I have updated previous post on Economcis Nobel Prize for 2008 being awarded to Paul Krugman.
Archive for October, 2008
Prof. Shankar Acharya has written a nice paper reviewing performance of Indian macroeconomy in 2000s.
The paper reviews India’s macroeconomic performance and policies since 2000.
The first section briefly summarizes key macroeconomic developments regarding economic growth, inflation, external balance, the fiscal situation and aggregate savings and investment.
The second section considers some of the challenges posed to macroeconomic management in this period and the efficacy of the policy responses adopted. In particular, it analyses the progress in fiscal consolidation and the policies adopted to deal with the challenge of the unprecedented surge in external capital inflows into India.
The final section outlines some of the major macro policy issues that need to be addressed in the years ahead, including: the resurgence of high fiscal deficits; the issues relating to external convertibility and exchange rate management; the role of the Reserve Bank of India in macroeconomic policy and coping with a weak international economic environment.
The concern over high fiscal deficit is becoming a central concern for Indian economy.
I had posted about lessons from Sweden’s Banking crisis of 1992. However, the crisis has engulfed Sweden banking system as well. The linkage is less via the financial channel as in the case of India and others but via an indirect trade channel.
Basically Sweden Banks have lent big time to Baltic region. Baltic region has grown previously on account of its exports to European developed countries. Now with European developed countries in near recession, the Baltic region has slowed. This is expected to increase non-performing assets in Sweden Banks’ books and concerns over Sweden’s Banking system.
The result is a plan by Sweden Finance Ministry to support its banks. It is a combination of capital injection, guarantee scheme and stabilisation fund.
Tough times for any economic policymaker. The channels can effect you from anywhere. What do you do?
Dutch Government has injected Euro 10 billion of capital in ING. The details of the deal are here.
ING is thus using the facility offered by the Dutch government, since 9 October 2008, to sound and viable financial enterprises that are facing unexpected external shocks. The Dutch government has made EUR 20 billion immediately available for the recapitalisation of the financial sector that is now proceeding internationally.
The government obtains EUR 10 billion in securities, which have largely the same features as shares. These securities qualify as core capital (Core Tier 1 as approved by DNB). There is to be no dilution of the share capital held by current shareholders.
The rate of return on the securities is 8.5%. That shall only be paid out if dividends are also awarded over the preceding year. Should the dividend in the relevant year exceed the coupon of 8.5%, this coupon shall be increased: in the first year to 110% of the dividend, in the second year to 120% and in subsequent years to 125%. This structure is an incentive to ING to withdraw from this government participation as soon as justified by the share price and the path of dividends
This is atleast much simpler than Swiss version of TARP. But still quite a bit of capital structuring going on.
This time Indian economy managers press a panic button. RBI reduces Repo rates by 100 bps to 8%! Record-high inflation, high money suypply, high credit and we have a rate cut and that too by 100 bps. In this global rate-cut coordination only Australia has cut rates by 100 bps.
The crisis has not just reached Indian shores but has created its tsunami as well. The numerous statements from Indian economy managers (see this)that things are well don’t sound good at all.
It looked like a liquidity crisis earlier and this was solved by CRR rate cut by 150 bps (10 Oct 2008; actually on 6 Oct 2008, RBI lowered CRR by 50 bps and on 10 October 2008 this was reviewed and another 100 bps was added to lower CRR by 150 bps). Then on 15 Oct 2008, RBI reviewed the situation again and lowered the CRR again by 100 bps to 6.5%. The liquidity situation improved dramatically and the liquidity infusion by RBI lowered from 90,00 cr on 10 Oct 2008 (add this and this) to net 1615 cr of infusion on 17 Oct 2008 (net this and this).
However, what looks now is that liquidity crunch has become a credit crunch in India as well. The RBI statement says:
India too is experiencing the indirect impact of the global liquidity constraint as reflected by some signs of strain in our credit markets in recent weeks. In order to alleviate the pressures and, in particular, to maintain financial stability, the Reserve Bank has decided to reduce the repo rate under the Liquidity Adjustment Facility (LAF) by 100 basis points to 8.0 per cent with immediate effect.
I don’t know where is the credit crunch as on 10 Oct 2008 indicates credit has been growing at almost 25% compared to levels in 2007 which is higher than 23% seen in 2007! So, may be we see the credit crunch in next weeks data. Another possibility is that credit is not really going to the certain productive sectors, but then we don’t have sectoral distribution so we are not sure of this.
