Was the Citigroup merger wrong?

The merger of Citibank and Traveller's Group in 1998 was one of the most publicised events in M& A history. Now that Citi is in deep trouble, people are questioning the merit of the merger. Adding to the intensity of the debate have been the forthright comments of former Citi CEO John Reed in the Financial times:

"The specific merger transaction clearly has to be seen to have been a mistake," Mr Reed said.

"The stockholders have not benefited, the employees certainly have not benefited and I don't think the customers have benefited because our franchises are weaker than they have been." ...

"Citi's troubles today are a culmination of a set of problems. There has been a general weakening of the management fabric," he said. "If the body loses its immune system, you are going to die of something. The core of what was happening was a lack of supervision and structure at the managerial level." ...

A few months back, the celebrated Daimler Chrysler merger broke down. Are we about to see the end of a long M&A boom?

Financial sector reforms need to deepen

According to Percy Mistry, one of the champions of Mumbai International Financial Centre, India's financial sector reforms have to accelerate. In particular, Mistry in an article in Business Standard has mentioned the folowing :

Reduce micro management by RBI and SEBI.
Dismantle the license control raj.
Liberalise derivatives and commodity markets.
Encourage more competition and innovation.

To be a global financial services player, Mistry argues, India needs :

An open capital account
Capable and efficient markets
World class institutions and responsive regulators
Less intervention by RBI and MOF.

Should the Fiscal Responsibility and Budget Management (FRBM) Act be scrapped?

The Business Standard came out with a very insightful editorial recently. "Should the Fiscal Responsibility and Budget Management (FRBM) Act be scrapped? For this law seems to be having the perverse effect of making the government hide more and more of its expenditure and not show it in the Budget. The finance minister can then claim that he is meeting FRBM targets, when in truth he is not. Scrapping the law might encourage more honest budgeting."
While Chidambaram claims that he has heroically slashed the deficit, the fact is that if all the "off balance sheet" items are considered including the oil pool deficit, farm loan waivers, the pay commission recommendations and last but not the least, the deficits of state governments, the deficit may cross 7.5-8.0% of the GDP.

Three main barriers to growth of the indian economy

According to a McKinsey report prepared about 7 years back, three factors reduced growth by as much as 4%. Little seems to have changed since then.
The factors are :
Multiplicity of regulations governing product markets.
Unfairness and ambiguity
Uneven enforcement
Reservation for SSIs
FDI restrictions
Licensing
Distortions in the market for land.
Unclear ownership
Counterproductive taxation
Inflexible zoning, rent and tenancy laws
Widespread government ownership.

Little progress on Pensions front

The government is not making much progress in the crucial area of pensions. The existing formal pension channels don’t cover unorganised sector workers.
Given the dismal levels of penetration of financial services, most Indian people are not contributing towards their old-age security.
The PFRDA Bill could bridge that gap, and give people greater control over their retirement benefits, but the Left has held it hostage.
Contrast this with the US. In 1981, Ronald Reagan launched the 401K plan in the US. The US pension industry, which was $60 billion then, is today a $9 trillion industry, with most of the money invested in equities.
Under the shadow of the Left, the government has hestitated to increase FDI limits from 26% to 49% in insurance. What a great pity.

India's rigid labour markets continue to create problems

The absence of a bankruptcy law and labour reforms, especially the difficulty in retrenching workers, has reduced the competitiveness of Indian firms.
The Industrial Disputes Act, 1947—particularly, Chapter 5B—bars manufacturing companies that employ more than 100 workers from firing employees without state government approval.
According to Amit Mitra, Secretary-General of the Federation of Indian Chambers of Commerce and Industry, employers have been reluctant to add extra staff during peak seasons because they cannot be laid off during lull periods.
"It has resulted in a paradoxical situation. Despite having surplus labour in the country, many large employers are expanding output through capital investment wherever possible."

India's business investment climate continues to be bad

It takes 71 days to get all requisite clearances for starting an enterprise in India. The same requires just five days in the US, six days in Singapore and 48 days in China.
It takes 425 days to enforce a contract in India, compared to 69 days in Singapore and 241 days in China.
In fact, according to a World Bank 2007 survey, ‘Ease of Doing Business’, India is ranked 177th out of 178 countries in enforcing business contracts.
Clearly nothing much to cheer for the Indian government despite its claims to be led by reformers like Manmohan Singh and Chidambaram.

Little in the 2008 budget for education

Despite the claims by the Finance Minister, nothing much is being done by the current government for education as the following statment by Nandan Nilekani of Infosys suggests. The statment by our Prime Minister on the other hand clearly suggests that for the government, education has a lower priority than giving away loan waivers ( Rs 60000 crores) to farmers.

"Higher education is a dark spot. Though FM has enhanced allocation for education, he hasn’t done much for higher education. Starting a few IITs is not going to make much difference to the country. Bold steps are called for to open the sector. While steps have been announced to invest in skills development and education, clearly they are timid.” Nandan Nilekani, Economic Times, March 1

“We are very keen to do more in these areas but we have our resource constraints. So we cannot do everything at one go.” Manmohan Singh, Economic Times, March

The fiscal deficit : India vs China

The Economist recently mentioned that according to official estimates, China's government ran a budget deficit of around 1%last year. But some economists reckon that the cautious government is understating its true fiscal health: it probably had a small surplus. If the profits of state-owned firms are also added in, the government could have a surplus of around 3% of GDP. China's public debt has also fallen to only 17% of GDP, well below the average ratio of 77% in OECD economies. Indeed, China has the best fiscal position of any big country.

By contrast, India, though improving, has one of the worst fiscal positions in the world. The government has tried hard to conceal this fact, boasting that it has reduced its deficit to an estimated 3.3% of GDP in the year ending March, from 6.5% in 2001-02 However, in a recent report the IMF argued that the true total deficit is closer to 7% of GDP once we add in the state governments' deficits and various off-budget items. If the losses of state electricity companies are also added in, the total deficit could top an alarming 8% of GDP. India's public debt is also uncomfortably high at about 75% of GDP.

Clearly, our Finance Minister should be more honest and transparent while presenting facts and figures.

A dollar rebound?

Will the US dollar fall further or will it stage a smart recovery? That is the big question for currency strategists as 2008 gains momentum and banks look beyond sub prime. There is still no consensus.

One is a bullish view on the greenback, despite the huge US trade deficit and the imminent slowdown of the world’s largest economy. The dollar bulls are hoping that investor expectations over the state of the US economy may have already stabilized. Although disappointing data will likely continue to come as the economy slows down, by its bold actions, the Fed has already inspired confidence in the markets and the US slowdown may have already been built into expectations. The 125 basis points cut towards the end of January in two tranches clearly signaled the Fed’s commitment to bold policy moves in order to get the US economy back on track. The Fed’s efforts to contain the fallout from any recession puts it ahead of the other G10 (Japan, Euro, UK, Switzerland, Norway, Sweden, Canada, Australia, New Zealand) central banks.

