Archive for September 9th, 2008

Dr. Subba Rao’s first press statement

September 9, 2008

After numerous rounds of speculation and media bytes (some covered here), Dr Subba Rao makes his agenda clear. In his first press statement after becoming RBI Governor, he focuses on two things- inflation and financial sector reforms. 

His stance on inflation:

The current high level of domestic inflation reflects a combination of supply-side pressures as well as demand-side factors. It is not surprising that after five years of 9 per cent growth, supply constraints will begin to emerge.

However, the present inflation is largely a global phenomenon and is being driven by key international commodity prices, especially of crude oil, metals and food. These external pressures are being exacerbated by strong domestic demand pressures.

Though demand is not the main problem, in the absence of further flexibility on the supply side, demand management has to be part of the solution. Dampening demand and anchoring inflation expectations has been the logic behind Reserve Bank’s monetary stance. 

So, demand side measures are still going to be the key to managing inflation. If supply cant be increaed demand has to be moderated a bit. What to expect in Monetary Policy?

I have been asked whether monetary policy will be tightened further. There are, as they say, several known unknowns.

First, we will have to watch the impact of the measures already taken.

Second, we will be watching the drivers of demand – in particular which sectors are triggering the growth in demand.

Third, in a globalised world, we will also have to be watching developments around the world and make an assessment of their potential impact on our economic management. 

What on financial sector?

I want to conclude on the subject of financial sector reforms with three short comments.

First, the liberalisation and development of the financial sector over the last few years has been a key factor in financing our 9 per cent growth. To sustain and accelerate this growth, financial sector reform, aimed at improved efficiency and financial stability, will remain important. In moving forward, we will draw from the lessons of global experience of the recent period, and be cognizant of the evolving global situation.

Second, financial sector reforms are not an end in themselves. They have meaning and relevance only if they are anchored in real sector objectives.

Third, financial sector reforms should promote inclusive growth through efficient and easily accessible financial services.

In all likelihood I expect developments in financial sector to be much like the past- gradual and slow and steady. With pretty bad global experiences and hardly any reforms in real sector, expecting reforms only in financial sector is too much to ask for. This is also what Dr Reddy has said in his outgoing interaction with the press.

Solow on financial sector excesses

September 9, 2008

I came across this book review by Robert Solow. The Book being reviewed is written by Kevin Philips and is titled as ‘Bad Money: Reckless Finance, Failed Politics, and the Global Crisis of American Capitalism’. I had pointed to the growing excesses in financial sector in various posts. Solow adds more weight to the arguement.

The book is on several topics and so is the review. I will just look at comments by Solow on financial sector.

Phillips’s focus on the size of the financial sector is not wholly misplaced. Everyone must have noticed that the total sums at risk in the markets for complex derivatives are enormous compared even with the $14 trillion size of the national economy itself. In addition to financing and allocating the uncertainties that arise inevitably out of production and consumption decisions, modern financial engineering creates unlimited opportunities for bets that are only remotely related to productive activity, if at all. A can bet B that C will be unable to meet its obligation to pay D. (A may then try to manipulate the odds by spreading rumors about C’s financial condition.)

Should the rest of us care if A and B want to gamble their fool heads off, whether on credit-default swaps or basketball games? If these were private arrangements between consenting (and rich) adults, one might say that it’s their business and nobody else’s. But in the world as it is, A and B seek leverage–that is, they borrow from banks and others so that they can bet larger amounts than their own private capital would permit. Even a small return on the leveraged bet amounts to a large return on equity. And once the banking system is involved in a big way–owning, and holding as collateral, assets whose likely value is hard to understand and impossible to calculate–then we are all at risk.

For this reason, if things start to unravel, as in the case of securitized sub-prime mortgages, the whole credit mechanism can freeze up. Banks that do not understand their own balance sheets can hardly expect to understand the balance sheets of potential borrowers. The system can be so paralyzed as it unwinds those leveraged losses that it is unable to perform the financing of “real” economic activity that constitutes its redeeming social value.

