Prospects for the US Dollar

Before World War II, the developed countries were on the gold standard. For every dollar printed, there was a dollar's worth of gold in the vault. After World War II, under Bretton Woods, gold was notionally valued at $35 an ounce but the discipline of the gold standard was gone. America could now issue paper money as basically IOUs to the world, where each dollar could buy a dollar of gold. The gold didn't have to actually exist.

By 1971, thanks to the free spending of the Vietnam War and rising trade deficits, the credibility of the dollar came under threat.That year, Richard Nixon abolished the fixed price of gold. The US could now devalue the currency and expand money supply freely.

The US is now the world's biggest borrower. But this period of debt financed expansion and printing of money may have gone too far.That is why countries Like China, who are major investors in US T Bills have cautioned the US government to control the fiscal deficit. What a reversal. China actually advising US how to manage its economy!

Central and eastern European currencies

Ref Financial Times dt March 6, 2009
The Hungarian forint has hit a fresh record low against the euro following comments from Jean-Claude Trichet, president of the ECB. In response to a question about whether the ECB’s collateral framework could be expanded to include eastern European assets, Trichet said that ’”sticking to rules as they are is important”. Concerns over the region’s ability to cover its funding requirements in the face of tightening credit markets and a slowdown in global trade have driven down currencies in the region in recent weeks.

Earlier an FT editiorial mentioned that a probable solution is to pursue a flexible approach and allow early entry of some if not all these currencies into the Eurozone. Currently, the Mastricht Treaty rules remain rigorously enforced on countries outside the eurozone even as some insiders flaunt the rules. For example, euro candidates must keep inflation at most 1.5 per cent above the three lowest rates in the EU; those three rates will probably soon be negative. Many new EU members have pursued a disciplined fiscal policy. The Czech Republic and Poland almost meet the criteria. Estonia’s and Bulgaria’s high inflation can be blamed on the Maastricht criteria themselves. By maintaining stable exchange rates in a credit boom, these countries became wide open to capital inflows that inflated their economies.

Many countries in the region are now under pressure in markets that fear a balance of payment crisis. They can be helped by speeding up euro accession. A quicker entry into the euro for countries with proven fiscal responsibility will help stabilise exchange rates. The requirement of two years’ participation in the EU’s exchange rate mechanism before being admitted into the Euro should be waived.

In contrast to Trichet's pronouncement, the FT editiorial mentioned : "A currency union needs rules. They must in the future be applied more strictly than they have been across the eurozone. But today they must be interpreted flexibly. A prudent Poland should not be made to atone for the sins of profligate Italy."

Recession fears mount due to uncertainty

Ref Gillian Tett, Financial Times March 5 2009

In the past few weeks, concerns about a sharp decline in global economic activity have mounted. In part, this can be blamed on tightening of credit by banks. But the sheer speed and global nature of this slump suggest that psychology is also to blame. People are feeling gloomy and uncertain on almost every front.

In the financial markets, the collapse of Lehman Brothers has created huge worries about counterparty risk. Also financiers are finding it increasingly hard to engage in the market “hedging” strategies they used to employ to mitigate risk. The pattern of deleveraging and forced sales has been so intense that traditional price relationships have completely broken down. Trading models have gone haywire.

Western governments do not seem to be doing much to remove this sense of uncertainty. The Lehman collapse has sown a sense of terror about creditors losing money on any bank bonds they hold. Governments must persuade investors that banks are so healthy they cannot collapse. Alternatively they must promise to protect creditors if they do.

The US and many European countries are rolling out piecemeal solutions. Meanwhile, efforts to persuade the public that banks are healthy, have been unconvincing mainly because there is still so much uncertainty about asset values.

Will the dollar remain strong?

Ref : Dollar strength will linger, Mansoor Mohi-uddin, Financial Times March 4 2009

What explains the strong dollar? The inability of non-US banks to roll over short term funding of investments in illiquid US assets has been a key factor behind the dollar’s strength since last summer according to Mansoor Mohi-uddin, managing director of foreign exchange strategy at UBS.