The prospects for a currency cannot be considered in isolation of other currencies. The bullish view on the dollar is supported by the disappointment of analysts with the ECB’s exclusive focus on inflation. In its most recent meeting held on February 8, the ECB did not change rates but admitted that there could be a slowdown. The dollar bulls argue that direction is clearly lacking from the ECB at present. So policy expectations will remain volatile, markets may feel uncomfortable and funds may flow out of the Euro zone. Jean Claude Trichet the ECB president did soften his stance at the most recent meeting last week and admitted that unusually high uncertainty was prevailing in the global financial environment. But the ECB’s stance towards inflation remains far more rigid than that of the Fed.


Meanwhile, the Bank of England, though not as aggressive as the Fed, last week, cut interest rates by 0.25% to 5.25%, citing deteriorating global growth outlook. But the bank did not completely shift its focus away from inflation as the Fed seems to have done. Unlike the Euro, there is little policy instability, especially since Mervyn King’s reappointment as BoE governor. However, there is weakness in the UK economy marked by slow growth and instability in the mortgage markets.

What about emerging market currencies? One reason for the greenback’s weakness in recent years is that US investors looking for higher returns have moved heavily into emerging market equities, assets and commodities. The latest data on US mutual funds, however, show that in December the share of foreign equities in American investors’ portfolios fell for only the second month of 2007 and only the fifth month in the last two years. The other times this occurred were during months of increased risk aversion. The last occasion was in August last year at the onset of the sub prime crisis. This increased risk aversion may well result in a further reduction of US investor appetite for overseas assets and thus reduce the downward pressure on the dollar.

What about the carry trade? That means borrowing low interest rate currencies like yen, selling them and investing in high interest rate currencies like the Aussie Dollar. Emerging data seem to indicate that arbitraging possibilities through carry trade are disappearing for the truly convertible currencies. The markets may well be coming around to the view that it is time to bet on low interest rate currencies (and the dollar is now one of them) as they have better fundamentals.

In January, the low-yielding yen and Swiss Franc were the two strongest currencies. Sharp sell offs in global equity markets on January 21 put “decoupling” further in doubt, and rating downgrades of bond insurers put credit concerns back in the spotlight. Historically, a rising level of risk aversion has helped safe-haven currencies such as the JPY and CHF and hurt “growth” currencies such as the Australian Dollar and New Zealand Dollar. Confidence in the carry trade collapsed in January. Indeed, the JPY outperformed all of the other G10 currencies in January, and ended the month up 5.3% versus the USD.

The medium term outlook for the dollar does seem bright, especially against the Euro. The dollar has held ground in the last 3 months against the Euro despite the steep cuts in interest rates. (See graph)The more the Fed eases now, the more it will remove these cuts, likely later this year when the US economy recovers. As long as the dollar holds up as the Fed cuts rates now, the dollar will have a good chance of rallying in the second half of the year when the Fed may start raising interest rates. When the Fed raises rates in a more upbeat environment, there might be a lot of support coming from the markets for the dollar.

The Fed rate cuts and their implications

These are truly exciting times provided you are an analyst or academic and you do not have any major exposure to the market! On January 30, the Federal Open Market Committee (FOMC), the monetary policy making authority of the US Federal reserve (Fed) decided to lower its target for the benchmark federal funds rate by 50 basis points to 3 percent. The Fed also cut its discount rate by 50 bp. (The Fed funds rate is the overnight interbank lending rate while the discount rate is the rate at which the Fed is prepared to lend short term to eligible banks.) The Fed explained: “Financial markets remain under considerable stress, and credit has tightened further for some businesses and households. Moreover, recent information indicates a deepening of the housing contraction as well as some softening in labor markets.” The Fed mentioned that it expected moderate inflation in the coming quarters, but it would continue to monitor inflation carefully. It hoped that the 50 bp cut would help to promote moderate growth over time and to “mitigate the risks to economic activity.”
The 50 bp cut has come on top of a 75 bp emergency cut on January 22. The FOMC’s justification then was the weak economic outlook and “increasing downside risks to growth.” The Fed added that while strains in short-term funding markets had eased, the general financial market conditions continued to deteriorate and credit had tightened further for some businesses and households. The Fed also anticipated the possibility of a deeper contraction of the housing sector as well as some softening in labor markets.
The aggressive stance of the Fed was earlier preceded by two 25 bp cuts on December 11 and October 31 and a 50 bp cut on September 18. In short, the Fed has cut interest rates by 2.25 % (from 5.25% to 3%) in a span of about 3 months. After being overshadowed briefly by the European Central Bank which led a major concerted effort by central banks to increase liquidity in the markets in December, the Fed has come back to centre stage.

The Fed clearly believes that more than anything else, it is interest rates which send the clearest and least confusing signals to the market. Some analysts have argued recently that instead of cutting interest rates in small doses and continuing the state of uncertainty in the markets, it is best to administer one major dose. The Fed’s actions seem to be aligned with this philosophy.

Some like the Economist have criticized the Fed for being influenced by short term movements on Wall Street. But this view is probably harsh. In a crisis situation such as this, action is usually preferable to analysis. Talk of rising headline inflation and hence the need to maintain status quo on interest rates is fine but the fact is investor confidence must be protected. We should also not bet too heavily on the emerging markets to bail out the global economy. The events of the last week have clearly demonstrated that the concept of “decoupling” can be taken too far. People are again talking about recoupling !

One of the widely cited reasons for the Great Depression of the 1930s was the lethargy on the part of the Fed to loosen monetary policy. The famous economist, Nouriel Roubini of Stern Business School recently argued in Newsweek that the current crisis is worse than the 1987 stock market crash. It is also worse than the Savings & Loan crisis of the late 1980s when only savings and loan thrifts and the commercial real estate sector were affected. And unlike the 1998 LTCM (Long Term Capital Management) crisis, today we seem to be facing both insolvency and liquidity problems. Today’s scenario is also different from the 2000-2001 US slow down when only the tech sector was affected. Roubini actually concluded: “We are of course far short of a Great Depression now but in terms of systemic risk and the risks of a financial meltdown, you almost have to go back that far to find a good analogy.”

Roubini’s views may be somewhat pessimistic. But at a time when we are still not clear about what is the extent of the sub prime losses and to what other sectors (like credit cards ) the contagion may spread, the Fed has not lacked in boldness and vision. The”Bernanke put” may be criticized by some intellectuals but will probably bring some cheer to the markets. And the animal spirits (a term coined by the famous economist Keynes) should not be allowed to flag. If they start flagging, restoring investor confidence will prove to be a monumental task.

From decoupling to recoupling ?

