Archive for December, 2007

Assorted Links

December 18, 2007

1. WSJ Blog points to  Fed waking up to inflation risks, points to views over the current credit crunch, points to five reasons why recession may be averted.

2. NBER is the final authority on recessions in US. Martin Feldstein, the NBER chief, says to get a full idea on whether there would be a recession we need to get more data. As December data would be available in 2008, wait till then. Thanks to WSJ Blog for the pointer.

3. Ajay Shah points to some critical appointments to be made in 2008.


Greenspan wisdom on sub-prime crisis

December 17, 2007

I have pointed a while back about this Alan Greenspan article on the sub-prime crisis.

The whole article is general stuff and he has already said most of it via his numerous interviews. However, these lines I believe form the crux:

The crisis was thus an accident waiting to happen. If it had not been triggered by the mispricing of securitized subprime mortgages, it would have been produced by eruptions in some other market. As I have noted elsewhere, history has not dealt kindly with protracted periods of low risk premiums.

So, if not sub-prime it could (rather would) have been anything else.  A crisis was waiting to happen.

Lessons from the recent sub-prime crisis

December 17, 2007

There are number of analysts understanding the sub-prime crisis etc. In the crowd, Stephen Ceccheeti’s analysis stands out. His research on monetary policy and financial markets is outstanding.

He is a regular on, which is becoming a great place to find numerous economist’s views on numerous topics. Stephen Cecchetti’s page is here.

He has posted the learning from the sub-prime crisis in 4 articles:

All 4 are a must read. I agree with points 1 & 3. Central banks need to take risks from financial system and asset prices seriously. In some countries financial supervision is given to some other authority but this won’t work.

In Point 2 he makes a case that despot insurance is a much better option then lender of last resort, which is still debatable. I think we need both, financial products are getting really complex and so would the crisis in future. Both would be needed.

In point 4, he says Central banks have not created moral hazard. I don’t really agree. Financial sector don’t want any interference when times are good and take on excessive risks. Sub-prime means higher risk and most banks ignored it knowing they would be bailed out if things go wrong. The financial sector knows that it is very important for the whole economy and can afford to be careless in good times. It is the manner in which Central Banks in developed economies have reacted to the crisis. First they were ignorant and all of a sudden all central banks were caught wrong footed.

The solution is to take on the role of financial supervision aggressively and take restrictive measures when economy is booming. Otherwise moral hazard problems are only going to become bigger.

Assorted Links

December 17, 2007

1. MR points to an Eugene Fama interview

2. WSJ Blog points to another Greenspan interview.

3. New Economist points to six experts’ views on probability of US recession 

4. Mankiw points to bad press for Bernanke

5. Econbrowser explains recent Fed move.

6. Ajay Shah points to what should be done if you are struck with a pegged exchange rate (I don’t see how cutting rates would help). He also points to  improving fiscal discipline at the state level, some good news on Delhi airport

Central banks need to apply behavior economics

December 14, 2007

I was very glad to know the Boston Fed has a behavior economics/finance research centre and is doing pretty active research in the field.

I came across this speech by Ric Battellino, Deputy Governor of the Reserve Bank of Australia, where he raises questions which can be solved using BE/BF. The speech basically discusses the way Australian funds management industry has grown and challenges.

The Aussie funds industry is amongst the top 10 in the world in terms of size mainly on account of rise in superannuation funds (ageing population is an Aussie problem as well). I was also amazed by this bit of statistic:

It is also notable that in Australia there has been significant direct participation by retail investors in the markets for sophisticated financial products. For example, retail and high net worth investors account for about two-thirds of the assets of Australian-based hedge funds, compared with less than half globally. Over the past five years, retail investors are estimated to have purchased around 15 per cent of the CDOs issued in Australia.

The reason for this is: 

One of the reasons for this higher participation by Australian retail investors in these markets is that the regulatory regime in Australia does not restrict retail access to any financial products as long as the provider meets certain disclosure requirements.