The size and the complexity of the financial sector has other consequences, too. It is worth repeating that the most important consequence is the one just mentioned: the danger to the viability of the whole credit mechanism, including the plain-vanilla part that merely finances real capital formation. And since the total volume of bets, and bets on bets, can vastly exceed the amount of underlying “real” activity, and since the fees of those who manage and direct this activity are (roughly) proportional to the gross volume of assets they manage or direct, the hedge-fund operators and others may earn perfectly enormous incomes. (Margaret Blair of the Brookings Institution was one of the first to point this out.) If they are clever enough, and they are, they can arrange their compensation packages so that they batten on profits and are shielded from losses.

Moreover–and this is definitely on Phillips’s radar–the fact that big-time financial operators make so much money, and spread enough of it around, gives them a lot of political clout with both parties. That is one reason why it will be so difficult to reform the system of financial regulation so as to provide adequate protection for the capital market as it goes about its useful functions. The same fact may also be part of the answer to the churchmouse’s question: why does anyone who already has a billion dollars need a second billion? A bigger private jet attracts bigger birds.

All this is pretty well known now. Solow saying it adds more weight to the issue. So what is the solution?

Could we redesign the mechanism to achieve most of the benefits of a broader supply of mortgage capital while sharply limiting the scope for predation and instability? This question calls for serious thought; but serious thought is not on Phillips’s agenda. Still, it is worth noting–and this is his sort of thing–that when the Federal Reserve recently proposed some fairly anodyne improvements in the regulation of mortgage lending, the industry instantly opposed them as incipient socialism, and claimed implausibly that even the smallest regulatory safeguards would dry up the supply of loan.

Again, it does not imply we do away with financial innovation/ curb financial activity etc. It just means we need to make the sytem more responsible and less prone to crisis.

We need to understand how can we regulate the system better.  Regulation is often misinterpreted as predatory, control/licence raj etc. The aim of regulation is to make the markets efficient and ensure fairplay, both of which are absent in financial markets as of now.

Fannie Mae/Freddie Mac could trigger CDS crisis

September 9, 2008

I have written number of posts on the growing credit derivatives markets and the risk it poses to the financial system. The instruments have been created at an exponential pace without thinking adequately about their settlement. I had pointed in my research that all it needed was a negative event ( a trigger) to show how problematic this market is.

FT Alphabville informsme that the recent Fannie/Freddie resue has been one such event. It is being expected that large number of CDS have been taken by financial firms and need to be settled.

Actually this itself is a puzzle.  As the twin companies are taken over by the government, the probability of default  is actually lowered (atleast is remote). Then why should their be a case of CDS settlement?

The reason is that these companies have been moved to a conservatorshipstatus and this status is a trigger event for a CDS settlement.

A conservatorship is an entity established by court order or regulatory authority, in the case of business enterprises, that some property, person or entity be subject to the legal control of another person or entity, known as a conservator.

The exact amount of CDS is not known as deals were done in  an OTC market and details are only known to the parties.

This has led to fervent activity and concerns in the financial sector. ISDA has has said that it will work out a protocol to settle the various deals.It will be interesting to see how these financial firms will honor these transactions as they hardly have any funds with them.


1. See this FAQs on conservatorship

2. Paulson statement explaing the events

3. James Lockhart (Chairman FHFA) Speech 

4. Bernanke statement

Assorted Links

September 9, 2008

1. WSJ Blog points Trichet welcomes Fannie/Freddie move. It also points Fisher is ok with the rescue.

2. Krugman on to Fannie/Freddie mess. Mankiw on Fannie/Freddie

3. ASB on oil subsidies and market distortion

4. JRV explains the development of currency futures markets in India

5. IDB points to microfinance spams

6. Fin Prof has some valuable advice

7. FCB on carbon taxes

8. PSD Blog has a superb post on property rights

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