Archive for September, 2008

Assorted Links

September 12, 2008

1. WSJ Blog asks would Fed allow Lehman to fail ( a superb post)

2. WSJ Blog says Fed and Treasury are working out a solution for Lehman. MR has a similar news about Lehman

3. WSJ Blog points to a Rodrik paper which says undervalued currency helped Chian grow

4. WSJ Blog points EU could be heading for a recession

5. ACB advises on how to give money to an NGO


The focus shifts from Fannie/Freddit to Lehman

September 11, 2008

I had pointed about Lehman Brothers’ disappointing performance in Q2 2008. The post was titled focus shifts from SocGen/UBS to Lehman. Lehman released its expected Q3 results yesterday and the losses continue to worsen.

In Q3 2008 it expects losses to be about USD 3.9 billion. Moreover, the talks about pumping capital by Korean Development Bank have been stalled. So expect some intensive efforts to raise capital or asset sales.

It has made a plan to sell a majority interest in its investment management divisison and expects to write down mortgages significantly

Lehman Brothers has announced its intent to sell a majority stake (estimated to be approximately 55%) in a subset of its Investment Management Division. The subset of businesses (the “IMD Business”) includes the asset management, private equity and wealth management businesses but excludes its middle market institutional distribution business and the Firm’s minority stakes in external hedge fund managers. The sale of a majority stake in the IMD Business will enhance the Firm’s already strong capital base.

Already Strong Capital Base!!

The maximum losses comes from its Capital Markets division (USD 4.1 billion). Within Capital Markets, fixed income markets led to loss of USD 4.6 billion and equity market to a gain of USD 0.5 billion. I-Banking and Investment divsions led to a gain of USD 0.6 billion respectively. Add expenses to this and we have a loss of USD 3.9 billion.

Another thing to note is within expenses compensation expenses have declined from USD 2.3 billion to USD 1.9 billion. It was maddening to see the compensation rising in previous quarter from USD 1.8 billion to USD 2.3 billion.

Let’s see how Lehman fares from now on. The markets were in a frenzy y’day seeing Lehman results expecting more to follow.

Assorted Links

September 11, 2008

1. WSJ Blog points to some words of advice from William Poole

2. Krugman points to one finger salute

3. TTR has a superb post on Fannie/Freddie crisis. He says:

FT estimates the cost of the rescue at around $200 bn – or nearly 1.5% of GDP. S& P places the cost at 2.5% of GDP. In India, the government has spent a total of $7.5 bn to recapitalise the banking system- or under 2% of GDP. But this was roundly condemned at the time. The same editorial writers (in India) are lauding the US government for its rescue act today- what’s good for the US is evidently not good enough for us Indians.

4. MacroBlog has an excellent post on economics of hurricanes.

5. Chris Blattman on darker side of Google’s development strategy

6. Rodrik points to a superb reading on growth diagnostics

7. Fin Prof on ill-effects of using Bloomberg

8. PSD Blog on Aid vs corruption

Time consistency is also a useful way to understand moral hazard

September 10, 2008

Moral Hazard is one of the most discussed topic in the ongoing crisis. Some say the intervention leads to moral hazard, some deny it. This post is about understanding moral hazard in another fashion.

We usually understand moral hazard from the angle of information asymmetry. This was a result of great analysis by Akerlof. Wikipedia explains:

Moral hazard is related to asymmetric information, a situation in which one party in a transaction has more information than another. The party that is insulated from risk generally has more information about its actions and intentions than the party paying for the negative consequences of the risk. More broadly, moral hazard occurs when the party with more information about its actions or intentions has a tendency or incentive to behave inappropriately from the perspective of the party with less information.

Another very useful way to understand moral hazard is from the angle of time consistency models developed by Finn Kydland and Ed Prescott. They got Nobel Prize in 2004 for their work. (Read Mankiw’s superb primer on the topic). I was reading this Nobel Committee primer explaining Kydland-Prescott work and it struck me that this can be modelled to understand moral hazard as well.