In recent months, analysts have been hotly discussing the concept of decoupling. Have the emerging markets finally broken free of their shackles and reduced their dependence on the US economy? And unlike the past when the US acted as the bellwhether and continued to come to the rescue of the global economy from time to time (Recall the Latin American debt crisis (1980s), Mexican(1994), Asian(1997-98 ) and Russian currency crises(1998) ) have the tables been turned at last? With emerging economies accounting for bulk of the growth in global GDP in recent moths, has the world reached another turning point?

Recent wild swings in the emerging markets seem to indicate that the theory of decoupling has been taken too far. While the world may not catch cold if America sneezes, it may not be that easy for the emerging markets to cure America if the largest economy in t he world does indeed catch cold.

As leading economist Stephen Roach of Morgan Stanley recently mentioned in Newsweek magazine, (Feb 4, 2008) we cannot talk of globalization and decoupling in the same breath. Interinkages between markets and economies across the world cannot be wished away, even if as Harvard Business School professor, Pankaj Ghemawat mentions in his recently released book, Redefining Global Strategy, we are living in a semi global world.

A second point is that the US is still a giant compared to India and China. American consumers spent an estimated $ 9.5 trillion last year compared to $ 1 trillion by the Chinese and about $ 650 billion by the Indians. As Roach mentioned, if the US does go into recession, “It is mathematically impossible to see a major decrease in US consumption being made up by the Chinese and Indians.” Clearly, despite their dynamism and their much higher growth rates, China and India are still small if we put things in perspective.

A third point , related to the second is that the emerging markets may be able to compensate for a slight slowdown in the US but they hardly have the firepower to reverse the impact of a deep recession on the global economy. As Jim O’ Neill of Goldman Sachs and a great believer in the emerging markets, has mentioned in the same issue of Newsweek, the US is 30% of the global economy whereas China is only 7%.” For now, I’m betting on recoupling. The world cannot ignore a US recession.”

A fourth point to note is that China and India are hardly “thought leaders” in the global economy. They get most if not all the ideas for doing business from the Americans. Most of the innovations by the Indian and Chinese companies have been process improvements. True, we have innovations like the Nano once in a while ( and we should be justifiably proud of these breakthroughs) but it will be quite sometime before India actually produces the kind of stuff which the Silicon Valley(California) or Route 21(outside Boston) clusters in the US produce. And many of our blue chips are heavily dependent on the US market for bulk of their revenues. They can hardly claim with any justifiable optimism that they will be able to make up for any loss in revenues due to a US slowdown by increasing their domestic business. Indeed the big bet, our IT services and outsourcing companies are making is that the Americans, driven by the pressure to cut costs, will further increase the quantum of outsourcing.

A fifth point is that our markets still take the cue from the US, not vice versa. After the terrorising fall in the Sensex on January 21 and 22, the markets recovered only after the US Federal Reserve made that bold 75 basis points cut. A few days later, when our RBI decided not to do anything about interest rates (and instead preferred to do what it seems to enjoy doing most, giving free advice to commercial banks on how much they should charge their customers!), the US markets did not panic. And let us remember that our blue chip companies are still doing well. Some have even shown smart increases in net income in the last quarter. On the other hand, billions of dollars have been lost by the Citis and Morgan Stanleys thanks to the sub prime crisis. If decoupling were really true, we should have seen funds arriving in hoardes in the developing countries just as in the past they would have moved out from emerging markets and taken refuge in US treasury bills.

That brings us to the sixth point. Indian and Chinese assets are rapidly becoming over valued. Anyone trying to buy a home today in one of our metros would need no further convincing about this point! At the same time, labour is also becoming expensive In India. As O’Neill mentioned, “ There’s been just a peristent, fantastic increase in emerging market assets , driving expectations of even more incredible gains. But assets in China and India aren’t cheap anymore. That means these countries are vulnerable to any kind of disappointing news.”

All this means that we need to be more cautious and get ready to tighten our belts. Clearly, the time has come to talk about recoupling and not decoupling.

Is more capital the solution to the banking crisis?

Two insightful pieces in Business Standard dt January 29, one an editorial and another an article by well known economist Lawrence Summers, explained at length the implications arising out of the sub prime crisis. Because of securitization, it has become difficult to pinpoint where risks lie and how to measure them. Financial institutions are holding various credit instruments that are impaired but difficult to value. This is creating uncertainty and freezing new lending.

Under the current circumstances, investors have become extremely risk averse, except for a few vulture investors like Wilbur Ross, who are on the prowl for distressed assets. So the valuations of asset backed securities are likely to be understated. During such times of panic, capital can give banks more staying power. As Summers put it “More capital permits more recognition of impairments and makes asset transfers easier by increasing the number of potential purchasers. It is preferable for the economy that banks bloster their capital positions by diluting current owners than by shrinking their lending activities.”

How valid are these arguments? To start with, we must appreciate that there are broadly speaking, three ways to deal with risk. One is to revamp internal systems and processes. That means strengthening risk measurement and control mechanisms. Unfortunately, in today’s situation, it has become difficult to identify tainted assets, leave alone measure risk accurately. Moreover, if banks swing to the other extreme and auditors start taking control of banks, lending and trading may be further discouraged. That is the last thing the financial system needs today.

A second method is to use derivatives and transfer risk quickly, ie avoid warehousing. If the bank does not understand the risk well or is uncomfortable managing it actively, it should be transferred through a derivative or insurance contract. Indeed, this is what Goldman Sachs, the player virtually unaffected by the sub prime crisis seems to have done.

The last is to have more equity, another name for capital. When risks are very difficult to identify or measure and we are in a situation where we do not know what we do not know, capital is the only credible alternative. Citi, UBS and other leading banks have all tried to recapitalise themselves in recent months, approaching sovereign wealth funds in the middle east and Asia.

There is no doubt that capital is critically important for a bank. Richard Brealey, an eminent academic ( from London Business School) writing in the Journal of Applied Corporate Finance( Fall 2006 ) observed that If the value of bank assets evolved smoothly and could be observed continuously then a bank would need only a minimal amount of equity capital. But to deal with “jump” risks, extra capital is required . Moreover, many asset values are observed only at discrete intervals. The greater the time between valuations of the bank’s assets, and the more volatile those assets, the more capital that would be needed. Finally, capital provides a safeguard against errors in valuing the bank’s assets.

But as the Americans say, there is no free lunch. Capital comes at a price. So banks should not hold too much capital. Otherwise they will not be able to meet the expectations of shareholders. Moreover, capital may be of little help if there is a run on banks. After all, the amounts raised by the global banks from the sovereign wealth funds, despite the media publicity and political reactions it has attracted, is only a small fraction of the estimated total exposure of banks to asset backed securities.

