Archive for December 1st, 2008

Tale of 2 India’s Inflation- CPI and WPI

December 1, 2008

India has 2 measures of inflation (we are not the only ones) – Wholesale Price Index and Consumer Price Index. Within CPI-IW there are 4 indices based on different population categories. (see this report for details and difference).

The Inflation based on WPI has been declining and inflation based on CPIhas been rising. Here is the table: (WPI is a weekly number and rest are monthly, so I have taken monthly figure for WPI as well)

2007 Jan 6.37 6.72 9.52
  Feb 6.36 7.56 9.80
  Mar 6.61 6.72 9.50
  Apr 6.28 6.67 9.44
  May 5.46 6.61 8.22
  Jun 4.53 5.69 7.84
  Jul 4.71 6.45 8.60
  Aug 4.14 7.26 8.80
  Sep 3.51 6.4 7.89
  Oct 3.11 5.51 6.99
  Nov 3.25 5.51 6.15
  Dec 3.84 5.51 5.90
2008 Jan 4.45 5.51 5.63
  Feb 5.27 5.47 6.38
  Mar 7.48 7.87 7.91
  Apr 8.04 7.81 8.88
  May 8.86 7.75 9.11
  Jun 11.82 7.69 8.77
  Jul 12.36 8.33 9.41
  Aug 12.82 9.02 10.29
  Sep 12.23 9.77 10.98
  Oct 10.97 10.45 11.14
  Nov* 8.94    

* Nov-2008 average is for 3 weeks- 1 Nov, 8 Nov and 15 Nov.

The findings are quite interesting

  • Throughout 2007 CPI (both) are higher than WPI. In Aug 2007 the difference is highest and then it declines gradually.
  • From Apr 2008 onwards WPI is higher than CPI and reaches highest in June 2008. The difference remains high till August 2008 and then declines sharply in Sep 2008 and more sharply in Oct-2008. So, WPI was falling but CPI continued to rise sharply from Aug 2008 onwards. From Nov onwards CPI could be higher than WPI
  • This is actually not a surprise as prices first change at wholesale level and the impact comes gradually at consumer level. So, say oil and food prices shot up in April 2008 leading to an rise in WPI which was then passed onto consumers later (say June 2008). And then as oil and commodity prices have declined it will take time for producers to pass on the price rises to the people.
  • WPI is like Producer Price Index in other economies and CPI is there is most economies. in India, WPI is the preferred measure and in most CPI is the preferred measure. Now, on a comparison with other economies like say US, UK etc what is happening is inflation is falling across indices – PPI- CPI etc. And latest we have for developed economies is also October data. So, the data is comparable across time as well.
  • In India’s case so far, we see WPI has declined sharply but CPI has continued to rise. This is also not a surprise as we hardly see any changes in prices of various goods we buy from stores. Infact, they continue to rise. Most people still ask me when will prices/inflation go down?
  • It will be interesting to see the change in CPI going ahead. Would it also go down as sharply as seen in case of WPI and CPI in other economies? I am also wondering what would have been the stance of RBI if it was tracking CPI?

What are synthetic CDOs?

December 1, 2008

Felix Salmon has written an excellent post on synthetic CDOs. It explains how they are created and how it could easily turnaround from a cool return to a hot hot loss. Thanks to Baseline Scenario for the pointer.

Actually Salmon post reminded me of a paper by Dean Foster and Peyton Young which was based on the same idea but had a different implication. The paper explains how the hedge fund manager can structure the derivative contracts which will make him appear as a skilled fund manager but in reality he is unskilled or even an ‘outright con artist’.

In another entry, Baseline Scenario explains a particular dealbetween five Schools in Wisconsin and Royal Bank of Canada involving synthetic CDOs. The Schools have lost a lot of money in the transaction. James Kwak, writer of the post says:

Now, structured financial products can play a role in reducing your risk. In general, derivative trades have a “safe” side and a “risky” side. For example, if you buy a call option, you are on the safe side: you are paying a fixed amount, and you may enjoy an unlimited gain. However, if you sell a call option, you are on the risky side: you are gaining a fixed amount, but you may face an unlimited loss. Credit default swaps are similar in that one side gets a guaranteed but small stream of payments, but faces a very large but unlikely loss. So it makes sense for a local government to use derivatives to hedge some other exposure it has – but not to basically write call options or credit default swaps for other people

The question that comes to my mind is why should someone be selling/writing these options then? One could understand the need to take the risks if the extreme events in financial markets are very rare. This is clearly not the case and most of the time the crisis strikes unexpectedly and very close to good times. This derivatives writing  lead to a collapse of AIG and similar concerns are felt for other forms as well. And if there is a risk in writing/selling options and gets limited in time to come, whom will you buy these options from? Would we see a decline in derivative volumes in future?

Another thing which always interested me (and pointed by Tyler Cowen in his blog, I can’t locate the exact post) is the swap transactions. We are taught in text books that swaps help change the nature of inflows/outflows. Say you are receiving (or paying) fixed rate on a loan and want to change it to floating. Instead of asking the bank to change the loan you can swap it with someone who needs a fixed income loan. Likewise, if you are receiving in dollars and want to change it to Swiss Franc you can swap it with someone.

Now, there are 2 questions- 1) The change to floating or swiss franc should be based on some logic (say floating rates are lower or swiss franc is more stable). So, doesn’t that apply to all and wouldn’t most want to do the same? 2) I can understand if the swaps are done after some sudden changes in say interest rate outlook and currency outlook. Why sudden? Because one swaps after taking into account the most likely future developments. And sudden changes are rare but the swap markets are fairly large. Why would one take a loan in USD and swap it with Swiss Franc immediately when he can take the loan in Swiss Franc rightaway? Another thing is this market is largely institutional (with banks doing swaps with each other) and people are paid to have some futuristic outlook. IF the outlook changes suddenly fine swap it. But why this constant swapping of inflows and outflows?

Again, I don’t mean to say swap/derivative markets are useless. I just don’t understand the huge volumes in these markets.

How does India’s Government Bond market work?

December 1, 2008

In his 2007 budget speech Finance Minister had announced :

106. World over, debt management is distinct from monetary management. The establishment of a Debt Management Office (DMO) in the Government has been advocated for quite some time. The fiscal consolidation achieved so far has encouraged us to take the first step. Accordingly, I propose to set up an autonomous DMO and, in the first phase, a Middle Office will be set up to facilitate the transition to a full-fledged DMO.

Now, Finance Ministry has released an interim report on India’s Debt Management Office (DMO) which will be called as National Treasury Management Agency (NTMA).

This is an excellent report. Apart from the mechanics of NTMA, it explains the working of India’s Government Bond market- the various departments involved, the flow of transactions etc.  It also compares the practices with a few countries helping to understand what happens elsewhere.

The report should be made a part of finance syllabus of B-Schools . It will help spread awareness about the G-Sec market which is still a largely unknown market.  It is going to be an exciting place to work for B-School graduates as well.

Assorted Links

December 1, 2008

1. Krugman points was great depression a monetary phenomenon. His post on Keynesian moment is also interesting

2. Mankiw points to moral hazard. very cute!

3. Mankiw summarises the key thoughts of members of Team Obama

4. JRV has an interesting post on sovereign default

5. TTR on Citigroup- too big to succeed

6. MR points to Al Roth Blog

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