Emerging Economies facing the heat now

A couple of policy initiatives suggest things have  turned tense at emerging economies as well. First 4 emerging economies central banks – S.Korea, Brazil, Mexico and Singapore set up a swap facility with Fed. The facility is for USD 30 billion each and is applicable till 30 April 2009. So after 10 developed economies (with NZ as the latest), emerging economies have set up swap facilities as well (though Both Korea and S’Pore are not strictly emerging).

Second, IMF has set up Short term liquidity facility for emerging economies with strong economic policies that are facing temporary liquidity problems in the global capital markets. Transcript of press conference to launch this facility is here.  Simon Johnson points the amount is not liely to be enough. Rodrik also shares similar views.

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Why Iceland collapsed and are there some economies like Iceland’s?

I had pointed to the interest rate policy reversal by Iceland Central bank. There is full chaos there. However, the falling of Iceland was not very well known

WIllem Buiter and Anne Sibert have analysed the Iceland problems in this voxeu piece. The article is a summary of a more detailed paper available here. The analysis points that Iceland model was always problematic and bound to fail:

In the first half of 2008, Buiter and Sibert were invited to study Iceland’s financial problems. They identified the “vulnerable quartet” of (1) a small country with (2) a large banking sector, (3) its own currency and (4) limited fiscal capacity – a quartet that meant Iceland’s banking model was not viable. How right they were.

The duo studies the problems but the report was not made public as it was pretty sensitive. As Lehman collapsed, Iceland’s banks foreign assets and exposure was noticed and rest is history. As things are well known now, Buiter et al have released the paper and it has very useful lessons.

Why it fell?

Our April/July paper noted that Iceland had, in a very short period of time, created an internationally active banking sector that was vast relative to the size of its very small economy. Iceland also has its own currency. Our central point was that this ‘business model’ for Iceland was not viable.

The mistakes made

Couple of mistakes were made worsening the crisis

The decision of the government to take a 75 percent equity stake in Glitnir on September 29 risked turning a bank debt crisis into a sovereign debt crisis. Fortunately, Glitnir went into receivership before its shareholders had time to approve the government takeover

Then, on October 7, the Central Bank of Iceland announced a currency peg for the króna without having the reserves to support. It was one of the shortest-lived currency pegs in history. At the time of writing (28 October 2008) there is no functioning foreign exchange market for the Icelandic króna.

In addition, outrageous bullying behaviour by the UK authorities probably precipitated the collapse of Kaupthing – the last Icelandic bank still standing at the time. The official excuse of the British government for its thuggish behaviour was that the Icelandic authorities had informed it that they would not honour Iceland’s deposit guarantees for the UK subsidiaries of its banks. Transcripts of the key conversation on the issue between British and Icelandic authorities suggest that, if the story of Pinocchio is anything to go by, a lot of people in HM Treasury today have noses that are rather longer than they used to be.

I liked the Pinocchio bit :-). Despite the policy mistakes, the fall was pretty clear as the large international banking model was unsustainable at the first place. An excellent analysis and if it had been released earlier, Buiter and Sibert would have joined Nouriel Roubini as Doomsayers.

However, they point similar conditions in other economies as well:

Iceland’s circumstances were extreme, but there are other countries suffering from milder versions of the same fundamental inconsistent – or at least vulnerable – quartet:
(1) A small country with (2) a large, internationally exposed banking sector, (3) its own currency and (4) limited fiscal spare capacity relative to the possible size of the banking sector solvency gap.

Countries that come to mind are:

• Switzerland
• Denmark
• Sweden

and even to some extent the UK, although it is significantly larger than the others and has a minor-league legacy reserve currency.

Ireland, Belgium, the Netherland and Luxembourg possess the advantage of having the euro, a global reserve currency, as their national currency. Illiquidity alone should therefore not become a fatal problem for their banking sectors. But with limited fiscal spare capacity, their ability to address serious fundamental banking sector insolvency issues may well be in doubt.

Incidentally, today’s Eurointelligence points Denmark is thinking of joining the Euro as they can’t have their cake and eat it too. By being a member of EU but not adopting Euro will not work forever.

I was also wondering what would have been the fate of India if Mumbai International Finance Centre reportwas actively taken up by policymakers. The idea behind international finance centre is to provide international finance options to both domestic and international companies from Mumbai. This would have implied Indian banking system would have become more international with times. Now, in this crisis out of the 4 conditions for Iceland, 2 would have been applicable to India as well-  (2) a large, internationally exposed banking sector, (3) its own currency

The other two i.e. (1) A small country  (4) limited fiscal spare capacity relative to the possible size of the banking sector solvency gap – would have depended on the magnitude of the crisis hitting Indian shores. As current experience shows countries that are large and have spare fiscal capacity are facing the brunt as well.