Bernanke, Mervyn King etc all had said before the subprime crisis that they would not intervene in financial markets. The outcome of financial decisions of various firms would have to be faced by respective firms. If they had stuck to their words, we would have called these policies as time consistent. Meaning your actions in future (not to intervene) were consistent with the policies made in the past.

However, they had to intervene and this made the policy time inconsistent. The financial markets knew all along the central bankers would be intervening as similar experiences had been seen in the past. The financial markets piled on huge risks knowing central banks and other authorities will have to intervene as health of financial system was important. This is exactly what moral hazard is and time consistent is another way to understand the approach.

The problem is not as much with current intervention but more with this time inconsistent policies with respect to financial sector. As a result, the risks get bigger with profits going to the firms and losses going to the taxpayers. This is leading to other issues like Too Big to Fail where a financial firm is bailed out as it is considered too big to fail.

Time consistency is as important a concept. The best way to follow it is to have some rules. That is why we have inflation targeting and even our FRBM act is a fine example of the idea. The problem is making rules to limit moral hazard in financial sector. How can we do it?

Rogoff on financial sector excesses

September 10, 2008

I came across this article by Ken Rogoff where he also talks about the growing excesses of financial sector and the need to prune it down. (Thanks to Naked Capitalism for the pointer). I had earlier pointed to Solow’s and various other views as well.

The idea that the world’s largest economies are merely facing a short-term panic looks increasingly strained. Instead, it is becoming apparent that, after a period of epic profits and growth, the financial industry now needs to undergo a period of consolidation and pruning. Weak banks must be allowed to fail or merge (with ordinary depositors being paid off by government insurance funds), so that strong banks can emerge with renewed vigour.

If this is the right diagnosis of the “financial crisis”, then efforts to block a healthy and normal dynamic will ultimately only prolong and exacerbate the problem. Not allowing the necessary consolidation is weakening credit markets, not strengthening them.

After a period of massive expansion during which the financial services sector nearly doubled in size, some retrenchment is natural and normal. The sub-prime mortgage loan problem triggered a drop in some financial institutions’ key lines of business, particularly their opaque but extremely profitable derivatives businesses. Some shrinkage of the industry is inevitable. Central banks have to start fostering consolidation, rather than indiscriminately extending credit.

It is time to take stock of the crisis and recognise that the financial industry is undergoing fundamental shifts, and is not simply the victim of speculative panic against housing loans. Certainly better regulation is part of the answer over the longer run, but it is no panacea. Today’s financial firm equity and bond holders must bear the main cost, or there is little hope they will behave more responsibly in the future. 

Rogoff’s words matter as he has done loads of research on financial crises He is a leading economist on issues related to macroeconomics and financial markets. He would most likely be disappointed as authorites are busy with one intervention after the other leading one bail-out to another.

Despite Singur West Bengal remains upbeat

September 10, 2008

News about a country/state usually leads to changes in the yields in the Bonds of the respective country/state. The impact of bad news on the bond markets differ. Bad news like higher than expected fiscal deficits, high inflation, poorer investment climate, rating agencies downgrade etc should lead to lower prices (yields hardening). Other bad news like lower GDP, higher unemployment leads to higher prices (easing of yields) as markets expect central banks to start easing interest rates.

However, in the case of West Bengal, we don’t see the logic working. West Bengal has been criticised for its handling of Singur Tata Nano project. As Tatas withdraw from the state, others like Infosys are also planning to withdraw. This will lower investments in the state of West Bengal. Investment is key to growth, and leads to higher employment and higher taxes as well.

THis should have showed in yesterday’s auctionof Bonds (called as State Development Loan) issued by West Bengal. The Bond on offer was for 10 years (all state bonds are mostly of 10 year) and was for 1800 cr.

However, the cut-off yields announced in the auction were 8.80%. The 10 year government bond yesterday was at 8.39%. The difference in yields between a 10 year India government bond and West Bengal government Bond was just about 51 bps.