Well, well! This is no small figure by any means. Because of high retail participation, there are usual challenges of full disclosure etc.

Here is the BF/BE bit:

A related challenge facing the industry is financial advice, and how this is paid for. There appears to be a general reluctance on the part of retail investors to pay for financial advice on a fee-for-service basis. Instead, there has been a preference for commission based advice, despite the conflicts of interest that can arise in this situation. This reluctance to pay for advice upfront appears to be a form of money illusion, whereby investors may feel that they are somehow paying less for financial advice if the cost is buried in reduced earnings in the future.

To understand what we mean by commission based advice and fee for service advice, see this. To put it simply, people often like to pay their costs upfront at one time (commissions) rather than pay based on the service of the advisor. It is a behavioral problem known as money illusion. The solution is – financial literacy. (However, even financially literate people are human beings and make the same mistakes!)

I always believe BE/BF can help us understand many a challenges in a better manner. It just needs better models and applications, which is being worked on by a few economists.

Assorted Links

December 14, 2007

1. So who would be the CEO who would be ousted next? MR helps. This is the website where bets are taking place.

2. MR pointsthat NBER charges $5 per download. I think it should be made free.

3. WSJ Blog points to Greenspan interview and Tim Geithner speech

4. New Economist points to a new paper on whether economic sanctions work or not.

5. Greg Mankiw points to effective tax rate in US.

6. EPSA Blog defends World bank.

7. Ajit Balakrishnan on the research dilemma at IIMs. I think the problem is huge. Apart from the suggestions he gives, IIMs need to put all their research together at one place and allow free download. Then, it should possibly also ask newspapers to cover their research in an informative manner (not like the way newspapers cover celebrate placements at IIMs)

8. AV Rajwade says: It seems market fundamentalists want freedom only so long as markets are favourable. I agree completely.

Innovations in Tennis

December 13, 2007

It is common to find research on various industrial and service sectors. However, it is rare to find reports on how sports industry has evolved and fared overtime.

I came across this note from Wharton which explains how innovations in Tennis have helped the sport grow. It is a fantastic note which analyses the developments in a pure economic framework. Highly recommended reading.

Are derivatives the panacea?

December 13, 2007

I came across this news in business standard which actually got me thinking. The snapshot of the news-item is:

Sundaram Multi Pap, a Mumbai-based paper stationery manufacturer, on Monday disowned exotic hedging contracts entered into with ICICI Bank, saying the bank had misled the company into taking derivatives positions much beyond their underlying export risks.

This is a classic case of fancy hedging structures, where exporters convert their dollar receivables into Swiss franc, which has begun to hurt exporters as the otherwise stable Swiss currency has appreciated against the weakening US currency.

The currency bets have gone wrong in many cases, so I am sure there must be many such cases. This has been reported so it spins many questions:

1) Can we forecast the currency movement? I think not. It is still very much a random-walk despite many models etc. on the same. A landmark paper by Rogoff et al in 1983 showed currency movement is random and still holds true. Read this superb article for details.

2) Issues in risk management: The companies have realised this and know there is 50% chance of getting things right. As a result we need to keep provisions etc for the negative 50% risks. In this case, I guess the risks were ignored and hence the losses.

3) Whose problem? ICICI Bank’s Puri-Buch said, “There is also an issue of precedence set in the market. As long as the market was doing well, companies reaped profits. Now that they are making losses, they want to renege on the transactions. Full disclosures are made to the clients.”

That is the problem. On hindsight, derivatives are still not understood by the best in the financial business. Still, they are sold and promoted as if it isn’t risky at all. The derivatives are for hedging but are like any other financial instrument- risky.

This brings me to a bigger problem. It is one thing to design derivative markets, it is altogether a different thing to sell them in a manner so that people understand the risks involved. A wrong position in derivatives can wipe out the entire capital in a second.