So, what explains this rate cut? One cue you get from Governor Subba Rao’s speech at IMF (on October 11, 2008):
Risk aversion, deleveraging and frozen money markets have not only raised the cost of funds for Indian corporates but also its availability in the international markets. This will mean additional demand for domestic bank credit in the near term. Reduced investor interest in emerging economies could impact capital flows significantly. The impending recession will also impact on Indian exports.
So, the rates could have been lowered as RBI expects demand for bank credit to go up. The funding sources from both debt and equity market (partcularly foreign markets) are expected to dry up. And as India Inc would need money to finance its investments and push growth, a lower interest rates (lower interest leads to higher investments) would lead to lower costs and more investments.
Another rationale for the rate cut is to join the global bandwagon. As John Taylor specifies in his speech at San Fransisco Fed (22 Feb 2008):
This phenomenon is seen all over the world. People in other countries try to predict what the Fed and other central banks will do and they base their predictions at least in part on policy rules. An email I got this week from a financial economist in Mumbai India is typical: “Should [the Reserve Bank of India] cut rates because the US is cutting rates?” he asked. Of course, central banks take account of the expected actions of other central banks when they make their own interest rate decision.
In a recent Monetary Policy Report, the Norges Bank stated that “It cannot be ruled out that a wider interest rate differential will lead to an appreciation of the krone. This may suggest a gradualist approach in interest rate setting.” In other words, actions by the Federal Reserve to lower the interest rate may factor into decisions by other central banks to lower interest rates. Deviating from expected responses can make it hard for other central banks to do the right thing.
You know who would have asked the question :-) The problem right now is opposite as Indian rupee is not appreciating but depreciating. But anyways, this global coordination cannot be ruled out.
But what about other things like still record inflation, still strong money supply etc? Though, GDP growth is expected to slip from 9% to 7.5-8% levels it is much higher looking at relative global growth levels. Even when India grew at 9% plus global economy was growing around 4.5%-5% levels. So relatively we seem to be much better off. The markets are also surprised by the magnitude of the cut. The debt markets are rallying but surprisingly equity markets are correcting. Clearly equity markets either want more interest rate cuts as they see the Central bank willing to cut 100 bps in one time or may be they interpret the signal as some dangers lurking somewhere.
Overall summary is the rate cut looked like coming mainly because of global stress, the magnitude of the cut is a puzzle.
Another reason to lower the Repo could be to lower the interest rate costs for the government. The government fiscal deficit is expected to be much higher as oil bonds and fertiliser bonds are accounted in the deficit. Moreover, higher bond issuances are expected for managing both the government expenditure and also for the oil companies and fertiliser companies. So a repo rate cut would also lead to lower interest rate costs for the government
Iceland’s plunge has been well discussed. After Iceland, Hungary and Ukraine seem to be going under as well and have approached IMF for help. Here is the IMF statement on Hungary and Ukraine Finmin’s statement. Reuters explains why Hungary collapses
Interesting times. After companies, countries are collapsing as well.
WTO has set up a task force on financial crisis. WTO has noted that because of crisis, developing countries will find it difficult to get trade finance and this will have an impact on trade activities. WTO Chairman Lamy says:
Let me now come back in more detail to the financial crisis. I suggested at the informal TNC that this may also be having a direct impact on developing-country access to financing of imports and exports. As everyone is aware, we have held a number of meetings on this issue at the WTO with both multilateral institutions and private banks, the last one in April this year, to check availability of trade financing at affordable rates. Up until then, the situation seemed to be stable with volumes and rates at normal levels. But just this week Brazil brought this issue to the forefront.
Given the deterioration of the financial landscape, and despite the welcome announcement last week by the World Bank International Finance Corporation of an increase in its trade financing programme by $500 million, I have reconvened major providers of trade finance to a meeting on 12 November to examine this issue and find ways to alleviate the situation if it was to deteriorate. One third of the world economy, mainly in emerging countries, still has a big growth potential and we must try and make sure that this engine can work through trade.
I had analysed earlier in this paper, that US crisis will impact other economies via 2 channels- trade flows and finance flows. The concern on finance was felt even then (The paper was released on 7 Jan 2008). The real question was the impact on trade flows which looks set to decline as global economies shrink demand levels.