A pervious West Bengal Bond auction worth Rs 800 cr on 31 July 2008 saw cut-off yields  of 9.90%! The 10 year yields of government bonds then were 9.32% and this implies a spread of 58 bps. The recent sentiment in Bond markets is very bullish and the yield for West Bengal in the latest auction was expected to decline as well. But atleast we should see a higher spread between Centre and State or a lesser easing. The central government 10 year bond yields have declined by 100 bps but for West Bengal it has declined by 110 bps.

So, overall risks for the state of West Bengal as assessed by financial markets have actually declined between July and September. The reality has been a lot different as clearly investment climate has worsened so we should see hardening of yields.

Overall I don’t understand the recent yield movement in goivernment bond markets in India. The markets have been rallying like crazy and yields have been easing sharply. The inflation is still very high and Prime Minister’s team itself said India’s fiscal deficit is much higher than reported. I would again like to reiterate the question I asked in my research paper- Are yields in sync?

Assorted Links

September 10, 2008

1. WSJ Blog points Summers backs a second fiscal stimulus

2. WSj Blog points whether FF mess would turn things around. It points to a new paper analysisng which economic news moves financial markets more.

3. WSJ Blog points to reversal of fortunes in EU economy

4. ACB has an excellent post saying Singur is not the first time for Tatas.

5. CB Blog points the most important price in the world

6. Rodrik posts after a long time and points to the books he has been reading

7. PSD points the Doing Business 2009 has been released. It points google’s new browser-chrome – could be used as a development agency.

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

Divergence in Fed and ECB monetary policy -II

September 8, 2008

I had written a post explaining the difference in monetary policy between US and ECB. ECB is more hawkish on inflation compared to Fed; Fed is more bearish on growth, though with the recent ECB monetary policy statement, ECB is pretty bearish as well. As a result, Fed has used both liquidity and interest rates to calm markets but ECB has only used liquidity measures.

I came across this speechby Janet Yellen, President San Francisco Fed. She is quite bearish on the US economy and upbeat about inflation coming down. She says:

monetary policy in Europe has been less accommodative during this period than in the U.S. For example, while the Fed cut its target interest rate substantially to 2 percent during the course of the credit crisis that began last summer, the European Central Bank kept its policy interest rate steady throughout, and then tightened by 25 basis points to 4¼ percent in July.

Part of the reason for the difference is that the European Central Bank’s mandate requires it to focus on controlling headline inflation, which reached 4 percent for the twelve months ending in July—a rate well above its official objective of below, but close to 2 percent.

In addition, even though much of the recent increase in inflation is attributable to commodity prices, and therefore likely to be a temporary phenomenon, the central bank has been worried about second-round effects on inflation expectations, wages, and other costs, and justifiably so.

The euro zone has a greater degree of wage indexation and collective bargaining than the U.S. So it is more likely that higher headline inflation will fairly quickly get built into wages there, setting off a wage-price spiral that could be persistent and difficult to stop.

That is a nice way of explaning the differences in the 2 economies and monetary policy actions. She points there is little chance of it happening in US:

However, that does not mean that we can afford to ignore the risk that such a damaging spiral could develop here.

 Fortunately, I do not see signs of this development at this point. First, the reports of our directors and business contacts are consistent with the view that no such dynamic has taken hold. Outside of a few booming sectors such as energy, we hear no reports of escalating wage pressures even though higher food and energy prices have eroded the real incomes of American workers. Our contacts note that high unemployment is holding down labor turnover, suppressing the need to raise wages more rapidly. The two broad measures of national labor compensation that we monitor have shown remarkably small increases recently

Moreover, various measures of longer-term inflation expectations suggest that they remain relatively well contained. With the recent decline in commodity prices, inflation expectations for the next five years have edged down slightly in both the Michigan Survey of households and the Philadelphia Fed’s Survey of Professional Forecasters. Furthermore, since June, compensation for inflation and inflation risk over the next five years—as measured in markets for Treasury Inflation Protected Securities—has dropped noticeably and is now under 2 percent.

The key is managing expectations. I don’t understand this focus on inflation expectations  over 5 years!! That is too long a time. As I have explained in this paper long term is a sum of short-term. If people realise Fed isn’t anchoring inflation, they will revise their expectations.  Moreover, she expects the inflation to be higher.