It also makes me recall stories related to ISO certifications. ISO -9001 was seen as a panacea for the Small companies in India. As it was an internationally accepted quality standard, any company which had the certificate had a much better chance to access foreign markets. In other words, it reduced the information asymmetry. The government even started providing incentives to small companies to get the ISO-9001 certificate.

However, some companies after getting the ISO certificate, appealed to take the certification back. Why? Managing ISO -9001 required a lot of effort continue to follow the processes and had costs as well. So the companies were not interested in the same anymore.

There is quite a bit of similarity in the two cases. The magnitude of losses may differ but problems are quite similar.

By simply saying that the rupee should be left to markets and one should develop currency derivative markets for exporters to hedge their risks, is not a good enough solution. A lot more needs to be done.

Assorted Links

December 13, 2007

1. Fed and other Central Banks have announced new measures to address liquidity problems. WSJ Blog as usual helps us understand the new measures.

It points to the Economists’ reactions to the steps.
MR points to some comments.
Econbrowser also has some superb analysis

2. This is really funny. MR pointsto this story where a fake municipal corporation office was set up outside Jhansi (a city in Uttar Pradesh). It collected taxes etc and did the usual work like street sweeping etc. The fake office was discovered only when the employees complained about salary issues to the actual office !!!

3. New Economist points to 2 must-read papers- one, on why forex activity has been rising and two, on monetary policy

4. Mankiw explains how left and right leaning economists differ.

5. Most Blogs are talking about this Greenspan article on sub-prime crisis

6. Rodrik on how his policies differ from Joe Stigilitz

7. PSD Blog points to a paper on Indian IPOs

8. Econbrowser analyses the stock market’s reaction to Fed rate cut decision on 11 Dec. It beats me as well.

9. Ajay Shah points to a really funny article on outsourcing

10. Shyamal Majumdar explains the importance of learning business etiquettes of the country you  are visitng. It is quite funny as well.

11. Nirmal Mohanty has some suggestions for infrastructure financing.

12. Shankar Acharya explains findings of three papers presented in 2 conferences held in Delhi. In winters, Delhi becomes a conference hub.

Assorted Links

December 12, 2007

1. Fed cut its benchmark rate and discount rate by 25 bps (the difference between the two is here). WSJ Blog points to the economists’ reaction. It has also analysed the 12 Fed presidents’ view via discount rate requests.

It points to another analysis which says US economy may now be shrinking.

2. Mankiw says Harvard education to cost USD 1 billion in future.

3. PSD Blog points all World Bank databases can be found at one website

BIS releases Q3 2007-08 review

December 11, 2007

BIS released its quarterly analysis of how economies and financial markets have fared. The press release provides a short summary of the developments in 3rd quarter.

The broad ideas are similar to what we already know. But as usual, the presentation is excellent. For instance see table 2 on page 16 of the report. It summarises what actions various central banks have taken during the crisis. This is excellent analysis from BIS.

Cooperation between Fed and ECB

December 11, 2007

Trichet gives a nice speech saying who US and Euro area are similar economies and how the 2 central banks cooperate on various issues.

Subprime Crisis simplified

December 11, 2007

There are a number of papers/articles explaining the sub-prime crisis.  I have made my own list here

Randall Dodd of IMF provides another good analysis of the sub-prime crisis.

How could a modest increase in seriously delinquent subprime mortgages, which amounted to an additional $34 billion in troubled loans, so disrupt the $57 trillion U.S. financial system last summer that worldwide financial turmoil ensued? Lax, if not fraudulent, underwriting practices in subprime mortgage lending largely explain the rise in the rate of seriously delinquent loans from 6 percent to 9 percent between the second quarter of 2006 and the second quarter of 2007. But the impact on financial markets and economies far exceeds any expected losses from mortgage foreclosures.

The answer lies in the evolution of the structure of the home mortgage market

Read further for details. Much of the analysis is similar to what one would find in another papers. However, his presentation style and simplicity stands out.

