Archive for September 15th, 2008

Will China further worsen the economic situation?

September 15, 2008

China’s inflation has eased to 4.9%  in August 2008, the slowest pace since June 2007.  This was after a series of rate hikes were done to control inflation. This news came on 10 Sep 2008 and  I immediately thought what if China eases its rates now?

Easing of rates in China would be a lot different than those in other advanced economies. Most developed economies are facing severe distress in financial markets and this is expected to hit their real economies as well. The real economy has stood up well so far but it can’t hold on if financial markets continue to deteriorate.

In China’s case if it lowers interest rates, it will again lead to a higher demand for food commodities and oil. This will lead to higher global prices and once again we have a global inflation problem.

Just to recall, inflation has been a global phenomenon for a while now, but Central Banks were not willing to act (read my paper here) The developed economies’ central bankers were blaming the recent rise in inflation on developing economies and expected latter to raise rates (IMF also joined in playing the same game).

They said as developing economies have grown, their consumption levels have increased leading to rise in prices  of food and oil prices. So, the onus was on developing economies to hike interest rates and bring the prices down. As these prices are global in nature, it will lower inflation in developed economies as well. In other words, the developed economies’ Central Banks can continue to manage their financial markets and growth and let inflation be managed by developing economies.

As I thought through this, now China has lowered its interest rates (see Reuters release as well):

China’s central bank said Monday it would cut the one-year benchmark lending rate by 0.27 percentage point from Tuesday and cut the reserve requirement ratio for smaller financial institutions from Sept. 25 to boost economic growth.

China’s benchmark deposit interest rate will remain unchanged, the PBOC said in a statement posted on its Web site.

It is actually pretty confusing. China has three policy rates –  1 year Lending rate, 1 year deposit rate and the reserve ratio (which is like the Cash reserve Ratio of the Banks).

So lending rate has been reduced for all the banks from 7.47% to 7.20% . The Reserve requirement has been reduced for all banks except  five biggest banks and the Postal Savings Bank by 1 percentage point. The 1 year deposit rate is unchanged at 4.14%. Further:

The PBOC said the aim of the easing was to maintain fast and stable economic growth.

It might appear from the statement that China’s growth rate is slipping. Lets see the data.

The recent data shows China’s industrial output grew by 12.8% in August which is lower than July – 13.7% and lower than August 2007 – 17.5%. The GDP is expected to increase by 9% in 2008 compared to 11.9% in 2007. The recent figures are surely lower than previous figures but still are much higher given global conditions. 

Moreover, the recent inflation and industrial output figures are just for August and we are yet to see a declining trend. It could just be a blip. But as the rates have been lowered, we might just expect the growth to pick up again and higher food and oil prices in future.

This will surely test the developed economies and their central bankers. They are banking on developing economies (esp large ones like India, China etc) to increase their interest rates. However, their expectations might just turn pretty sour. They would just hope that China’s Central Bank does not lower the rate further.

Some might say that China’s economy might not really expand as it is an export driven economy. With developed economies down, China will not find any takers for its exports. Agreed but this just turns the entire problem on its head. 

This just implies, the developed economies central banks’ would hope that their economy does not pick up soon.  Because if it does, so would China’s exports followed by rise in incomes and then in prices of food and oil. This would lead to higher inflation again putting Central Banks in a dilemma.

Pretty troublesome times for sure.


As I write this, the yields in the Indian G-sec market eases further. Participants joke saying it is because of the rate cut in China. 🙂

One set of alphabet soups lead to another

September 15, 2008

As the subprime crisis started to unfold , one got a list of fancy finance terms- ABS, CDO, ABX, NINJA Loans, No Doc loans etc. (see some explanation here). This was aptly called alphabet soup.

With the crisis, Fed has started another set of alphabet soup. These are the various new facilities launched to calm financial markets- TAF, TSLF, PDCF etc. Here is a brief summary:

  • TAF provides additional liquidity via auctions. The basic idea was firms were not willing to borrow at the discount window because of the stigma problem. Discount window provided a signal that this firms was in trouble. Moreover, in discount window the rate was known but amount was not.  In TAF it was opposite, Fed decided the amount and the rate of borrowing was determined via auction. TAF is open to depository institutions. Against the liquidity, the firms have to park collateralised securities with the Fed. Fed keeps revising the accepted securities
  • TSLF is another facility which helps exchange other securities for Treasury (Govt securities) and is available to the Primary Dealers. Basically two things happened which led to TSLF. One, it was seen Primary Dealers were as important as commercial banks and needed funding. PDs are organisations like Merrill, Lehman etc (see the entire list here. Two, the confidence wrt to other securities declined and markets only wanted government securities. So via this facility a PD could exchange other securities and get treasuries on its books.
  • PDCF is another facility available to PDs where they get overnight loans in exchange for a collateral. Unlike TSLF, this is an overnight loan

In sum TAF and PDCF provide liquidity and TSLF helps exchange collateral. Still confused? Nothing to worry most are.  Need to read it again and again.

In its recent move Fed has expanded the acceptable collateral in both PDCF and TSLF facilities.

The collateral eligible to be pledged at the Primary Dealer Credit Facility (PDCF) has been broadened to closely match the types of collateral that can be pledged in the tri-party repo systems of the two major clearing banks. Previously, PDCF collateral had been limited to investment-grade debt securities.

The collateral for the Term Securities Lending Facility (TSLF) also has been expanded; eligible collateral for Schedule 2 auctions will now include all investment-grade debt securities. Previously, only Treasury securities, agency securities, and AAA-rated mortgage-backed and asset-backed securities could be pledged.

So Fed is accepting almost anything these firms have on their balance sheets. Newswire report that Fed is accepting equities as well but I Don;t see that in the statement. RGE Monitor has a superb post on the subject

Though, I am still confused.  As Fed revises these facilities, I always need to go back and revise what each facility means. May be Fed should also appoint a Chief Communications Officer like UBS to help understand this alphabet soup.

Assorted Links

September 15, 2008

1. US financial markets are expected to explode this week after Merrill Sale and Lehman expected to file bankruptcy. WSJ Blog points to official statements.

2. WSJ Blog points what to expect in the upcoming FOMC meeting

3. Krugman on Lehman, TSLF Put

4. Mankiw says rent control is the best way to destroy a city

5. PSD Blog says there is a need to develop some guidelines for randomised evaluations.

6. MR points to some links on the financial mess.  MR on financial regulation

7. Ajay Shah pointsto an article on problems with IIP data.

8. TTR on Lehman Brothers

9. IDB points out health insurance initiative. It also reflects on Singus crisis

10. ACB on financial sector hypocrisy

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