Headline inflation is likely to remain much higher than I would like for a quarter or two as previous increases in commodity prices boost the prices paid by consumers for food and energy. With regard to core inflation, I wouldn’t be surprised if it runs modestly higher for a while, too, as businesses pass on some of their higher energy, transportation, and other costs to customers. However, for several reasons, I expect both headline and core inflation to move down to a much more moderate rate of just over 2 percent next year.

So, if inflation continues to be high, inflation expectations would follow as well. You need to have a more immediate approach than a 5 year approach to inflation.  And she also says inflation would ease by next year. Next year when? December?

However, Yellen has been quite right in her view on employment numbers as they have deteriorated further. So there is hope for sure. But again, never underestimate inflation. It has more surprises than you can ever imagine. That is the biggest lesson learnt.

Dr Subba Rao’s to do list

September 8, 2008

There has been vast amount of newsprint since Dr. D. Subba Rao (DSR) was namedas the new RBI Governor. Well, I must say times are changing as one of the newspapers tells me this is the  first time Finance Minister has announced the name of the new RBI Governor. The importance of Monetary Policy and Central banker is growing in India (and media) just like we see in developed economies.

The media speculation has shifted from who the RBI Governor would be to what Dr. Subba Rao would do.  The focus on Dr DSR started with his profile (see this ET version as well, Mint).

It has now has moved to on what Dr. DSR should be doing – Business Statndard  , Mint , ET, FE. As Dr. DSR has himself indicated the priority now would be on inflation and then financial sector reforms. The talk is on what he should do on both the fronts. It will be interesting to see what he does.

I would say Dr. Reddy has left quite a legacy behind and would be interesting to see how Dr DSR takes up the challenge. Meanwhile, Dr. Reddy has left him with lots of food for thought while leaving.

Dr Reddy’s reality check on Indian economy and policy

September 8, 2008

There is vast amount of coverage on Dr. Reddy’s tenure. (Hindu, ET). However, this last press coverage of Dr. Reddy is a standout for his insight on Indian economy and policy …and yes his humor.

On interest rates: According to Reddy, if he had it, his way monetary policy would have been tighter. He said charges that growth would be hurt because of RBI’s rate hikes have been belied. “While those with balance sheet interest do speak about the negative impact of higher interest rates, the decision has to be looked at analytically.”

I liked his take on those with balance sheet interest. Actually it is a puzzle. Usually, tight monetary policy leads to higher interest rates and lower corporate borrowing and industrial activity. However, in my research paperI have noted this is not really the case. Infact, both interest rates and industrial activity grow together. One of the main reason is that Indian firms rely more on internal resources for capital expansion and not much on debt/equity capital. (Read this Mint analysis as well; scroll down). Infact, this puzzle could also be the reason why credit has continued to expand despite Dr. Reddy hiking rates through out his tenure.

On exchange rates, the former governor made it clear that he is vehemently opposed to allowing the rupee to appreciate, even if a rising rupee adds to inflationary pressures. According to him, the rupee cannot be allowed to appreciate excessively in an economy, which runs a current account deficit, a wide trade deficit and a wide fiscal deficit merely because global capital, for the present, finds India attractive.

This is a challenge RBI has been facing for a long time (my paper on the challenges here). What should it do? Can we allow the rupee to appreciate and let the trade deficit widen? Or should it suppress the appreciation and allow some imported inflation and manage the sterilization? I would suggest problem is with excessive capital flows and there is a need to revisit them.

On making RBI a true monetary policy manager: Mr Reddy let out a secret on how initially, when he took charge as deputy governor, he was favoured the creation of a separate independent entity to manage government debt and how Mr Jalan was opposed to it on the grounds that it was unlikely that the fiscal deficit would improve. Given the Indian context, he said one should not go with an ideological approach, and the next step should be taken only after progress on fiscal consolidation. “The law of the land says that RBI should manage public debt. It was a mandate given to us by Parliament. Change the law. There is no empirical evidence that this function is not being managed efficiently.”  