Assorted Links

December 11, 2007

1. WSJ Blog points to bull view vs bear view, Morgan Stanley thinks recession is ahead. Also read viewsof Soros, Shiller and Volcker on the crisis. Read Soros in particular.

WSJ also points to this articlewhich discusses a paper which says it is easier for Fed to slow down a growing economy but not kick-start a slowing economy.

2. WSJ Blog points to some suggestions for solving the dollar problem. The problem is:

The world economy faces an acute policy dilemma that, if mishandled, could bring on the mother of all monetary crises. Many current dollar holders, including central banks and sovereign wealth funds as well as private investors, clearly want to diversify into other currencies. Since foreign dollar holdings total at least $20 trillion, even a modest realization of these desires could produce a free fall of the U.S. currency and huge disruptions to markets.

Moreover, none of the countries want to receive such huge inflows as domestic currencies would appreciate.

3. ESAP Blog points to a lecture that uses game theory to understand polices on climate change. Excellent.

4. JRV points to a new FASB document that would involve substantial changes in current accounting standards.

5. TTR points to an interesting story- Bangaloreans do not like the IT chaps.

What is a non-deliveravble forward?

December 10, 2007

A market for Non Deliverable Forward in Indian Rupee has often been made as a case for India to open up its currency futures market.

But what is an NDF? This non-technical note from New York Fed is a good one explaining the basics and mechanics.

In a forward market, the settlement happens in the currency for which we have bought a contract. However, in an NDF what happens is that you buy a contract taking an exposure to a currency but settle in another currency mostly US Dollar.

NDF market exists as few emerging markets have capital controls and do not have a currency futures market. But emerging market currency risk is crucial especially for multinationals who operate in emerging markets. So, we have an alternative- NDF market where one can structure forward contracts on emerging market currency but settle it on another currency.

Assorted Links

December 10, 2007

1. JR Varma points to SEC admitting rigging share prices. He also suggests private sector should try and help generate more data on Indian economy and financial markets.  

 2. TTR on Glodaman Sachs

3. WSJ Blog summarises various economists’ outlook for the FOMC on 11-12 dec.

4. New Economist pointsto the OECD Economic Outlook. It also tells you which country is going to be the world’s next factory after China- Vietnam

5. Mankiw explains positive vs normative economics

6. Rodrik on trade wisdom

7. Fin Prof points Freakonomics would become a documentary now.

8. ESAP explains another B’Desh Paradox.

9. Ajay Shah shares his thoughts over new issues in Indian Macro policy. He also points to an interesting interview of CB Bhave (NSDL chief), and to internationalisation of rupee.

Bank of England joins the Fed Bandwagon

December 6, 2007

As I finished writing this post over inflation concerns, Bank of England cut its benchmark rates by 25 bps. So now we have 3 developed countries cut rates- US, Canada and England. The press release of BoE says:

Although output in the United Kingdom has expanded at a brisk pace for the past two years, there are now signs that growth has begun to slow. Forward-looking surveys of households and businesses suggest spending is moderating, broadly in line with the projections contained in the November Inflation Report. But conditions in financial markets have deteriorated and a tightening in the supply of credit to households and businesses is in train, posing downside risks to the outlook for both output and inflation further ahead.

CPI inflation was 2.1% in October. Higher energy and food prices are expected to keep inflation above the target in the short term. Although upside risks to inflation remain, which the Committee will continue to monitor carefully, slowing demand growth should ease the pressures on supply capacity, bringing inflation back to target in the medium term.

This is a typical 2-handed economist message. Economists can sill talk using 2 hands, but an inflation targeting central bank should not. Why should BoE cut rates when risks from inflation remain?

How equity markets function?

December 6, 2007

This picture is the best way to show how equity markets function. However, in Indian equity markets, anything you say means “Buy, Buy and Buy” 🙂

Rising food prices and inflation

December 6, 2007

I had posted on the issue of rising food prices earlier as well. That time I had said they might rise now it is actually rising.