If prudent risk management demands that banks should only hold those risks which they should hold, this is a great opportunity for soul searching and financial restructuring. In an insightful article in the Harvard Business Review, (Nov 2005), the Nobel prize winning Robert Merton had mentioned: “ In most large companies, equity capital is used to cushion against a great many risks that the firm is no better at bearing than anyone else. If it can strip out the non value adding or passive risk, a company will be able to use its existing equity capital to finance a lot more value adding assets and activities than competitors and its shares will be worth far more.”

Equity is also an expensive source of capital. It does not enjoy tax benefits. Moreover, there are agency costs associated with equity that favor managers over shareholders. Unlike debt, where there are mandatory cash outflows, equity can make managers complacent.

To avoid these agency costs, some economists have argued that banks should be obliged to make regular issues of subordinated debt. The holders of this subordinated debt would have the incentive to monitor the bank. At the same time, the prices at which the debt is issued will reflect the bank’s creditworthiness. True subordinated debt will not solve all corporate governance problems. But there is no doubt that higher discipline will result if banks have to go to the market to raise debt from time to time. And we must remember that market discipline is one of the three pillars of Basle II, the others being supervisory review and minimum capital requirements.

As the banking system finds itself at a cross roads, there is little doubt that regulators today face the onerous burden of coming up with the right policy response. Merely raising the capital adequacy ratio may not be enough.

The Indo American Nuclear Deal

Why the Communists are barking up the wrong tree

Going by Indian media reports, one would think that the whole issue was about India compromising on her sovereignty by agreeing to various terms and conditions imposed by the US. Of course, it is the communists who have made the maximum noise. So much so that even during the past few days when much of the country’s attention has been riveted on the Hyderabad bomb blasts, the communists have remained completely focused on the 1-2-3 agreement. How misguided our communists are and how jaundiced their mindset is, can be best gauged when we read better informed and unbiased reports in some western media. The Economist (Aug 25) has for instance criticized the US for agreeing to give so many concessions to India. As we all know, India has not signed the Nuclear Proliferation Treaty (NPT). By making India accept International Atomic Energy Agency (IAEA) safeguards, even if on her own terms and conditions, the Bush administration has attempted to bring India out of isolation and make her take on similar responsibilities like the five major nuclear powers, USA, UK, France, Russia and China. India has not agreed to sign the test ban treaty. Moreover, India has reserved the right on what reactors can be inspected and when. As the Economist mentions, “Such unprecedented laxity in India will make it hard to get others to accept the tougher inspections that the IAEA wants as standard for all NPT members… Exemptions from India will convey a different message, “first get your bomb." Such rule bending puts at risk the anti nuclear regime that everyone else’s safety and security is built on."

In short, India seems to have succeeded in extracting several important concessions from the US. All this talk from the communists about India compromising her sovereignty must be dismissed as rubbish.

The essence of the India-US nuclear deal

(Ref: The Economist, August 25, 2007)

Though a nuclear arms power,India has not signed the Nuclear Proliferation Treaty (NPT). India has consequently been barred from civilian nuclear trade by America and other developed countries. Through the recently negotiated agreement, America has made an exception in the case of India. USA will supply India with civilian nuclear fuel and technology. In return, India has agreed to submit to safeguards on its civilian nuclear programme and will separate it from its military one.

But India has negotiated special terms. India will have a say in what reactors are inspected and when. India will retain the right to reprocess atomic fuel for energy generation, a procedure which will also yield fissile material for weapons. America’s nuclear technology will, however have to be returned, if India tests another nuclear weapon. At a meeting of the IAEA next month, India will seek approval for “India specific” safeguards. India will also need an exemption from the 45 nation Nuclear Suppliers Group (NSG) which bars nuclear trade with countries such as India, that refuse to apply international safeguards to all their facilities.

The sub prime crisis : Will cuts in interests rates restore risk appetite?

Will cuts in interests rates restore risk appetite and encourage entities to take up new debt. Or will growth slow down? According to George Magnus, writing in the Financial Times, the reduced availability of cheap credit will lead to a sharp reverse in spending. Magnus also mentions that the current crisis is different from 1998 when liquidity was the main concern. This time the problem is about solvency. The rapid deterioration in financial conditions and rising cost of capital will almost certainly lead to higher default rates. Magnus expects that in the near future, the price of capital will depress borrowing, capital mobilization, capital spending and employment. While the US will be the worst hit, Europe and Japan will slow down though not so much. But overall, the world economy may lose momentum and the business cycle may get rough.

Meanwhile, there have been wild swings in prices of some of the safest and most liquid government securities. After a flight to quality, there has been a massive sell off of T Bills. On August 22, the yield on one month treasury bill rose 83 basis points to 3.15%, while the 3 month T bill yield increased by 17 basis points to reach 3.44%. Swings of 50-100 basis points in T bill yields have become quite common. These fluctuations are of course the result of serious concerns about the $2130 billion commercial paper market, 50% of which is estimated to be backed by assets such as consumer loans, including mortgages and complex structured securities such as CDOs (Collateralised Debt Obligations) Money market funds, which are usually major buyers of such paper have shifted to the much safer T Bills. Till the markets become more confident that the skeletons are out of the cupboard, uncertainty and mistrust will continue. So will the market fluctuations.

Meanwhile, a more optimistic view has been expressed by Ken Fisher again writing in the Financial Times. According to him, while credit spreads have widened, they have not widened all that much compared to credit crunches of the past. Fisher also argues that a lot of cash hoarding is taking place, a clear signal that these are the late stages of a panic or correction, not the early stages of a bear market. Even today, interest rates remain low and debt is attractive. Firms can borrow globally and buy back shares to increase EPS. If that continues, the supply of equity will shrink and the bull market will resume.

Meanwhile, shakeouts continue. On August 23, Lehman Brothers announced plans to shutdown its sub prime mortgage unit, BNC Mortgage. Lehman will take a charge of about $52 million. According to company sources, sub prime lending activities account for less than 3% of revenues in recent quarters. Some 1200 people are expected to lose their jobs.

Meanwhile, Accredited Home lenders, a sub prime lender and HSBC have announced combined job losses of more than 2000. Accredited will cut 1600 jobs while HSBC will slash 600.

On the other hand, Bank of America has plans to invest $2 billion in country wide financial, the troubled mortgage company’s current market cap of about $12.6 billion. Bank of America’s move indicates that some companies are seeing a big opportunity to pick up undervalued stocks even as the market turmoil continues.

