20.6	43.8
2004	11,99,607	11.3	43.4
2005	14,81,587	23.5	47.4
2006	19,28,336	30.2	54.1
Compound Annual Growth Rate (Per cent)
1991 to 2000		15.7
2000 to 2006		17.7

How much Credit do each of the instituions give? Commercial Banks clearly have a major sharte in the credit system.

Distribution of Credit – Category-wise Share (Per cent)
		1991	2006
1.	Commercial Banks	59.7	78.2
2.	RRBs (and LABs)	1.8	2.1
3.	All-India Financial Institutions	24.9	5.8
4.	Urban Co-operative Banks	4.1	3.6
5.	State Co-operative Banks	3.4	2.1
6.	District Central Co-operative Banks	6.0	4.2
7.	Primary Agricultural Credit Societies	3.3	2.5
8.	SCARDBs	0.7	0.9
9.	PCARDBs	1.0	0.7
All Institutions		100.0	100.0

 

 

 

 

 

 

Whom do Commercial banks give most of the credit to? The preference has moved from Industry to Services sector. Within services, the credit is being increasingly given as Housing Loans.

Table 4.5: Distribution of Outstanding Credit of Scheduled Commercial Banks (Per cent to total credit)
Sector	Mar-90	Mar-95	Mar-00	Mar-01	Mar-02	Mar-03	Mar-04	Mar-05
Agriculture	15.9	11.8	9.9	9.6	9.8	10.0	10.9	10.8
Industry	48.7	45.6	46.5	43.9	41.4	41.0	38.0	38.8
Transport	3.2	1.9	1.8	1.6	1.4	1.2	1.3	1.2
Personal Loans and Professional Services	9.4	11.3	14.4	15.8	16.8	19.6	25.3	27.0
of which:
Loans for Purchase of Consumer Durables	0.4	0.3	0.6	0.6	0.5	0.4	0.5	0.6
Loans for Housing	2.4	2.8	4.0	4.7	5.0	6.5	9.7	11.0
Trade	13.9	17.1	15.6	16.6	15.4	13.8	11.5	11.2
Financial Institutions	2.1	3.8	4.8	4.9	5.7	6.7	6.7	6.4
Miscellaneous / All Others	6.8	8.5	7.1	7.5	9.5	7.7	6.2	4.6
Total	100.0	100.0	100.0	100.0	100.0	100.0	100.0	100.0

What is the tenure of credit by Commercial Banks. As economies and financial systems mature one would expect to see movement in favor of long-term credit. Thankfully, we see it in case of India.

Type of Credit to Industry By Banks (% of total)
	Short-Term Loans	Medium term	Long Term
1995	82.5	5.8	11.6
2000	74.3	6.8	18.9
2005	52.4	10.6	37.0

I don’t want to praise the report more. One of the best on India’s Financial System and markets.

Assorted Links

1. A number of recent papers on India and China. Marginal Revolution pointsto a paper from Fogel. New Economist points to two papers one on China which focuses on rising inequality, and one on Indiawhich cites reasons for worsening public deficit.

2. Rodrik mentions about 15 commandments of economics. All are funny and true.

3. Global Financial Capitalism…??? Rodrik critiques an article written by Martin Wolf.

4.  Ajay Shah in BS writes a very good piece on India’s education system:

A lot of extremely successful people in the world have a college degree in fields like history or the liberal arts, where no tangible technical skills were learned. A lot of top CEOs frankly say that their MBA education was useless. An extensive research literature finds remarkably little impact of either elementary or higher education on GDP growth. 
 
Universities may play a role in socialisation and in screening but the education that is imparted there is much less important in the working years than is presumed to be. In other words, the Indian model of having difficult entrance examinations coupled with no teaching has its strengths, for it achieves the things that matter (screening and socialisation) while skimping on the things that matter less (learning history or economics in an undergraduate programme). 
  
If learning does not happen in universities, then where does it happen? What appears to dominate is “learning by doing”, the learning that is acquired at the workplace. People learn inside firms, and their learning is best when the firm is in a brutally competitive and globalised market. 
  