IMF’s chief Economist Simon Johnson sums up the entire development in his recent note. To see a snapshot of rising prices across commodities see this.

Why have prices risen?
1. Global growth particularly in emerging markets
2. Supply also rises with a lag
3. Serious droughts in some parts of the world
4. A focus on Bio-fuels means the land which was supposed to for wheat (just an example) is now being used for corn putting further supply pressures.

1. Developed world – not much as food as a % of consumption is low.
2. Exporters of agricultural products- would gain from rising prices. This includes both emerging and developed countries.
3. Emerging and poor countries- would impact as food as a % of total consumption is still quite high. This would lead to higher inflation.  

Rising inflation would lead to tighter monetary policy (higher interest rates) in emerging markets. This would lead to widening interest rate differential and higher capital flows. So, problems of higher capital flows would continue. To this Johnson adds:

There’s nothing wrong with capital flowing from rich to poor countries—in fact, if it happens in the right form and with deliberate speed, it can definitely help development. But the IMF’s work on financial globalization emphasizes a very important health warning: if you get too much capital, too fast, and in too footloose a fashion, there can be serious consequences for your economic stability and growth.

Inflation is also going to rise in advanced countries as well. In developed countries, both direct and indirect impact of rising food prices on total inflation is low. (Indirect impact is when food prices effect other things like say wages. So if people start having higher food budget, they would demand higher wages and hence inflation would rise.) So inflationary concerns are low but remain.

Inflation is expected to rise and Central Banks in these countries are cutting rates (Canada and US). Testing times for Central Bankers.

Financial crisis of the future

December 6, 2007

In December edition of its quarterly magazine, Finance & Development, IMF has taken up issues related to future.

One essay deals with financial crisis of the future. It basically looks at answering the question – “Will they resemble the contagious crises of the 1990s or the country-specific crises of the 1890s?”

In 1890s financial globalization was much more than what we see today

The typical portfolio of a British investor around the turn of the 20th century was probably more internationally diversified, and included a far larger share of emerging market securities, than that of his great-grandchild living at the beginning of the 21st century

And globalization collapsed in the world war period and has only begun to pick up now. Earlier, the crises were limited to the country  but now we see crisis hurting other economies as well (what we call a contagion). An exception was the Argentine crisis which only hurt Uruguay a bit.

IMF says in Argentina’s case most knew it is going to do badly and had already started withdrawing monies from it. Whereas with others it was a sudden stop and hence people withdrew money from other similar countries. Hence contagions could not be ruled out and perhaps would continue in future.

Moreover with increasing financial innovation and aggressive players (hedge funds, private equity etc) if a crisis takes place, contagions are more likely to happen. To manage them we would need coordination across countries and number of questions need to be addressed- Should these new entities be restricted? If not, should they be asked to disclose their portfolios?

Read the entire piece. It is full of fresh insights on what to expect.

 In a related piece on global governance, IMF thinks we need to take a re-look at the 20th century model:

…what we have today is a multiplicity of independent actors, both public and private, each pursuing its own objectives and priorities, with its own clientele and constituency, with its own technical language and organizational culture, with its own mandate and specialized focus. These attributes may have been appropriate for a time when international relations focused on several important issues but just a small number of important countries. The lasting effect, however, is that we have inherited a system that is fragmented and that relies heavily, perhaps too heavily, on market forces, competition, and ad hoc public reactions to try to channel energies and allocate resources.

In the 21st century the challenges require more coordination than ever before:

The problems and the challenges of the 21st century—absorbing demographic change, reducing poverty, expanding the provision of safe and clean energy without aggravating climate change, alleviating health risks, and many others—require far more coordination than is possible within such a system. Each of these challenges, even if addressed locally or nationally, has the potential to affect the lives of people everywhere. Specialized technical expertise by itself is unlikely to be fully effective if it is not guided by a global and holistic vision.

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