This does not imply not to have an international finance centre in Mumbai but be prepared for such events as well.

Assorted Links

1. TTR points western regulation is on trial

2. Mostly Economics also joins MR in support of Felix Salmon

3. WSJ Blog points Recession call is awaited keenly

4. Mankiw points to Roubini’s next prediction- get ready for deflation. Hamilton doesn’t agree

5. Rodrik points to good news for emerging markets but qs still remain

6. FIn Prof points Deutsche Bank in black because of accounting changes

7. Bogle Blog points to NYT profile of the man

8. ALB says we need fin edu more than ever

IMF and BIS resources on financial stability

Financial Stability is surely the flavor of the season (I hope it remains as a main concern and challenge). Both BIS and IMF have done their bit and have developed websites for the cause.

Here is IMF’s web portal which has IMF’s comments and superb collection of papers on financial stability.

Here is BIS link which is a collection of recent Central Banker speeches on the subject.

Iceland does a reversal- raises rates by 600 bps to 18%!

It is not just Denmark but Iceland too. Central Bank of Iceland has raised rates by 600 bps from 12%to 18%. However, there is a difference. Denmark continues to raise rates but Iceland reverses its previous decision taken on October 15 2008 (this is just 13 days ago) . On 15 Oct it said:

The Icelandic economy has been subjected to unprecedented turbulence in the past few weeks. The Icelandic banking system has not been able to withstand the trials it has faced as a result of difficult market conditions, global deterioration of confidence in economic affairs, and domestic risk appetite.

A variety of jobs have disappeared virtually in the blink of an eye, demand has declined precipitously, and by all measures, expectations are at a low ebb. The impact of the collapse of the banking system will be extremely burdensome and the accompanying economic contraction very sharp.

On 28 Oct 2008 it says:

Last week the Icelandic Government and a mission from the International Monetary Fund concluded an agreement. One of the points in the agreement was that when it will be presented to the Executive Board of the Fund for its approval, which should happen in the next few days, the Central Bank was to have raised the policy rate to 18%. This has now been done. This decision has been taken with reference to the fact that, with the collapse of three banks and the harsh external measures that followed, Iceland’s foreign exchange market became paralysed. Although the situation has eased somewhat, some restrictions continue to be inevitable.

On checking the IMF loan to Iceland , it is just about USD 2.1 billion. Isn’t it too less?

Anyways, the decision on 15th Oct 2008 was to save falling economy and on 28th Oct 2008, it is to prevent currency depreciation. So, whichever market you try to save, the other goes for a toss. This is precisely the problem faced by all emerging economies.

Assorted Links

1. WSJ Blog points how much Fed cut? Does it matter really? It points ex-Fed Governor advocates a zero fed funds rate

2. JRV is pessimistic on Indian eco outlook. ACB as well

3. TTR points Fed should add fin stability as its 3rd objective.

4. MR points markets are pricing a deep deflation. It also points to the banking linkages of developed economies with emerging economies

5. NB points to a must read paper for Beh eco people- If behavioral economists wrote financial regulations…

6. Mankiw points to an article from Summers on fin sector excesses

7. Rodrik on emerging market dilemma

8. Fin Prof points despite all the mess bonuses continue even in failed firms like Merril Lynch

Cox says Municipalities under stress as well

Though much of the discussion in this Oversight Senate hearing is on Greenspan’s testimony, SEC Chairman Cox’s testimony is interesting as well. He says concerns are being felt in Municipalities as well:

Now that the credit crisis has reached the state and local level, investors need to know what they own.

This multi-trillion dollar market entails many of the same risks and is subject to the same abuses as other parts of the capital markets. Individual investors own nearly two-thirds of municipal securities, directly or through funds, and yet neither the SEC nor any federal regulator has the authority to protect investors by insisting on full disclosure. The problems in Jefferson County, Alabama are only the most recent reminder of what can go wrong.

The multi-billion dollar fraud in the City of San Diego, in which we charged five former City employees this past year, has injured investors and taxpayers alike. The economic slowdown will now make it even harder for many states and localities to meet their obligations. Many municipalities continue to use interest rate swaps in ways that expose them to the risk that the financial institution on the other side of the derivatives contract may fail.