The Sub Prime Crisis: The Fed’s impact on money markets

(Ref: Wall Street Journal, August 21, Financial Times August 21)

About a week back (August 17th) the Fed reduced the discount rate, the interest rate at which the Fed provides funds to banks, as a lender of last resort. The Federal funds rate, the interest rate at which banks led to each other, has still not been cut. But the stock markets, in anticipation of such a cut, have bounced back a little. In contrast, the money markets, for whom the message was intended, have reacted in a negative way. Money market investors have retreated to safety, investing heavily in short term US government debt. On August 20, the yield on the one month treasury bills fell to 1.34% (about 160 basis points) while that on three month treasury bills fell to 2.51% (123 basis points). This retreat to safety is a clear indication that risk aversion has seized the markets. There is now speculation that the Fed will cut the Federal Funds rate on September 18, the date of the next policy meeting. Meanwhile, yesterday (August 20), major central banks continued to pump funds into money markets. The ECB has so far injected liquidity to the tune of Euro 95 billion on August 9, Euro 61 billion in Aug 10, Euro 47.7 billion on August 13, and Euro 7.7 billion on August 14. Yesterday (August 20) the Fed pumped in $3.5 billion of overnight funds while the Bank of Japan added $8.76 billion to short term money markets.

The Sub Prime Crisis: Some investors see an opportunity

(Ref: The Financial times dt August 21)

Wilbur Ross, the US financier specializes in distressed businesses. In 2000 he bought a bankrupt lender, Kofuku Bank of Osaka and sold it three years later for a profit. Planning to invest in the sub prime segment in a big way, Ross recently remarked, “We are going to be in sub prime. It is a valid business. There is nothing wrong with lending sub prime, what is wrong is doing it recklessly.” Having lent $50 million to American Home Mortgage, a move which he equates to getting his feet wet, Ross has much bigger plans ahead.

Ross’s move is reflection of the maturity and dynamism of the US financial markets. True there is currently a crisis. But even in a crisis, people are seeing opportunities. There is a lot of soul searching going on out there. No one is trying to downplay the magnitude of the crisis. The only debate is on what is the best policy measure under the circumstances. And what are the structural measures needed in the long run? If such a crisis had happened in India, the country’s leaders would have almost certainly gone into a state of denial, arguing that the crisis had been exaggerated. In contrast, the crisis is being discussed in a very transparent way in the US. Even Henry Paulson the highly respected Treasury Secretary and former Goldman Sachs CEO has admitted that the US economy will take a hit. The strength of the global economy, less dependence on the US, pragmatic measures by the Fed and the arrival of bargain hunters like Ross mean that there is still a silver lining in the cloud. The markets may stablise faster than expected.

The structural reasons behind the Sub Prime Crisis

(Ref Financial Times dt August 22)
In a recent article in the Financial Times, Martin Wolf, the well known columnist has dug deeper into the sub prime crisis. Many of the articles written on the subject have focused on the linkages between different markets. But this one looks at broad macro economic factors contributing to the crisis. We all know the US has been running a major current account deficit in the recent past. A current account deficit essentially means the country is spending more that it is saving. According to Wolf, there is an excess of savings over investment (and consumer spending) in much of the world. This has been offset by an excess of investment (and consumer spending) over savings in a smaller part of the world. In 2006, the countries with surplus savings generated a current account surplus of about $1300 billion. The US current account deficit absorbed about two thirds of this surplus.

In simple terms, foreigners have been buying US assets on a vast scale. The funds provided by foreigners have been absorbed by the US government and households since the stock market bubble burst in 2000. Between the first quarter of 2000 and the third quarter of 2003, there was a negative swing in the US budget balance of 7% of GDP. Household spending has also been on the rise since the 1990s. By 2006, households had accumulated a financial deficit of close to 4% of GDP. This household deficit has absorbed the financial surpluses of the business sector. This rise in household indebtedness has worked through asset backed borrowing. Or more precisely mortgages. This had to happen because with the US absorbing so much of capital, the government already having piled up a huge fiscal deficit and businesses showing surpluses, somebody had to spend to prevent the economy from going into recession. That is also why the Fed is likely to cut interest rates and sort of prolong the party. The other alternative which the Fed has, cutting the current account deficit or increasing the budget deficit, are not that practically feasible.

Wolf concludes on a poignant note: “Today’s credit crisis, then, is far more than a symptom of a defective financial system. It is also a symptom of an unbalanced global economy. The world economy may no longer be able to depend on the willingness of US households to spend more than they earn. Who will take their place?”

The Sub Prime Crisis: The dollar as a safe haven

(Ref: Wall Street Journal, August 20)

Whenever there is a crisis or a major instability in the global markets, the dollar attracts investor attention. As the saying goes, when the going gets tough, the tough get going. And the dollar is indeed a tough currency despite occasional see saws. During the Sub Prime crisis, with many market participants getting into serious trouble, the dollar has actually risen against the Euro. The yields the US government pays on its debt have fallen. The Wall Street Journal quotes Michael Dooley of the University of California at Santa Cruz: “The collapse of the yield on the 10 year treasury is probably the best indication of how quality is defined in people’s minds. The fact that the US still produces by far the best assets in the world, will as things settle down, be very good for the US.”

The fact that the ECB had to intervene with much bigger chunks of liquidity is an indication that the European markets are less able to adjust to rapid price movements than the US. The US has some structural problems to address but these are in a relative sense not all that daunting. Professor Catherine Mann of Brandeis University feels that the US current account deficit can be easily financed by investors unless an alternative investment emerges.

The Sub Prime Crisis: The impact on Asia

(Ref: Wall Street Journal, August 20)

If consumption in the US weakens, Asian economies will get affected. While ruling out an Asian financial crisis, Singapore PM Lee Hsien Loong admitted that economic growth could be affected if uncertainty continues and the US economy slows down. South Korea’s Kospi index fell 10.4% last week. Shares in big Japanese companies like Toyota and Canon also fell sharply on August 17th due to concerns that the rising Yen would affect export performance. The rising Yen is due to the unwinding of carry trade positions by investors who are scrambling for liquidity. IPOs are being postponed in Japan. More and more analysts feel that the Bank of Japan will not raise interest rates in the near future. This is a reversal of earlier expectations. Malaysian company MISC and South Korean car maker Kia are postponing their bond issue.

The Sub Prime Crisis: Strange developments in Asian currency markets

(Ref: Wall Street Journal, August 20)

Strange developments are being reported in the Asian currency markets. These are related to the carry trade, a favourite strategy among forex dealers for the past few years. The carry trade consists of borrowing the low interest rate Yen, and selling it and investing in high interest rate currencies like the Aussie $ and the New Zealand $.
In the wake of the sub prime crisis, with many investors scrambling for liquidity, there has been unwinding of these positions. That means people have sold the Australian and New Zealand currencies and bought Yens and squared off their positions to book profits. Consequently, the Yen rose 9% against the Aussie Dollar last week.
Indeed, trading in these Asian currencies has become so one sided that traders have been struggling to find buyers. In Australia, the trading reached panic levels on 17th August. Because of illiquid positions in London and New York, the Reserve Bank of Australia had to intervene. This is the first time in 6 years that the Reserve Bank has intervened. The Bank has indicated that it is ready to act again if needed.

