Archive for May 3rd, 2011

How west has destroyed invaluable economic facts

May 3, 2011

This is a shocking article from Hernando De Soto (HT: MR who else). He argues that the financial crisis wasn’t just about finance—it was about a staggering lack of knowledge:

During the second half of the 19th century, the world’s biggest economies endured a series of brutal recessions. At the time, most forms of reliable economic knowledge were organized within feudal, patrimonial, and tribal relationships. If you wanted to know who owned land or owed a debt, it was a fact recorded locally—and most likely shielded from outsiders. At the same time, the world was expanding. Travel between cities and countries became more common and global trade increased. The result was a huge rift between the old, fragmented social order and the needs of a rising, globalizing market economy.

To prevent the breakdown of industrial and commercial progress, hundreds of creative reformers concluded that the world needed a shared set of facts. Knowledge had to be gathered, organized, standardized, recorded, continually updated, and easily accessible—so that all players in the world’s widening markets could, in the words of France’s free-banking champion Charles Coquelin, “pick up the thousands of filaments that businesses are creating between themselves.”

The result was the invention of the first massive “public memory systems” to record and classify—in rule-bound, certified, and publicly accessible registries, titles, balance sheets, and statements of account—all the relevant knowledge available, whether intangible (stocks, commercial paper, deeds, ledgers, contracts, patents, companies, and promissory notes), or tangible (land, buildings, boats, machines, etc.). Knowing who owned and owed, and fixing that information in public records, made it possible for investors to infer value, take risks, and track results. The final product was a revolutionary form of knowledge: “economic facts.”

Hmm.. This is something which Americans and Europeans have been destroying:

Over the past 20 years, Americans and Europeans have quietly gone about destroying these facts. The very systems that could have provided markets and governments with the means to understand the global financial crisis—and to prevent another one—are being eroded. Governments have allowed shadow markets to develop and reach a size beyond comprehension. Mortgages have been granted and recorded with such inattention that homeowners and banks often don’t know and can’t prove who owns their homes. In a few short decades the West undercut 150 years of legal reforms that made the global economy possible.

The results are hardly surprising. In the U.S., trust has broken down between banks and subprime mortgage holders; between foreclosing agents and courts; between banks and their investors—even between banks and other banks. Overall, credit (from the Latin for “trust”) continues to flow steadily, but closer examination shows that nongovernment credit has contracted. Private lending has dropped 21 percent since 2007. Outstanding loans to small businesses dropped more than 6 percent over the past year, while lending to large businesses, measured in commercial loans of more than $1 million, fell nearly 9 percent.

He says there is a lot of failure to digest in a single paragraph. So let’s look sector by sector at the sorry state of facts in the financial system. He discusses how this destruction has led to issues in mortgage markets, CRAs etc.

In the end he says:

If we can agree that the recession wasn’t about bubbles but about the organization of knowledge, we can move on to restoring the systems that allowed the global economy to expand more in the last 60 years than in the previous 2,000.

We are now staring at a legal and political challenge. A legal challenge because American and European governments allowed economic activity to cross the line from the rule-bound system of property rights, where facts can be established, into an anarchic legal space, where arbitrary interests can trump facts and paper swirls out of control. The rule of law is much more than a dull body of norms: It is a huge, thriving information and management system that filters and processes local data until it is transformed into facts organized in a way that allows us to infer if they hang together and make sense.

Mainly, though, it’s a political challenge. Politicians must raise the financial crisis to commanding heights, where the entrenched institutional problems of a failing order can be addressed. Markets were never intended to be anarchic: It has always been government’s role to police standards, weights and measures, and records, and not condone legalized sleight of hand in the shadows of the informal economy. To understand and repair one of mankind’s greatest achievements—the creation of economic facts through public memory—is the stuff of nation-builders.

Hmm…He has been making these points earlier as well. Though this article is even more insightful…


Economics of expanded military bases

May 3, 2011

Bette Joyce Nash of Richmond Fed has a nice write up on this topic. The summary is there are both costs and belefits of military expansions:


RBI Annual Monetary Policy 2011-12 – a quick review

May 3, 2011

Each time you think the hype and dilemmas would be lesser for RBI, each time it increases.

April-2011 policy started with another effort to increase transparency at RBI. Till April-2011, RBI announced its monetary policy closed doors with bankers. This was followed by interaction with media in the evening and researchers next day.

From Apr-2011, RBI decided to live telecast the policy announcement on TV. The telecast was also streamed live on bank’s website. This was a great measure as now public knows the policies along with the others attending the meeting.

Now coming to the policy. First, RBI has made changes in the operating framework of monetary policy. Earlier it was both reverse  and repo rate which changed (along with CRR, SLR depending on the situation). Now, going by Deepak Mohanty report, RBI has decided to adopt a one rate framework with a corridor like seen in other central banks. New framework is 

  • Reverse repo lower than repo by 100 bps. Changes automatically with Repo rate and no more independent rate. To form bottom of the corridor
  • Repo rate in the middle becomes the policy rate
  • A new rate called – Marginal Standing Facility (MSF) above Repo rate by 100 bps. In this Banks can borrow overnight up to one per cent of their respective NDTL.  This is like the discount rate of Fed which is higher than Fed Funds Rate. To form top of the corridor.  Mohanty committee had suggested making bank rate as the top of the corridor. But a new rate has been added. RBI should have given some reason for the same.  
    Another important thing is banks will not need to take permission for waiver of default from SLR compliance. This is something this blog suggested in Dec-10 (taking insights from behavioral economics)
  • Weighted call rate becomes the operating target. This means the call rate movement becomes critical. RBI will try to keep it closer to Repo and in the corridor.