That is why, repeatedly over the last two years, I have asked Congress to give the SEC the authority to bring municipal finance disclosure at least up to par with corporate disclosure. Knowing what we now know, I would have begun this campaign on my first day on the job.

So, this market is also largely unregulated (like the credit derivatives market) and still has grown to a trillion dollar market.

After dollar, now the turn of Euro Funding

So far, the Central banks had set up swaplines with Fed for USD funding. Now, Denmark Central Bank has set up a swap line with ECB for Euro funding upto USD 12 billion.

So, after concerns in USD markets, the concerns are shifting to Euro market as well.

IMF bails out emerging markets

IMF has given $2.1 billion to Iceland and is about to give $16.5 billion to Ukraine and is in talks with Hungary. Dani Rodrik says IMF needs to step up and has to act as a global lender of last resort to emerging markets. Though he feels pity for the emerging markets but there is little choice now:

Emerging markets have every right to say that they are being swept under by a crisis that is not their own doing. But the real reason the rest of the world needs to move on this front is naked self-interest. Combine a deep recession in the advanced countries with an uncontrolled depreciation of emerging-market currencies, and the pressure to erect trade barriers in the U.S. and Europe will be impossible to withstand.  A vicious cycle of unemployment and protectionism feeding on each other a la 1930s could transform the deep recession everyone is already expecting into a second great depression. It can get worse…

Apart from this there are concerns in Korea, Pakistan, Belarus as well (Read the IMF statements linked).

Korean won has depreciated substantially and is facing a currency crisis. Korean must be feeling dejavu as current events similar to what happened in South East Asian Crisis as well. In that too, Korea went down suddenly. The Korean central bank has recently reduced interest rates by 75 bps as well. Now, I don’t even understand this. If it lowers interest rates, the pressure on Korean Won would be more and would depreciate further. How do you balance it? This is actually going to be a problem for all emerging economies.

Pakistan is not really hurt by the global crisis but because of home grown political instability.

Belarus case is also quite interesting. Recently, Doing Business Blog pointed that Belarus has undertaken numerous reforms to make doing business in Belarus easier. In Doing Business 2009 report, it is the 4th global reformer in 2007-08 and has jumped from 115 ranking to 85 ranking! This should lead to more prosperity in Belarus but this crisis has simply led to a reversal of sorts. What do you really do as a policymaker?

Krugman in his blog says that we are going to see a mother of all currency crises. Expect more fireworks in emerging economies going ahead.

Another important point is IMF itself is not in a good financial shape. So, it will be interesting to see hopw it fares in this crisis.

Mostly Economics in Nobel company; Happy Diwali to all

I had pointed a while back that as per Econolog ranking, Mostly Economics has been ranked as one of the friendly blogs.

The same  ranking has been updated and Mostly Economics has jumped ahead. It is now ranked 30th in the list of top 50 economics blogs on the web! It didn’t feature in this top ranking earlier and was just ranked as a friendly blog.

It is simply amazing to be ranked in the same list as Blogs of econ giants Paul Krugman,  Tyler Cowen, Gary becker, Steven Levitt, Chris Blattman etc. (Though I don’t understand how Mostly Economics comes ahead of Bekcer and Blattman’s Blog; it does not even have Mankiw and Rodrik Blog in the rankings which is surprising). The ranking would change in days to come and the Blog ranking might slip lower, but I don;t mind this temporary ranking at all

Mostly Economics thanks all the visitors for visiting it and passing their comments. It couldn’t have been possible without you all.

WIth this, Mostly Economics also wishes all the visitors and their families a Very Happy Diwali.

P.S. Blogging is not going to be very active as this week we have many holidays.

Assorted Links

1. WSJ Blog points China preparing for the crisis. It points to a report which compares the previous recessions with this one

2. JRV points beggar thy neighbour policy could be very dangerous

3. TTR points ICICI Bank draws judiciary’s ire

4. ACB has an excellent post walking to school. He also points Keynes is back

5. MR points to a paper which measures the true cost of social security in US. MR on Alan Greenspan’s comments

6. Krugman says after all the mess we could have mother of all currency crises. Rodrik agrees and suggests IMF intervention 

7. FCB on credit rating agencies

8. DB Blog says US Treasury is a crisis snob

9. Econbrowser analyses Fed’s Balance sheet

Opt-in strategy not working in Germany

I had posted how NZ seems to be using lessons from behavioral economics to protect its financial system. Basically NZ had used a opt-in strategy where banks had to choose to be part of the deposit guarantee program. The main reason could be that NZ wanted to provide the signal that its banking and financial system is safe (read nudges blog view as well).