The puzzling ways of the left in India

The left parties live in a world of their own. Their leaders are well educated and articulate. But they are probably the most misguided people in the world. Full of knowledge and little wisdom! Not surprisingly, they are bent upon creating problems for the current government on what is clearly a trivial issue (The1-2-3 agreement) and if need be, even bring it down.
The left finds it easy to open its mouth on any issue for no rhyme or reason. They have an uncanny knack for backing the wrong horse, be it Palestine or Cuba or North Korea. Not having any meaningful vision in life, they tend to support others without vision! That is why they did not criticize North Korea’s nuclear test. The left is a master of obstruction. They criticized the Marrakesh agreement that gave birth to the WTO and have consistently criticized economic reforms, including more recently those relating to pensions.
Unfortunately, the Congress lacks the guts to call a spade a spade. Instead of holding the bull by the horn, the Congress is trying to placate the west in various ways.
As I mentioned in one of my earlier blogs, the lack of enlightened political leadership is a major structural flaw in our economy. Whether it be Brazil or Russia or China or Argentina, the leaders in those countries may be a bit less intelligent but they are certainly wiser. There is a basic sense of purpose and a general consensus on economic reforms and progress. Just like a company cannot become great without sound leadership, without the right kind of politicians, there is little hope for the country.
The one man who has emerged the clear hero from the uproar is the US ambassador, Ronen Sen. By calling critics of the Indo-US nuclear deal, headless chickens he has articulated the view of many in the country. Notwithstanding his apology, Sen has done what Manmohan and Sonia could not! And for that he deserves a big round of applause.

The Sub Prime crisis : Impact on the real economy

(Ref: The Economist, dt. 18 August; The Financial Times, August 20)

Are the problems in the housing market affecting the real economy? Wal-Mart the bell whether of the US economy recently announced that spending by American consumers could fall in the coming months. The company gave a downward profit guidance.

As the pressure to generate liquidity increases, there have been sell offs in the oil market. Oil prices have fallen substantially from their peak of $79 per barrel reached in late July. The Economist’s metals index is 14% below the highs it reached in May.

Meanwhile, hundreds of US companies are facing significantly higher interest rates on the short term debt used to fund their day-to-day operations. Walt Disney, Heinz and Motorola are among the well known US companies which have major commercial paper borrowings. So far, however, the higher end of the CP market featuring issuers such as GE, IBM and AT&T, with higher credit ratings has been spared. The yields of these blue chips seem to be stable, at least for the time being.

The Sub Prime Crisis: What next from Fed?

(Ref: The Economist, dt. 18 August; The Financial Times, August 20)

How will the Fed respond to the recent turn of events? Many analysts are recalling what happened in 1998, as they try to predict what might happen now. In 1998, against the backdrop of the Asian currency crisis, the collapse of the Russian rouble and the Long Term Capital Management (LTCM) bankruptcy, the Fed cut interest rates by 25 basis points each, three times, beginning on September 29. Accordingly some analysts are predicting that the Fed will cut interest rates by 25 basis points on September 18 and again in October if required.

Expectations from the Fed are high keeping in view that the venerable financial institution played a key role in restoring sentiments both after the 1987 stock market crash and the 1998 LTCM collapse. Knowledgeable observers argue that the Fed, however, will be careful to avoid moral hazard. It will send signals based on the possible impact of market events on the real economy, not because of the plight of the financial intermediaries alone.

Meanwhile, the Economist in its recent issue has examined the kind of role that a Central bank should play during such crises. The Economist recalls how in 1873, the famous writer Walter Bagehot urged the Bank of England to stave off financial panics by “lending quickly, feely, readily at a penalty rate of interest to any bank that can offer good securities as collateral.” By lending liberally, central banks make it less likely that their money will be needed. By demanding good collateral, the central banks can distinguish insolvent banks from illiquid ones and by charging a penal rate of interest, they ensure that they are truly the lenders of last resort.

What Bagehot mentioned in 1873 is exactly what the Fed (and the European Central Bank) seems to have done in the past few days. The only difference (but a big one) is that the Fed did not charge a penal rate of interest. Meanwhile, William Buiter and Anne Sibert, two London based academics argue that central bankers must become the “market makers of last resort,” by setting a price for securities that can no longer be sold on orderly markets. This will prevent distress sales that can further aggravate the market turmoil. For example, the central bank could make a market in CDOs, either by accepting them as collateral or by buying them out right. But Buiter also makes it clear that hedge funds should not receive from central banks the same kind of protection as banks, unless they accept similar restrictions (i.e., like those applicable to banks) in the way they conduct their operations

The Sub Prime Crisis: Hedge funds in trouble

(Ref: The Economist, dt. 18 August; The Financial Times, August 20)

One of the first groups of market participants to find themselves in trouble when the sub prime crisis unfolded was hedge funds. Some of the hedge funds which have found themselves badly mauled by the market turmoil include the global equity fund of Goldman Sachs, Renaissance, a successful quant fund and various hedge funds in Japan. Basin Capital of Australia has also lost heavily.

Both human factors and computer driven models have contributed to the sad plight of these hedge funds. Banks started putting pressure on hedge funds to increase their collateral forcing them to take desperate measures to generate liquidity. At the same time, long-short equity neutral funds which assume that some stocks will rise while others fall, found that underlying assumptions behind their computer based trading strategies were faulty.

On August 13th, Goldman announced its leading global equity fund had lost more than 30% of its value within a week. The bank had to put in $2 billion of its own money and $1 billion contributed by investors. Renaissance, founded by James Simons, a prize wining mathematician also suffered big losses. Quantitative hedge funds in Japan seem to be among the worst affected. Whether hedge funds will stage a comeback in the foreseeable future depends on a big question. Will the pension funds, endowments and rich individuals investing in hedge funds hold their nerve?

As hedge funds find themselves in serious trouble, quantitative models are again coming under close scrutiny. Recall that they were the undoing of the celebrated Long Term Capital Management (LTCM) in 1998. Quantitative models try to find minute market inefficiencies and exploit them. Computers help in finding these inefficiencies quickly so that the traders can take advantage of them before they disappear. As many people start using similar models, such opportunities disappear.The only way to get ahead is to come up with more complex and sophisticated models. Long-short funds, for example generated profits as recently as February/March 2007, using this approach. But to get really good returns, leverage is needed. And as we have seen, leverage can be a risky proposition.

One major lesson which seems to be emerging from the crisis is that quantitative models also cannot overlook the behavioural factors involved in trading. As John Authers has mentioned in the FT (Aug 20), “ …human judgement when it comes to investment is flawed in predictable ways that lead to predictable mis-pricings in the market. A quantitative model that will follow rules set for it by humans, without the risk of human judgment subsequently messing things up, is needed to take advantage of those mispricings.”

In recent weeks, these models have come to naught. The models wanted the funds to hold certain positions. But the need to generate liquidity forced funds to sell their good investments. As many quants followed suit, what we saw were 25 standard deviation events which in normal circumstances, would happen only once in 100,000 years. Leverage amplified these losses. In other words, the models failed to account for the “fat tails.”