However, I didn’t analyse this inter-linkage between finance and trade that WTO points. The exporters and importers need finance as well and financial crisis will impact the flow of trade and finance as well. Tough times ahead for exporters and importers. This will impact the economies that depend on trade flows.
I have written a paper titled -Demystifying TARP and its extensions . It is an attempt to explain Treasury’s Troubled Asset Relief Program (TARP) and its extensions. It gives a time-line of evolution of the plan, rationale for the plan and the various issues about the plan.
Let me know the comments.
Swiss have introduced their own version of TARP. This goes one step further. In TARP and other supports, Treasury has taken asset-buys or capital infusions and Fed has provided liquidity.
In the Swiss TARP, Swiss Central Bank takes charge and sets up a SPV to transfer distressed assets from UBS.
According to the agreement with the SNB, UBS sells the securities to a special purpose vehicle and provides capital in the maximum amount of USD 6 billion, which will serve as a first protection against losses. The SNB finances the purchase of these assets by granting the SPV a secured long-term loan in an amount not exceeding USD 54 billion and obtains control over the SPV. After full repayment of the loan, the SNB participates in profits generated by the SPV with USD 1 billion up-front and with 50% of eventually remaining equity value.
Distressed assets worth USD 60 billion will be transferred to the SPV. The SPV willl be funded by USD 54 billion from SNB and 6 billion from UBS. Further try and understand this:
The loan granted by the SNB in an amount not exceeding USD 54 billion will be secured by a security interest perfected in all of the SPV’s assets. The SPV pays interests at the one month USD-Libor-Rate plus 250 basis points. Payments streams from interest payments, repayment of principal, and the sale of assets will be used primarily to repay the SNB loan after coverage of operating expenses. The term of the credit will be 8 years but can be extended to a maximum of 12 years in order to permit an orderly liquidation of the assets.
The SNB will have no recourse against UBS for this credit. The SNB’s credit is in USD since the assets are primarily denominated in this currency. Initially, the SNB will provide for the necessary currency from the US Federal Reserve through a Dollar-Swiss-Franc swap. Thereafter, the SNB will turn to the market for refinancing. It does not intend to use its currency reserves.
Pheww! There is just too much i-banking and capital structuring is going on. Private sector complexity has been replaced by public sector complexity. Are there any changes? Any lessons? Does the public in Switzerland (apart from fin people) understand the deal?
If this was not enough, just see UBS website for asset types included in the deal:
US commercial real estate and mortgage-backed securities
US student loan auction rate certificates and other securities backed by student loans
US reference-linked note program (RLN)
So, almost everything illiquid and highly risky. Reading the UBS statement further will give even the best fin guys a headache. And we thought we will have some simplicity after UBS appointed a communication officer.
The statement from Chairman, Jean Pierre Roth says the action despite its need is “unprecendented”. What is going on?
Read FT Alphaville comments
Minneapolis Fed has an excellent interview/profile of the Romer couple – Christina and David. They both have done some excellent research and the profile explains the research and its implications.
WSJ compiles a nice Q&A session with Bernanke. I didn’t like this statement:
Now, as I’ve described, we are involved now in the capital-injection program. One of the great virtues of the TARP is that it is flexible and it can be used in different ways, as required.
I had pointed to Senate hearing on Lehman and AIG.
I was reading testimony of Richard Fuld, ex-chief ex- Lehman. He says:
The second issue I want to discuss is naked short selling, which I believe contributed to both the collapse of Bear Stearns and Lehman Brothers. Short selling by itself can be employed as a legitimate hedge against risk.
Naked short selling, on the other hand, is an invitation to market manipulation. Naked short selling is the practice of selling shares short without first borrowing or arranging to borrow those shares in time to make delivery to the buyer within the settlement period – in essence, selling something you do not own and might not ultimately deliver to the buyer.
Many of the firms that have recently collapsed or have been forced into emergency mergers, takeovers, or government bailouts – Bear Stearns, Lehman Brothers, Merrill Lynch, Fannie Mae, Freddie Mac, AIG – did so during the gaps of time in which there was no meaningful regulation of naked short selling.