Infact, most of the bailout packages have been structured in that fashion. The firms have to opt for the plan rather than the opt-out plan where all are included and a firm which does not want the plan, has to opt out of the plan .

However, Eurointelligence points (scroll below) that this opt-in strategy is not working in Germany.

There are increasing signs that the German bank rescue plan is not working. Lucas Zeisemakes the point that the money market is still frozen, and that the biggest mistake of the German plan had been the voluntary nature of bank rescues, which has led to the perverse situation that so far only one state-owned bank, BayernLB, has asked for new funds. Zeise says the German government made the mistake to ask the banks to co-draft the rescue plan, rather than forcing banks into recapitalisation, as the British and French have done.

So, what Germans instead needed is an opt-out plan.

Who says behavioral economics does not matter? This selection of what should be the default seems to be quite critical for the bail-out plans. As a policymaker, you need to take a call whether your financial system/banks are safe or not? If things are bad, there is no point having an opt-in strategy (like Germany) and one should simply include all the banks and let the safer ones opt-out of the plan. In case things are fine, opt-in makes sense as it sends the signal that all is well.

Some research to understand the various signals and default strategies is welcome.

Denmark continues to raise interest rates

I had posted a while back that Denmark seems to be the only Central Bank to have raised interest rates. I had also said in the same post that may be Denmark would have to undo its decision soon.

However, it continues to raise rates to support its currency (Danish Krone). Basically, Denmark is raising rates to prevent capital outflows and depreciation of its currency. Earlier, the rates in Denmark and Euroarea was at same levels leading to capital outflows and depreciation of the currency. Now ECB has lowered rates and is expected to lower further (same would be the case for BoE, Sweden, Switzerland etc). So the interest rates in Denmark would be much higher compared to other economies going ahead. Let’s see for how long it continues to maintain higher rates.

Interesting times surely for the Central Banker.

RBI Mid-term review of Monetary Policy 2008-09

It is a status quo policy.

a)  Bank Rate – unchanged at 6.0 per cent.

(b)  Repo Rate/Reverse Repo Rate – The repo rate under the LAF has been kept unchanged at 8.0 per cent. The reverse repo rate under the LAF has been kept unchanged at 6.0 per cent.

(c)   Cash Reserve Ratio – On a review of the current liquidity situation, it has been decided to keep the CRR unchanged at 6.5 per cent of NDT

Let me read the details and point any new development

Assorted Links

1. The event being most discussed is Greenspan testimony to Senate Oversight committee. WSJ Blog points Greenspan ‘Shocked’ to Find Flaw in Ideology

2. Krugman on Greenspan testimony. Fin Prof points as well

3. FIn prof has some bad news on hedge funds

4. TTR points GSachs cutting jobs

It could be structured by cows and we would rate it!

I had pointed to the Lehman and AIG Hearing and had also summarised Richard Fuld’s testimony.

The same Oversight Senate Committee had a hearing on credit rating agencies. The findings on the hearing are not comforting at all. I only read the opening statement by Chairman Waxman. The committee has shown evidence that things weer quite messy in these elite halls of fame.

In October 2007, a Moody’s management report said:

We heard 2 answers yesterday: 1. people lied, and 2. there was an unprecedented sequence of events in the mortgage markets. As for #1, it seems to me that we had blinders on and never questioned the information we were given. … As for #2, it is our job to think of the worst case scenarios and model them. … Combined, these errors make us look either incompetent at credit analysis, or like we sold our soul to the devil for revenue.

At S&P:

The documents from Standard and Poor’s paint a similar picture. In one document, an S&P employee in the structured finance division writes: “It could be structured by cows and we would rate it.” In another, an employee asserts: “Rating agencies continue to create [an] even bigger monster — the CDO market. Let’s hope we are all wealthy and retired by the time this house of cards falters.”

I had posted a while back that soul searching was needed at rating agencies. A complete overhaul is needed to thew way these institutions function. Let me read the testimonies and point if I find anything interesting.

UK National debt and battle of waterloo

Mervyn King has given a speech after a long long time ( The last speech was on 18 June 2008.

In this speech King says why the recapitalisation of UK Banks was important. In sum, move was not to save the banks but to save the economy from the banks.