In this respect, there is something of great importance which has been going on in India from 1991 onwards. For 16 years now, we have been building a new cadre of individuals who have learned inside competitive firms with an increasing degree of globalisation. Trade barriers have come down, capital controls have eased, and a middle manager in Tata Steel today is competing in the world market for steel. Ten years of experience in Tata Steel is worth more in building top-quality staff for running a steel company than any university education that I can think of.

Assorted Links

1. Prithvi Haldea revisits  divestments in ET. I agree that more PSUs should be divested of government stake but I am not sure whether public offers are the best way to divest. It should be a case by case basis.

2. A welcome article from ET on the number of tests one has to give for getting through colleges in India. This is much needed and would help more people take tests. One test would help immensely to the poor who are often forced to take so many tests and spend their limited resources.

3, RBI launches a website for a common person. A good initiative but it needs more material on financial education.

4. Amar, Akbar, Anthony revisited. This is Funny. Nice edit from ET.

Food Prices could rise higher in future

These days, agriculture seems to be attract my attention quite a bit. I read this speech from Alan Bollard, Governor of Reserve Bank of New Zealand where he talks about agriculture and rising commodity prices.

The reason for rising prices is partly China. He adds:

The rapid pace of industrialisation of China, coupled with its relatively low per capita endowment of natural resources, has led to a sharp increase in world commodity demand. For example, according to the International Monetary Fund, China was responsible for 51 per cent of the growth in the world copper market from 2002-2005, 54 per cent of the increase in the steel market, 48 per cent of aluminum growth and 87 per cent for nickel.

However, what caught my eye is this:

The most marked increases have been in dairy prices. Over the last year, dairy prices have increased by 73 percent. Milk powder prices have led the way, rising almost twice as fast as other dairy products.

Why prices have increased?

In large part, the recent gains in dairy prices can be traced back to a basic imbalance between global demand and supply. Global demand for protein has been on a structural uptrend for some time. Demand for protein is very income sensitive and rising income levels in emerging markets have led to improvements in diet, incorporating more meat, eggs and milk. In recent years, the strongest growth in consumption of dairy products has come from emerging Asian markets, particularly China.

Why Supply hasn’t caught up:

1) At the same time, dairy production from the major exporting regions, such as New Zealand, Australia and the European Union (EU), has been relatively lacklustre, hampering the ability of global dairy supply to meet the growth in demand.

2) The recent boom in biofuel demand has further hindered global dairy supply. Strong demand for ethanol has seen corn prices, the primary source of livestock feed, advance over 50 percent in the past six months.

The outlook for future is prices could rise further:

There is certainly no compelling reason to suggest that strong global demand for dairy products will slow markedly soon. Supply responses in dairy are slow inevitably slow. And with the boom in biofuel demand sending production costs in many parts of the world soaring, the ability of supply to “catch-up” to demand will be constrained further. As a result, any increase in global dairy supply may well rest on the prospects for emerging exporters such as Argentina and the Ukraine, along with the ability of China to increase production to meet its own demand. It is certainly possible that we could be heading into a “new era” for dairy prices.

He then goes on to talk about impact on NZ economy (a good snapshot). But the graphs etc presented are very good. Thanks Mr. Bollard.

Update 1:

I just checked the above mentioned food prices in India. (The website of Office of Economic Advisor (under Ministry of Commerce and Industry) provides detailed analysis of the Wholesale Price Index , the most popular measure of inflation in India). Here are a few findings:

1. From March 2006 onwards foodgrain prices (cereals and pulses) have been increasing in double digit every month vis a vis same month pervious year ( i.e. comparison is between March 2006 and March 2007 and so on).

2. Poultry Products ( Eggs, Meat & Fish) saw double digit growth rates from July 2005 onwards to June 2006. And now again from Feb 2007 there is an increase in the index .

3. There has been a huge jump in prices of milk powder when we see double dogit increase from March 2006 onwards but the index has not increased, hence it is basically more of base effect. The prices are not incvreasing but when we see the year on year growth the numbers are in double digits.

So, bit of a mixed story. But yes we see quite similar trends in India as shown by Bollard in his speech. Keep watching this space for developments.

Update 2:

Apurv rightly asks:  “Well, dairy products price rise is understandable based on your post. But how is it just possible to generalize it to include all food products? Confused a bit..”