It is an old saying that one only feels the brunt when he faces it himself. In times of Asian crisis when short-selling etc was banned I am sure Lehman along with other wall street firms would have cried hoarse.
Actually, I have never really understood the stance over short-selling. It looks good in theory but there seems to be a problem in its application. Especially, no firm likes it if it is being shorted. SEC and others banned short-selling in a big way. As Indian markets have collapsed debates have begun whether similar steps need to be taken here. In all, academicians like it, the practitioners like it only in good times and detest it in bad times. Earlier, these policy measures were seen in emerging economies but we can’t say the same anymore.
Further, Fuld blames market rumors:
Naked short selling, followed by false rumors, dealt a critical, if not fatal blow to Bear Stearns. Many knowledgeable participants in our financial markets are convinced that naked short sellers spread rumors and false information regarding the liquidity of Bear Stearns, and simultaneously pulled business or encouraged others to pull business from Bear Stearns, creating an atmosphere of fear which then led to a selffulfilling prophecy of a run on the bank.
And I believe that unsubstantiated rumors in the marketplace caused significant harm to Lehman Brothers. In our case, false rumors were so rampant for so long that major institutions issued public statements denying the rumors.
Can rumors (even as other factor) really lead to a downfall of giants like Lehman? Is this a case of smoke without fire? Lehman was clearly highly overleveraged and was bound to fail.
But then, this rumor problem was even seen in the case of ICICI Bank, which led to numerous clarifications from the bank officials and several policymakers. And ICICI Bank is pretty well capitalised and can’t be compared to Lehman at all. There are so many firms like ICICI Bank which have felt the brunt.
So, how does one manage the rumors?
The movement in financial markets is because of information. A person who acts first on the news gains and other loose out. So market participants have various ways to get news- newswires (Reuters, Bloomberg etc), Business TV channels, own market networks etc. Now, how does one separate a rumor from an actual development? For instance, suppose there is a news over a problem with a bank, there is little time to check whther it is rumor /true news and what follows is a run. And before bank officials and policymakers clarify much of the damage is already done.
All this makes things very complicated and there are no easy answers. You can’t prevent information from flowing as then the question of more efficient markets does not arise. And if information flows easily, the separation of rumors and actual news is no easy task. Moreover, positive rumors are good and no one objects to it but negative rumors can really wipe out the company and very large ones at that.
What do you do as a policymaker?
Eurointelligence has an excellent post summarizing the plans issued by various European Governments to rescue their financial systems.
In the same post, it says the crisis has moved to credit cards
A recent Brookings report puts restoring financial stability as the number one concern for the next US President. It is written by Eswar Prasad who has written numerous papers on capital flows and financial globalisation; always stressing both are beneficial and we need more of them.
Yeah restoring financial stability is a concern but am sure with such dollies being thrown by central banks and Treasuries, it will eventually happen. A bigger concern is a reality check on financial markets and the massive damage it can bring if things are not kept on a check. A revisit to financial globalisation should also be done.
Interestingly (and obviously), in its 2007 report didn’t have financial stability mentioned anywhere.
This reminded me of the Copenhagen Consenus 2004 which listed financial instability as one of the 10 challenges facing world economy. However, in its final analysis it said there was no conclusion on whether financial instability is a challenge. And they ignored it. In 2008 consensus, the list was expanded to 30 but obviously financial instability was not included.
Most Central Banks especially the inflation targeting ones issue financial stability reports. IMF also has a bi-annual report on financial stability.
So, pretty mixed fortune and financial stability is either not seen as a challenge or is revisited in times of crisis. Why should this be?
Financial stability (or instability) should always be in such lists as it has substantial costs. The amount of money being doled out to have stable financial markets is for all to see. Chris Blattman points what USD 700 billion could do for development:
And we know it is already many times over USD 700 billion. There is a $2.5 trillion plan for Europe, some 800 billion for UK and a separate $ 250 billion plan for recapitalising US Banks etc. And add all that Central bank liquidity. When I see how much poverty could be eliminated as pointed by Blattman, I also wonder which is a bigger crisis – Letting so many people die every year because of poverty as there is little financial help or helping billion dollar firms survive? It is an irony of sorts.
Financial stability is one of the most important challenges and should remain in all challenges list. Just because markets are stable now we shouldn’t sit and relax. Infact only when markets are stable, is there a case for some instability building in some corner.