Authers mentions that mathematical models will need to improve significantly in the months to come. The quants must take into account:
 The herding effects, i.e., other funds taking similar positions
 Impact of their own actions on the market
 Need to use leverage to magnify returns.

If the regular steam of profits based on the models, comes up with huge losses occasionally, the combination of rigid quantitative strategies with leverage may not be all that appealing.

In short it looks as though there may not be that many leveraged active quant funds we will see going forward. Quite likely the ones that remain will belong to the large well capitalized investment banks.

The Sub Prime Crisis: Trouble at banks

(Ref: The Economist, dt. 18 August)

Many banks and financial institutions have been affected by the sub prime crisis. These include HSBC, Lloyds, HBOS (England), Coventree (Canada), Citi (USA), IKB, West LB, Sachsen LB (Germany). Some of these banks have used off balance sheet investment vehicles popularly called “conduits”. These vehicles are typically funded in the asset backed commercial paper market. The loans are cheap but of short maturity and are rolled over every few months. The conduits use the money to buy Collateralised Debt Obligations (CDOs), which are much higher yielding securities. But as market conditions have worsened, the source of funds has dried up and the problem has spread to banks who typically provide the conduits back up credit. The global asset based commercial paper market is estimated at $1.2 trillion, up from $650 billion three years ago. These are not trivial numbers and the rapid growth confirms that greed can drive markets crazy.

Banks have also gone beyond conduits and set up the more leveraged structured investment vehicles (SIV). Indeed, SIVs represent one of the fastest growing areas of structured finance. Some 23% of SIV assets seem to be in residential mortgage securities. Covenant-lite versions of SIVs (i.e., SIVs with less restrictions) are also floating around. These involve borrowings of up to 40-70 times the equity collateral. The SIV lites seem to have gone heavily into sub prime assets.

In an environment of mistrust, as these kinds of information come to the notice of the public, banks are being viewed increasingly with suspicion.

The Sub Prime Crisis: Trouble in the inter bank market

(Ref: The Economist, dt. 18 August)

The inter bank market is supposed to be one of the safest places in the financial system. After all, the borrowers are people with some of the best credit ratings gong around. But the sub prime crisis has challenged this assumption. On August 9th/10th, US rates hit 6%, 75 basis points over the Fed benchmark and in the Euro area, 4.7%, 70 basis points over the benchmark of 4%. Under normal market conditions, these spreads would have been much smaller. To ease the situation, the ECB provided funds to the tune of $131 billion on August 9th followed by about $85 billion on the following day. The Fed injected liquidity to the tune of $24 billion and $38 billion or the two days respectively. The Fed also allowed mortgage backed securities, though guaranteed by federal agencies, as collateral. The liquidity injection did succeed in pushing money market rates down. But it is not clear whether these moves have really dealt with the core of the problem – the absence of trust in the markets today. As the Economist summed up, “Markets are jumping at every shadow. Only when imagined bad news has been flushed out will inter bank markets return to obscurity.”

The Sub Prime Crisis: Dispersed risk becomes dispersed mistrust

(Ref: The Economist, dt. 18 August)

Securitization has been one of the major financial innovations of modern times. Securitization has helped banks in the past two decades to repackage mortgage loans, convert them into liquid instruments and sell them in tranches with varying degrees of risk to other market participants. They in turn have sold securities to other investors. This way, the risk has spread across the system. But this seems to have created more problems than solved them.

As the Economist (August 18, 2007) mentions, the dispersal of risk should logically lead to many players holding small losses. “But the swings in almost all financial markets this month have made dispersed risk suddenly morph into dispersed mistrust.”

The magazine quotes Avinash Persaud, a respected financial analyst: “Securitisation has meant that credit risks have moved from knowledgeable long term hands to fast hands, where the principal risk management strategy is to sell before the prices fall more.”

Let me give my own take now. Think of a spicy Indian dish. If big chilly pieces are seen floating, one can easily pick them out and avoid getting into trouble. If on the other hand, we have cut them into small pieces or ground them nicely, and the dish becomes “too hot,” people are going to consume little of that and whole dish may have to be discarded. A very crude anology but that may well sum up the situation today.

The Sub Prime Crisis: Is it worse than we thought?

(Ref: The Economist, dt. 18 August)

If one were to go by the recent issue of The Economist (18 August 2007), things are much worse than we thought. The mess has gone well beyond rash mortgage lending. Banks no longer seem willing to provide liquidity to each other. As the magazine puts it, “It is alarming when the very outfits that exist to supply the economy with credit start to hoard it from each other. At best, this tightens monetary policy, at worst a shortage of cash will cripple the payments systems and cause runs on otherwise solvent banks and businesses that cannot rapidly raise funds.”

The Economist has also neatly summed up the basic reasons contributing to the crisis. Lenders have indulged in reckless lending because they could easily securitise the loans and sell off the risk to someone else. Logically, risk should be borne by the party which is best equipped to understand and manage it. But thanks to slicing, repackaging and selling of risk, no one really knows where the risk has finally landed. There is fear all around that risks may have ended up with people who least understand them. Illiquid long term securities have been bought with short term debt, leaving borrowers vulnerable to a change in sentiment every time the debt falls due.

Now the markets seems to be adjusting and retreating to a new level of risk. The market jargon for this process is deleveraging. And going by past history that process may not be smooth. Yet, the Economist argues that central banks must resist the temptation to intervene. If at all they intervene, it must be not to save the financiers but to save the rest of the economy from the folly of the financiers. The Economist concludes on a note of warning: “ …anyone who says the worst is definitely over is either a fool or someone with a position to protect.”

A primer on the Sub Prime crisis

(Ref: Time, August 27, 2007)

Time Magazine recently gave a lucid account of the US sub prime crisis. For generations, U.S. home price appreciation largely tracked inflation. But since 1995, home prices began rising at an unprecedented pace. The boom created a lot of wealth but also created risks that spread far beyond the housing market.

To attract more home buyers, lenders began offering mortgages with only a cursory scrutiny of the borrower's qualifications. Many of these loans had low starting interest rates that would rise over time. As long as home values rose and interest rates stayed low, everyone was happy. But once prices flattened or fell and interest rates crept up, sub prime borrowers became vulnerable. They could not sell or refinance their loans because they owed more than what their home was worth.

In recent weeks, the scenario has changed for the worse and defaults by borrowers have increased. In the past, the trouble would end with a borrower in default and a bank foreclosing on the home. But today few banks hold onto mortgages until maturity. Most loans are securitized, ie bundled together and sold as mortgage-backed securities.

The new owners of the mortgages can use them as collateral to issue bonds to finance other deals. Money from thousands of homeowners covers the interest payments on those bonds. To attract investors, the bonds are rated by risk groups, called tranches. The more secure the bond, the lower the payoff for investors. Those who buy the riskiest pool of bonds - the ones backed by the riskiest home mortgages - are promised the highest return.