Based on this, policy rates have changed to:

  • Repo rates increased by 50 bps to 7.25%
  • Rev repo automatically becomes 6.25%
  • MSF to be operational from 7 May 2011 at 8.25% 
  • Bank rate and CRR unchanged at 6%

RBI has put up a paper to debate deregulation of savings bank rate. As spread between savings deposit and term deposit rates has widened this rate has been increased to 4%. This will hit banks further as now they will have to pay higher interests. Research shows savings deposits at around 12.5 lakh crore on March-2011. This would imply additional cost of Rs 6,250 Cr. The latest profitability numbers are still not out. In Mar-2010, net profits of banks was Rs 57,109 Cr. Based on 2010 figure the impact on banks profits could be around 10-11%. It should be lower as of now as profits must be higher. The Net interest margins will be affected as well.

The basis of the hike is based on purely inflation concerns. The statement notes how inflation has been so persistent and always higher than RBI projections. Inflation control forms the theme of the RBI stance. RBI even says if growth is lower on a short-term because of inflation control measures let it be:

Over the long run, high inflation is inimical to sustained growth as it harms investment by creating uncertainty. Current elevated rates of inflation pose significant risks to future growth. Bringing them down, therefore, even at the cost of some growth in the short-run, should take precedence.

I never really understood the statements made by even noted names – one has to tolerate high inflation for high growth. It was plain silly. The fact is  low inflation is one of the most important factors for high sustained growth. In 2003-08 high growth period, average headline inflation was 5.30% and core was 5.00%. This made high growth possible. If inflation then had ran to around 10%, 9% growth would have been not possible.

The statement takes Gokarn’s highly useful speech forward. He showed there is a threshold inflation level for economies and if inflation higher than it, growth gets affected. This threshold inflation around 5-5.5% and current levels almost double this threshold. So, if your growth pushes inflation to 9-10% levels as is the case, growth will be affected via high interest rates and lower investment.

Some said you cannot have 9% growth and 2% inflation. Well we are talking about more reasonable 5-5.5% inflation. Who is even mentioning 2% when RBI’s long-term average inflation is 3%.  Subbarao rightly says in his press statement:

Before I close, I want to reiterate what I said earlier, by making a brief comment on the growth-inflation trade off, an issue that has been widely debated in the run up to this policy. High and persistent inflation undermines growth by creating uncertainty for investors, and driving up inflation expectations. An environment of price stability is a pre-condition for sustaining growth in the medium-term. Reining in inflation should therefore take precedence even if there are some short-term costs by way of lower growth”.

I hope that ends the so-called trade-off talks.

RBI has also hinted in inflation projections that inflation to remain at 9% till Sep-11 and then trend lower to 6% by mar-11. There is tremendous uncertainty on that outlook given uncertain oil prices, external demand etc.  

RBI’s projections for FY 2011-12:

  • GDP at 8%
  • inflation at 6% with upward bias by Mar-12
  • Non-food Credit at 19%, Money growth at 16% and deposit at 17%

The stance of monetary policy of the Reserve Bank will be as follows:

  • Maintain an interest rate environment that moderates inflation and anchors inflation expectations.
  • Foster an environment of price stability that is conducive to sustaining growth in the medium-term coupled with financial stability
  • Manage liquidity to ensure that it remains broadly in balance, with neither a large surplus diluting monetary transmission nor a large deficit choking off fund flows.

RBI also says meeting fiscal targets look difficult given high food and fuel prices. So monitoring of ficsal targets to be done with vigilance. Also deregulation of oil retail market to be done for better assessment.

Overall a much-needed policy. With policy rates even lower than core inflation, 50 bps was the need of the hour. Negative real interest rates in a high growing economy is just a disaster waiting to happen on inflation front. Banks were reluctant to hike deposit and credit rates saying 25 bps rate hike will not lead to any changes. So RBI has gone tougher. This should lead to tighter monetary policy and better transmission.

Other than this there are some measures to improve the financial market infrastructure as it is given in annual  and mid-term reviews. Some important ones:

  • Measures taken to improve banking sector resilience. Provisions enhanced for NPAs of banks. This to hit banks further.
  • Banks investing in debt oriented MFs leading to circular flow of funds. This investment capped to 10% of banks net worth. Aggregate bank’s net worth around 5 lakh crore. So net investment in debt mutual funds at 50,000 Cr.   RBI explains:

The liquid schemes continue to rely heavily on institutional investors such as commercial banks whose redemption requirements are likely to be large and simultaneous. DoMFs, on the other hand, are large lenders in the over-night markets such as collateralised borrowing and lending obligation (CBLO) and market repo, where banks are large borrowers. DoMFs invest heavily in certificates of deposit (CDs) of banks. Such circular flow of funds between banks and DoMFs could lead to systemic risk in times of stress/liquidity crunch.

  • G-sec trading: to extend the period of short sale of G-sec from the existing five days to a maximum period of three months.
  • Financial Inclusion: to allocate at least 25 per cent of the total number of branches to be opened during a year to unbanked rural (Tier 5 and Tier 6) centres.
  • Urban Coop banks:
  • to permit scheduled UCBs satisfying certain criteria to provide internet banking facility to their customers.
  • to permit well-managed and financially sound UCBs to become members of the negotiated dealing system
  • M-banking:
    • to treat mobile-based semi-closed prepaid instruments issued by non-banks on par with other semi-closed payment instruments and raise the limit from Rs 5,000 to Rs 50,000, subject to certain conditions.

    There are many others.  Read the report for more details….

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