At the height of the credit bubble in mid-2007, major European banks’ dollar funding needs was around $1,300bn. As the credit crunch worsened after the bankruptcy of Lehman in September 2008, securing this funding became very difficult due to the severe disruptions in interbank and foreign exchange swap markets and in money market funds. Also, some central banks withdrew dollar foreign exchange reserves they had placed with commercial banks before the crisis.

To ease the dollar shortage, the Federal Reserve provided swap lines with other central banks in October 2008. These have been extended until October this year, reflecting the need of foreign banks to keep borrowing dollars from domestic central banks.

While the dollar funding shortage in global banking persists, the greenback may continue to be strong against the other major currencies.

Bank of England cuts interest rates to 0.5%

Ref : Norma Cohen Financial times, March 5 2009

The Bank of England’s monetary policy committee (MPC) cut its key interest rate by half a percentage point to 0.5 per cent on Thursday and rolled out a programme to buy up to £150bn in government gilts and corporate bonds. It is the first central bank in Europe to begin quantitative easing – in an effort to kick-start demand. The programme will begin with an initial £75bn of asset purchases, to be composed mostly of government gilts.

The size of the full programme will be up to a maximum of £150bn but £50bn of that may be used to support the purchase of private sector assets – corporate bonds and commercial paper.


The MPC agreed that in future meetings it would monitor the effectiveness of the programme in boosting money supply “and in due course, raising the rate of growth of nominal spending, adjusting the speed and scale of purchases as appropriate.”

In deciding on the 50-point rate cut, the MPC considered the forecast in its March inflation report, which implied a substantial risk of inflation undershooting its 2 per cent target in the medium term. Moreover, data released since that report had done nothing to suggest an improving economic outlook.

Paul Keating calls for a new global financial architecture

Former Australian prime minister writing in the Financial Times has stressed the need for democratisation of the global financial governance process and improved
policy coordination across the world. Keating suggests the need to radically restructure the IMF with a governance structure that truly represents the wider world it claims to serve.

Keating adds that big fiscal deficits and recapitalisation of banks offer only a temporary respite to the crisis. Fiscal policy also has its limits. The US federal deficit may hit $1,700bn this year, or about 13 per cent of gross domestic product. Clearly the US is reaching the limit. What we need is for deficit countries to save more and spend less and surplus countries to do the opposite. This savings imbalance will not be remedied unless the global governance structure changes.

For instance, China has no intention of dealing with its surpluses by letting its real exchange rate redirect national resources. We cannot fully blame China for this stance. Following the crisis of 1997, what every Asian government fears is the political consequence of capital outflow. A good example is Indonesia, where Suharto was forced out of office in 1998. Until international monetary governance is sufficiently democratised, or at least is made more representative, no major developing country, will fall in line.

For Keating, inclusion is the only way to make the world anew. If it happens, the impact on confidence will be profound. What the world badly needs today as the recession deepens is for confidence to be restored quickly.

ECB slashes interest rates to 1.5%

Ref Ralph Atkins, Financial Times March 5 2009

Eurozone interest rates have been slashed by a half percentage point to the lowest level ever. The interest rate in the Eurozone will fall from 2 per cent to 1.5 per cent, bringing the total rate cut since early October to 275 basis points.

But official borrowing costs are still higher in the Eurozone than in the US and the UK - highlighting the central bank’s conservative stance in relation to the US Fed and the Bank of England.

The latest cut came after ECB governing council members received updated forecasts that indicated much worse contraction than in previous projections, released in December.

Spain reported industrial production in January was 20.2 per cent lower than a year before. German engineering companies reported January’s foreign orders were almost 50 per cent lower than a year before.

AIG's huge losses.

Ref : AIG still facing huge credit losses
By Henny Sender in New York Financial Times, March 3 2009

AIG has declared a $62bn fourth-quarter loss and confirmed that it would give the US government a stake in its two biggest divisions as part of a fresh $30bn rescue.
Meanwhile more losses may follow. AIG retains $12bn in exposure to credit insurance on positions mostly involving subprime mortgages. As of February 18, AIG could have to pay counterparties up to $8bn on these positions.

Ben Bernanke, Federal Reserve chairman, expressed his strong sentiments in an appearance before the Senate budget committee: "If there is a single episode in this entire 18 months that has made me more angry, I can’t think of one other than AIG.There was no oversight of the financial products division. This was a hedge fund basically that was attached to a large and stable insurance company.”