This is an excellent anecdote from Dr. Reddy. You really can’t have a debt management office with such high fiscal deficit.

Financial markets: Mr Reddy said it is not possible to develop the financial markets without changes in policy and the real sector. According to him, it is not possible to have a market for interest rate futures when you have an inadequate and imperfect spot market, with different level of preparedness between foreign banks, public sector banks and corporates. “You have to consider how much of volatility the public can expect and handle. Foreign banks and private banks may have the capacity to manage it, but others might find it difficult to handle.

Lots of insight. This media hue and cry over absence of various derivative markets in India is simply not needed. We had success in equity derivative markets only when we had a very efficient spot market in equities. Debt and forex both being much more complicated and has taken time to develop. Same is the case with commodities….after much euphoria over the commodities derivatives launch, there was furore that the derivative markets are leading to an increase in prices. The expert committee found the problem is with efficiency of spot markets…I also liked his view on volatility….

On Percy Mistry and Raghuram Rajan reports: According to Mr Reddy, one cannot take a view on issues of such magnitude just because there is an expert committee report. “We are not only looking at Mumbai as a financial centre. Our own stance is a more comprehensive framework. If a table of the decisions were to be prepared with a column on who was required to take action, it would be clear that it was the government which had to act on most of the recommendations.”

This is an excellent comment on expert committees and where the problems lie. Apart from this, check out his humor as well:

The trademark humour was quite evident when he said there was no formal offer of an extension. “ I didn’t have the pleasure of saying no.”

Mr Reddy, who spent over ten years in Mint Street, including five years as governor, said it had been a learning experience. Only to add, “I hope that there was no major cost in educating me .”

Overall a very interesting insight from the man who was closest to all the ongoings. I think we need to have a similar outlook towards central banks policies as we see in growth and institutions literature. After much discussion we have come to the conclusion that no single formula works. Each economy is different and a result central bank would have to tune its policies accordingly. Infact this has been the experience in research as well with central bank operations differing widely.

Assorted Links

September 8, 2008

1. The big news is Fannie and Freddie have been nationalised. WSJ Blog pointsto official statements. It also pointsto email from Freddie outgoing and incoming CEOs

2. The other news is US unemployment has worsened. WSJ Blog points. Krugman also has a good post. Econbrowser as usual has good analysis

Understanding A to Z of Banking in India

September 5, 2008

I always wait for this report from RBI – The report on Currency and Finance. The previous one was on India’s financial markets. The previous report was for the year 2005-06 and has been a while waiting for the new report.

 The latest report is focused on Banking sector in India and is for the year 2006-08. It is a very detailed report on India’s banking sector across time zones- past, current and future. The theme says:

The Report undertakes an in-depth analysis of the various aspects of Indian banking such as management of resource mobilisation; management of risk and capital, lending and investment operations of banks; financial inclusion; consolidation and competition; efficiency, productivity and soundness; and regulatory and supervisory challenges.

The thrust of the Report is to critically examine the various issues and, going forward, what further needs to be done to ensure the growth of the banking sector in a way that supports/accelerates India’s current growth momentum and enhances the stability of the financial system. Various measures suggested in this Report set out only the broad direction in which reforms in the banking sector could move in future. The pace and sequencing of measures would need to be calibrated keeping in view the degree of comfort in moving forward in a credible way.

The report has already been covered well in the press. What I found more interesting was this study by RBI which says Public sector Banks on an average are more efficient than foreign banks! It has a very detailed chapter on financial inclusion and other aspects of banking.

Happy reading

Understanding the surge in housing prices in India

September 5, 2008

I came across this interview of Deepak Parekh, Chairman of HDFC. It has loads of wisdom on housing markets, reforms, indian economy etc.