What was however amusing was his discussion of the govt. deficit. Recapitalisation would lead to higher government deficit. He says:

The cost of supporting the banking system will inevitably raise the level of national debt. Managed properly, however, such a rise in national debt need not prove inflationary. Indeed, within a reasonable period it should be possible for the Government to reduce its stake in the banking system, for example by selling units in a Bank Reconstruction Fund, and repay the additional debt that had been issued. That is one difference between past increases in national debt in times of war and the increase now to pay for recapitalisation of the banking system which involves the acquisition of an asset.

To help understand the difference between war-times and current times, King tells you a story:

Let me take you back again to 1958. In the very first television interview given by a Governor of the Bank of England, Cameron Cobbold explained national debt to RobinDay on “Tell the People”, the highlight of ITN’s Sunday evening schedule fifty years ago. Here is the exchange:

Cobbold: The National Debt represents the sums of money which the Government have over the years borrowed from the public, mainly in this country and, to some extent, abroad. That is really the amount of expenditure which they have failed over the period to cover by revenue.

Day: Have we paid for World War II?

Cobbold: No.

Day: Have we paid for World War I?

Cobbold: No.

Day: Have we paid for the Battle of Waterloo?

Cobbold: I don’t think you can exactly say that.

🙂

New Zealand lowers interest rates by 100 bps

Reserve Bank of NZ has lowered its interest rates by 100 bps to 6.50%. NZ did not join the central bank coordination to cut rates.

This rate cut is however in line with the 100 bps rate cut by Australia. Previously, NZ had cut rates by 50 bps to 7.50% on 11 Sep 2008.

It seems to be rate cutting season of central banks. I however still fail to understand how such dramatic rate cutting would help? When banks don’t want to enter the markets and there is absolutely no confidence, how would lowering the interest rates help?

Another thing which I don’t understand is as follows. The usual claim of central banks is monetary policy works with a lag i.e. when inflation is high, central banks increase rates gradually and the impact on inflation is seen after some months. For advanced economies, the lag is about 6 months and for emerging economies it is about 9-12 months. If this is the case, it should apply to opposite scenario as well. If central banks are lowering rates, it should impact with the same lag. So, how will lowering interest rates impact the situation immediately? And that too in such frozen times? Why are they panicking so much?

Assorted Links

1. WSJ Blog points Bernanke still avoiding the R word. WSJ Blog on whether asset prices can be targeted by mon pol

2. Macroblog gives a reality check on the eco forecasts

3. Rodrik points to old wisdom from James Tobin

4. ALB points how households don’t diversify risks adequately

5. FCB points to how ridiculous things are at credit rating agencies

6. DBB points Belarus has undertaken reforms making it easier to do business

7. JRV comparesconditions in India in Oct 2008 and in US/Europe in Aug/Sep 2007

8. ACB on the importance of good quality roads.  

9. MR points Cayman islands are not doing badly at all

What does Raghu Rajan imply?

Raghuram Rajan in this speech given at Institute for Economic Growth, Delhi says:

A second lesson from the crisis is that the incentives and abilities of players matter enormously. Our regulations assume that management has financial knowledge, control over the financial institution’s operations, and cares about the long run. Yet, the growing revelations, for example from UBS, suggest that none of these assumptions need be true. Traders ran amuck building large positions, with management seemingly unable to restrain them.

Raghu Rajan first indicated the damage incentives can bring to the financial system in a superb paper presented at Kansas City Fed Symposium -2005. He even analysed the subprime crisis from the perverse incentives angle. So so far so good. Then he says:

In this context, a major source of concern in in India are the state-owned public sector banks. While some of the finest bankers in India are to be found in public sector banks, their inability to pay market salaries to top managers has eroded their strength. The chairman of the State Bank of India, India’s largest bank, makes less than $1000 a month in basic salary. The worry mounts as generations that were recruited in good times, when the public sector had a monopoly, retire.

So, what exactly is his concern? Above he says high incentives lead to the crisis and next he says low incentives erode strength of the Indian Public sector banks? How do you draw the line between high and low?   

This huge incentive structure in finance is clearly overdone. The salaries of public sector banks may be little low but what makes it look really low is the huge salaries in private sector banks. Huge salaries lead to higher risks, which has been proven time and time again.  I am sure with this crisis regualtors would take note and push to limit incentives. When this happens, the salaries of public sector banks would be more in line with markets.

I have noted all the governments which have passed various bailout packages have introduced limits on compensation in case the firm participates in the bailout plan. On these grounds, I think all financial sector regulators should make Indian government/regulators its consultant on designing appropriate incentive structure.