AIG burnt its fingers badly when it moved agggressively into selling credit default swaps to provide credit protection for collateralised debt obligations.AIG ran into trouble when its credit rating was downgraded and the value of the CDOs it insured fell, This forced it to post tens of billions of dollars in additional collateral with its counterparties. Pushed to the wall, AIG had no option but appeal to the government for a bailout in September.

In November, the Federal Reserve Bank of New York set up a limited liability company called Maiden Lane III – backed by $5bn from AIG and borrowings of up to $30bn from the Fed – to deal with the crisis. Maiden Lane III would buy CDOs from AIG’s counterparties and then tear up the credit insurance issued by AIG.

In the days after the creation of Maiden Lane III, AIG and the Fed approached about 20 counterparties with an offer to buy CDOs. By the end of the year, Maiden Lane III had paid nearly $30bn for CDOs with a face value of $62bn. AIG paid $32.5bn to terminate the credit insurance on the CDOs, recognising a 2008 loss of $21bn. Counterparties received 100 cents on the dollar for the CDOs, but the prices paid by Maiden Lane III suggested that the CDOs were worth 47 cents on the dollar.

Land acquisition in India

Ref Leader, Business Standard March 3, 2009

Land acquisition remains one of the key factors which is slowing down industrial growth in the country.The government’s failure to get land acquisition and rehabilitation bills passed by Parliament before the elections is a setback to reforms in this area. The two bills — the Land Acquisition (amendment) Bill, 2007, and the Rehabilitation and Resettlement Bill, 2007, aimed at avoiding a repetition of the violent incidents that rocked Nandigram and Singur. The final version, passed by the Lok Sabha without debate and in the absence of the Opposition got stuck in the Rajya Sabha because of stiff resistance from opposition parties.

The Bill to replace the antiquated Land Acquisition Act of 1894 sought to balance the need for acquiring land for development with the interests of the land owners and moved the law quite significantly to the side of the land owners. Thus, it confined forcible land takeover to just three purposes — strategic use, public infrastructure projects and commercial ventures which are strictly in the public interest. Also industry would have to commercially buy 70 per cent of the land required for a project before the state government could step in to acquire the rest. Industry has complained in some cases that such a change in the law would have made it difficult to set up new units, because land acquisition would have become next to impossible. However, this is not really true. The experience with some of the special economic zones shows that land was privately acquired to a substantial degree, without the use of force.

The rehabilitation Bill, too, had some welcome stipulations—like undertaking rehabilitation prior to land takeover, and providing employment or equity participation to the affected families. The value of land goes up dramatically once it changes from agricultural to industrial. The benefit from this flows almost entirely to industry. It is only fair that those who did not get any benefit from such change of end use should get an additional benefit, in terms of jobs or shares.

However, the whole legislative exercise could have proved futile, since the amendments would not have been binding on states as they are free to have their own policies in these areas. Some state governments have already put in place their own land acquisition and rehabilitation policies. Considering this, it makes sense to leave it to the new government to decide on the best course of action.

Explaining the role of central banks in the sub prime crisis

Ref The Economist dt Sep 11, 2008

According to George Cooper of JP Morgan, one of the main reasons for the global financial melt down is that central banks have subscribed to one economic philosophy in an expanding economy and quite another when the economy is contracting. When things are going well, central banks leave the markets alone. But at the merest hint of crisis, central bankers cut interest rates to stimulate their economies and prevent asset prices from falling. Indeed, this is what the Fed under Greenspan did. Greenspan argued that it was impossible to spot bubbles while they were inflating. Instead, he felt that central banks should quickly respond once the bubble had burst.

This school of thought believes that prices reflect all available information. On that basis, asset prices are always “right”, there can be no bubbles and central banks should not intervene to restrain speculative excess. Even if there is a temporary mispricing, the market will correct itself.

Cooper argues that markets are far from efficient. Investors may simply be unable to get enough information to make correct judgments about the value of securities, or indeed may be given misleading information by insiders such as company executives or salesmen from the financial-services industry.