First and more importantly his view on housing:

I personally feel that the developers have gone totally haywire. They were buying land as if there is no tomorrow. That was a big mistake.
RBI prohibited all of us from lending money to buy land. In fact, the RBI directive was repeated – first, it was meant for banks but later (it was) extended to housing finance firms too. It expected the asset bubble. RBI had said that banks can only fund the developers after the projects get the commencement certificate. We followed the RBI norms and most of us are safe today.
When we stopped lending, foreign equity flowed in. A host of private equity funds and venture capital funds came to invest in land and they all were promised the moon… phenomenal rates of interest. Most of the transactions were debt transactions from overseas in the garb of equity.
They came through the automatic approval route under FDI (foreign direct investment) and money came in quickly as equity deals do not need prior approvals. They are mostly convertible debentures and preference shares, with conditions that before three years they will be redeemed. The developers borrowed money from overseas to fund their land deals at 18-20% interest. The land prices have crashed but they have committed to pay high phenomenal interest rates. Overall, 60% of such deals could be debt and the rest equity, and my estimate is that between $12 billion and $15 billion (Rs53,160-66,450 crore today) has come through the FDI route.
This is superb and explains what has been going on in the housing markets  in India . I have explained in numerous posts (see this) that despite interest rates rise etc, we don’t see any correction in housing markets in Mumbai. The prices continue to rise. Moreover, the developers expect sales to pick up during festivals and prices to rise. The developers have borrowed money for development and only way it can be recovered is by keeping the prices high. They seemed to have forgotten basic economics – when prices go up, demand comes down.
Where will the maximum correction come?
Is there some more pain coming?
Yes. How will they (developers) pay back? Where is the liquidity? Sales have stopped. Even those financial institutions, who have disbursed money carelessly, will find themselves in trouble as a large number of builders will face difficulty.
We need to categorize developers’ investments in various segments — malls, shopping centres, commercial and residential complexes. The malls have been worst-hit and the residential units the least-hit.
The advantage with the residential segment is even if the prices come down, there is some demand because of the shortages, but the malls are going abegging and people are converting malls into offices.The maximum pain left is in the retail segment; followed by IT, commercial; and the residential segment.
How much pain is left depends on the locality. For instance, in south
Mumbai, there is a shortage and hence prices will not come down drastically as you are not reclaiming more land, increasing FSI and redevelopment is not happening. Where are the new buildings? So, prices cannot go down. But in the suburbs, they can…
I worry about Bangalore, Chennai, Hyderabad because supply was ten times last year. The maximum pain left is in the retail segment; followed by IT and commercial segments; and finally residential segment. I’d think that Mumbai will be relatively less affected because of lack of land here.
I never really understood the concept of building so many malls in Mumbai when housing supply itself is short (see my post here). You see malls springing everywhere. I can understand all this consumption buzz but it has been overestimated. Most people visit malls to just enjoy the cool AC, eat food in the food courts and do window shopping. I have been noting quite a few shops which had taken space in Malls have vacated it. Only big brands are managing to stay float. The question over cheap housing  in Mumbai still remain.
How do you make housing affordable?
The land prices have gone very high and the only way to get cheap land is to do rehabilitate a slum and you can really move fast if there is political support.
Loads of wisdom from the man who is closest to the housing market in India.  I also liked his take on reforms in India:
The Indian economy has had a phenomenal growth till recently. Do you see any missed opportunities?
We didn’t do many things. Particularly, we did not start any large project. There are six steel mills under planning but not even one of them got the (required) approvals. There are problems of land allocation, environment, iron ore, lack of infrastructure…. The Mittals, the Tatas, the Essar group, the Jindals (JSW Group) and Posco, all have big plans but none of them has started construction as yet.
Similarly, I know plans of a dozen-odd greenfield and brownfield cement plants are. For instance, LafargeSA has plans for four states – Himachal Pradesh, Karnataka, Rajasthan and Meghalaya, but not a single project has started. 
If we don’t increase our domestic supply of cement and steel, it’s going to kill us in the long run. In every sector, I see the same thing.
We have been hearing horrendous stories about FCI. Food is rotting there. Has anybody looked at reforms at FCI? Shouldn’t there be a public debate on it? These are all adding to our inflation….
We have killed our fertilizer industry by giving them unremunerative prices. The government subsidy comes after 18 months and banks do not give working capital to the fertilizer companies. I was a director on the board of fertilizer company but I left as the company was turning a defaulter. I could see this coming and resigned very quickly as otherwise RBI would have blacklisted me (for being a director of a defaulting company)

Assorted Links

September 5, 2008

1. WSJ Blog points to Fedspeak – Fisher and Yellen

2. Macroblog says the next release on unemployment are going to be a key

4. IEB has a superb post on political economy of oil

4. TTR says there is nothing to worry about rising interest rates. TTR points to reasons why certain countries win more olympic medals than others.