To further complicate the picture, some firms create structured finance products, called collateralized debt obligations (CDO), from pieces of other mortgage securities. These new bonds are re-rated, creating an illusion of safety even though the top-rated bonds may include very risky original loans. Last year nearly $500 billion in CDOs flooded the market. Many hedge funds invested heavily in them, often using borrowed money, and thus increasing their exposure.

In short, the entire process is based on using borrowed money (home mortgages) as collateral to borrow more money (mortgage-backed securities) to borrow yet more money (CDOs), and hoping the payment chain does not break. Once home-mortgage defaults started, the whole system began to unravel. Without the payments from homeowners, the issuers could not pay off the bonds. The bonds lost value, and the hedge funds that borrowed money to buy the bonds had to put up more collateral. Alternatively they had to try to sell the bonds, which caused their value to drop even more. The rout began. Banks tightened credit, raising the cost of financing corporate and private-equity deals. Other investors then wanted to reduce their risk. Stock prices fell, and bond prices rose. With global markets so closely linked, fear began to spread rapidly around the globe. Tighter credit meant fewer people getting home mortgages, further depressing the housing market and perpetuating the cycle.

The Sub Prime crisis-How legitimate are the fears of a crash?

(Ref: Gillian Tett, Financial Times August 17)

An insightful article by Gillian Tett in the Financial Times dt. 17 August 2007 mentions that the current market turmoil cannot really be called a crash. We have not seen a big drop like what we did after the dotcom boom of 2000, say. The article then goes on to cover the various concerns arising out of the market turmoil.

Is the turmoil a prelude to a bigger bear market? There is no doubt that the contagion is spreading. Initially, defaults were rising among American households with bad credit histories who had taken out mortgages – i.e., the “subprime” sector. This hit the debt markets because mortgage loans were repackaged into new securities and sold by banks to new investors. When US homeowners defaulted, the value of these related securities suffered.

Then came the hedge funds who bought sub prime securities. These hedge funds, typically borrowed money from investment banks. When these funds suffered losses on their sub prime securities earlier this year, banks asked them to funds post more “collateral”. At the same time, some hedge fund investors started to demand their money back. So hedge funds came under pressure to raise cash in a hurry. Some responded by cutting their risky strategies and conducting firesales of their assets. This is how the contagion is spreading to other markets.

When things go wrong, many things often go wrong at the same time. That is what seems to be happening now. In the past couple of weeks, the computer models that some hedge funds use to make trades have gone haywire. These models typically scan markets to spot tiny price discrepancies, and accordingly place large orders. Under normal market conditions, this technique often produces great results. But in recent weeks it appears to have triggered a flurry of equity sales, which has not only hurt the markets, but also created big losses at some hedge funds.

Now the concerns are shifting from hedge funds to banks. True banks have sold subprime securities to other investors, which means they are not directly affected. But banks have also promised to provide credit lines to other institutions with subprime exposure, such as mortgage lenders, if those institutions have problems raising finance in the financial markets. Right now, some of those secondary groups are facing funding woes, making it likely that they will soon demand credit lines from the banks.

True most of the global banks have very strong balance sheets. But what makes the situation very intriguing is that they are under pressure right now from several sources. For example, banks have arranged loans to risky companies, such as private equity buy-out groups. They are now finding it hard to sell these loans because investors are so nervous. That means an estimated $300bn worth of unsold loans are sitting on their balance sheets. And, these pressures are coming at a time when banks themselves are facing problems raising funding in the money markets.

Indeed, raising funds has suddenly become more difficult, creating serious liquidity problems. Investors in the money markets are very nervous about lending money to anybody who might be potentially exposed to subprime losses! And because of financial innovations and slicing and dicing of risks across the financial system, it is hard to know who is holding subprime exposure. So anyone looking for funds is being punished in an indiscriminate fashion without seriously examining the fundamentals.

Central banks are now getting involved. Last week, the European Central Bank pumped liquidity into Europe’s overnight money markets. The Fed, has also sprung into action cutting a key discount rate by 50 basis points. The Fed has promised to pump even more money into the market, to help the banks get access to funding. It has also signalled its willingness to take even more dramatic steps, in the future. But we don’t know yet whether all this will be enough to ensure that the money markets will work normally again or stop investors worrying about where the losses on subprime loans now lie.

One way to understand the market turmoil is to see it as a period during which investors and institutions cut their debt levels. De-leveraging a financial system is never easy, and financial history suggests this often leads to economic shocks. However, in many ways, de-leveraging is good news. For in recent years, debt levels have become unhealthily high in parts of the financial world, because the cost of borrowing money has been quite low.

What might make the current bout of de-leveraging less painful than before is that it is not mainstream companies that are burdened with excess debt. Instead, the pain is now being felt in hedge funds or private equity groups. Meanwhile, the “real” economy has been performing pretty well recently. In theory, this according to the optimists should provide some cushion against these market shocks. Will the optimists be proved right? That is the billion dollar question staring at the markets.

The Rupee

Some observations on RBI's exchange rate management

I used to teach International Finance to CFA students in the late 1990s. Those days, the main question which would come up in the class was whether the rupee would plunge, (as it did in Asia, during the Asian currency crisis) if we had less restrictions on capital flows. Those were the days when the prospects for the Indian economy in general and the Indian IT industry in particular were not that firmly established. Neither had growth rates picked up nor had companies like Infosys and TCS reached anywhere near today’s scale. The general feeling we had was that the country had been saved by the lethargy of our policy makers (articulated in as many words by the famous economist, Paul Krugman, who was then on a visit to India). Several rounds of discussions had not built up political consensus about the need for capital account convertibility. As a result, decisions were postponed time and again. This benefited the country as the rupee held its own even as the South Korean Won and the Indonesian Rupiah plunged as did the Malaysian Ringitt and the Philippine Peso during 1997-98.

In general, the Reserve Bank of India (RBI), has been comfortable maintaining the rupee in a narrow band. Notwithstanding its pretensions, RBI likes to micromanage and dole out directives/instructions one after the other to market participants. Now, however, there are signs of change. Since March 2007, RBI intervention seems to have decreased and the currency has appreciated by 10% in the last 4 months or so. One reason for this trend is that the RBI feels rupee appreciation, by making imports cheaper would help control inflation. That way the RBI will not have to raise interest rates again. Remember earlier interest rate hikes created turmoil in our mortgage market. But another unsaid explanation is that a central bank, especially in an emerging economy like India, is under less psychological pressure when the currency is appreciating compared to when it is falling.

Meanwhile, intervention does involve costs. Rupees have to be sold and dollars bought. These dollars have to be invested in risk free instruments. The risk free interest rate on dollar assets is currently about 3% less than that on rupee assets. But as well known econom