My apologies for missing out that point. The dairy products are consumed by themselves and are also used to manufacture other food products as well. For instance cakes (eggs, cream) , Processed Cheese (milk), Salaamis (meat) etc all need some form of dairy/poultry items.

Thanks Apurv once again.

Bernanke answers my problem finally

I have often wondered and asked this question elsewhere as well (here and here) that why finance has not been given its due in discussion on growth and development.

I had read number of papers on the subject which said why finance is important for growth and number of ways it helps but none which said why finance has been ignored after all in growth literature.

Bernanke in his latest speech answers the same in his usual simple yet profound style:

Economists have not always fully appreciated the importance of a healthy financial system for economic growth or the role of financial conditions in short-term economic dynamics.  As a matter of intellectual history, the reason is not difficult to understand. 

During the first few decades after World War II, economic theorists emphasized the development of general equilibrium models of the economy with complete markets; that is, in their analyses, economists generally abstracted from market “frictions” such as imperfect information or transaction costs.  But without such frictions, financial markets have little reason to exist.  For example, with complete markets (and if we ignore taxes), we know that whether a corporation finances itself by debt or equity is irrelevant (the Modigliani-Miller theorem).

Then how did all of it begin?

The blossoming of work on asymmetric information and principal-agent theory, led by Nobel laureates Joseph Stiglitz and George Akerlof and with contributions from many other researchers, gave economists the tools to think about the central role of financial markets in the real economy.  For example, the classic 1976 paper by Michael Jensen and William Meckling showed that, in a world of imperfect information and principal-agent problems, the capital structure of the firm could be used as a tool by shareholders to better align the incentives of managers with the shareholders’ interests.  Thus was born a powerful and fruitful rejoinder to the Modigliani-Miller neutrality result and, more broadly, a perspective on capital structure that has had enduring influence.

Hmm, so the assumption of perfect markets was the main reason why finance was never considered important.  A great thought. Thanks a ton Ben. Your team at Fed is superb at speeches and educating people like us. Read this for how finance helps:

Economic growth and prosperity are created primarily by what economists call “real” factors–the productivity of the workforce, the quantity and quality of the capital stock, the availability of land and natural resources, the state of technical knowledge, and the creativity and skills of entrepreneurs and managers.  But extensive practical experience as well as much formal research highlights the crucial supporting role that financial factors play in the economy.  An entrepreneur with a great new idea for building a better mousetrap typically must tap financial capital, perhaps from a bank or a venture capitalist, to transform that idea into a profitable commercial enterprise. To expand and modernize their plants and increase their staffs, most firms must turn to financial markets or to financial institutions to secure this essential input.  Families rely on the financial markets to obtain mortgages or to help finance their children’s educations.  In short, healthy financial conditions help a modern economy realize its full potential.  For this reason, one of the critical priorities of developing economies is establishing a modern, well-functioning financial system.  

The speech is a super-one and helps one understand/revise his concepts of finance. He further says he looked at two channels in 1983 by which the financial problems of the 1930s may have worsened the Great Depression:  

The first channel worked through the banking system.  By developing expertise in gathering relevant information, as well as by maintaining ongoing relationships with customers, banks and similar intermediaries develop “informational capital.”  The widespread banking panics of the 1930s caused many banks to shut their doors; facing the risk of runs by depositors, even those who remained open were forced to constrain lending to keep their balance sheets as liquid as possible.  Banks were thus prevented from making use of their informational capital in normal lending activities.  The resulting reduction in the availability of bank credit inhibited consumer spending and capital investment, worsening the contraction.

The second channel through which financial crises affected the real economy in the 1930s operated through the creditworthiness of borrowers.  In general, the availability of collateral facilitates credit extension…… However, in the 1930s, declining output and falling prices (which increased real debt burdens) led to widespread financial distress among borrowers, lessening their capacity to pledge collateral or to otherwise retain significant equity interests in their proposed investments.  Borrowers’ cash flows and liquidity were also impaired, which likewise increased the risks to lenders.  Overall, the decline in the financial health of potential borrowers during the Depression decade further impeded the efficient allocation of credit……

He goes on to explain the concept of external finance premium, Financial Accelerator, Monetary Policy and credit channel, all very useful concepts. Must read for a finance professional (those with non-finance background can go through it as well).