5. Nudges points how small food packs are dangerous

6. PSD Blog points to some interesting presentations on financial literacy and consumer protection

Central Banks of countries unite

September 4, 2008

I wrote a research paper with the same heading.

I wrote this paper with the following puzzle in my mind. If inflation is a global phenomenon why are central banks reluctant to react? Moreover, why do central banks blame the others and instead call the factors as external?

In this paper I review how globalisation impacts inflation and how initial research was too narrowly focused. It only looked at whether globalisation could lower inflation. But it coudl also lead to higher inflation as prices rise on a global level. Another point which research ignored is it ws short-termism and failed to include higher inflationary times in their research.

Now with global inflation, central banks are choosing to instead focusing on financial markets and waiting for other central banks to act. This case is especially true for developed economies’ central banks who are waiting for emerging markets’ central banks to act. Rest of the discussion is in the paper.

I sometimes don’t understand who is in a position to give up growth – developed economies or emerging market economies? I also don’t understand this focus on growth/financial stability when inflation continues to surge.

The 2 puzzles of US economy

September 4, 2008

It has been a while since I got to read speeches from Central Banks explaining basic concepts/research issues. Most of the recent speeches have been explaining stateof financial markets,  inflation, their action etc. I can’t blame them for the same as times are such. Earlier speeches explaining concepts/research were very common, now rare.

I came across one such rare speech by Randall Krozner, Fed Governor. His speech focuses on the linkages the US economy has with the World Economy. He looks at 2 main linkages – trade and finance. Read the speech for details.

I will focus on the 2 puzzles he raises:

  1. the income received by U.S. residents on their foreign investments has consistently exceeded that received by foreigners on their holdings in the United States. This difference totaled $90 billion in 2007. So, at first blush, it might appear that the rest of the world pays the United States for the privilege of lending to it.
  2.  Why does it seem that the United States can borrow without a corresponding increase in its debt? To be more specific, over the past six years, the United States has run current account deficits that add up to over $3.8 trillion ….. Over the same period, U.S. net liabilities increased by only $600 billion, which is $3.2 trillion less than the cumulated current account deficits.

For both the puzzles, the answer is the same:

Most U.S. liabilities are debt securities, which realize small capital gains, while a large fraction of U.S. claims on the rest of the world are equity securities, which realize much larger capital gains. The result is a net difference in the capital gains rate slightly in favor of U.S. investors. When this rate differential is applied to the enormous gross claims and liabilities positions, however, it generates a sizable adjustment to the net investment position.

So, the differences in portfolio explains the two puzzles. The foreigners invest in debt securities (in search of safer haven) and US invests in equity securities (have a higehr risk profile, invest in emerging market equities etc). This leads to the differences in incoem earned (Puzzle 1) and a lower external debt (Puzzle 2).

How much is the interest rate differential?

Taking into account the differences in returns and the differences in the composition of assets, the total return on U.S. claims turns out to be about 2 percentage points per year higher than the return that the United States pays on its liabilities to the rest of the world.

Is US unique in this aspect?

As also was the case with the first puzzle, the United States is not unique in regard to this second puzzle. For several other countries, including the United Kingdom, Canada, Australia, and New Zealand, the international investment positions have for extended periods diverged from the value suggested by historical current account balances, in a manner similar to that of the United States. The divergence can go the other way as well–Switzerland and Japan currently report net investment positions substantially less positive than those suggested by their persistent current account surpluses.

One should expecially see the graphs Krozner points towards the end. They explain the 2 puzzles rather well. Excellent speech.

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