During a market crash, central-bank intervention to prop up markets is often popular. There are few people who relish banking collapses or recessions. But it creates problems in the long run. The first is that consumers (and companies) are encouraged to borrow, not save, thanks to the low level of interest rates and a belief that central banks and governments will always rescue them if things go wrong.

The second danger is that the system becomes progressively less stable as risk-taking is encouraged. Instead, central banks should permit some short-term cyclicality in order to purge the system of excesses. They can do this by preventing excessive credit creation. This means that credit growth should not be far ahead of economic growth.

Letting the markets have their way would risk a repeat of the Great Depression. But the danger of bailouts is that central banks may inflate another credit bubble, saving the economy from disaster in the short term but raising the stakes still further when the next crisis comes around. The Bear Stearns, Fannie Mae, Freddie Mac and AIG rescues, suggests the world is heading in that direction.

India's growth story at a cross roads

Till the recent slowdown, we had taken India's growth for granted. But now circumspection has increased. It is a good time to look at some of the structural issues which are impeding growth. The Economist dt Dec 13, 2008 ran a detailed feature on India. Here I look at few key points covered in the report.

In 2005 some 456m Indians, or 42% of the population, lived below the poverty line. In 1981, the numbers were 420m and 60% respectively. Clearly poverty in India is not falling fast enough. India has 60m chronically malnourished children, 40% of the world’s total. In 2006 some 2.1m children died in India, more than five times the number in China.

Some 65% of Indians live on agriculture, which accounts for less than 18% of GDP. Shifting them to more productive livelihoods would be hard.

India continues to be plagued by fiscal indiscipline. Public expenditure has risen by over 20% in each of the past two years. But the spending has not been productive. Instead, the government’s largesse was handed out in the usual wasteful ways—on oil and fertiliser subsidies and public-sector pay increases—and on some high-profile welfare schemes where a lot of leakages can be expected.

If India is to sustain a growth rate of 8% or higher, it will need to manage four potential constraints- infrastructure, education, labour laws and land laws.

The infrastructure is bad. It takes an average of 21 days to clear import cargo in India; in Singapore it takes three.

India’s 3.3m km road network is the world’s second-biggest, but most of it is in bad condition. National highways account for only 2% of the total, and only 12% of them, or 8,000km, are dual carriageways. By the end of 2007 China had some 53,600km of highways with four lanes or more. India’s urban roads are choked.

India faces an acccute shortage of power. Last year peak demand exceeded supply by almost 15%. According to the World Bank, 9% of potential industrial output in India is lost to power cuts. Some 600m Indians are not connected to the electricity grid at all.In the next five years, the government plans to increase India’s generating capacity by an annual 14%, or 90,000MW. China added 100,000MW in 2007. But India last year added only about 7,000MW.

Roughly 14m Indians are now being added to the labour market each year. They cannot all work for IT companies. Indeed, because of underinvestment in education, many lack the necessary livelihood skills.

Our labour laws continue to be drag. Our labour markets lack flexibility putting insiders at a tremendous advantage vis a vis job seekers.

Land aquisition continues to be nightmare. Recall Singur. Unless this issue is resolved, there will be strong incentives for industrialists.

Clearly there are many challenges ahead for the next govt. In the past 5 years, high growth came about to favourable circumstances and the dynamism of the private sector, not because of a visionary govt. But in future, things may not be that easy. If our leadership cannot rise to the occasion, we can expect China to increase the already large gap further.

Will UK, Iceland, Denmark and Sweden join the Euro?

Ref : The Economist dt December 13, 2008

The assets controlled by Britain’s banking system amount to 450% of GDP. This has drawn inevitable comparisons with Iceland. Like that Nordic country, Britain does not have a global reserve currency, to draw on if it needs to act as lender of last resort. Britain has access to currency swap lines from the world’s biggest central banks, which would help it prevent a run on the banks. But the cost of this insurance will make London less competitive as a global financial centre. Among larger European countries the British government’s exposure to its banking sector is by far the highest. Switzerland, Denmark and Sweden are also not too different from Iceland. Will all these countries now seriously think in terms of embracing the Euro? Going by the current levels of public and political sentiments, only Denmark seems a possibility.

India’s GDP growth slows sharply to 5.3%

Ref : Financial Times February 27 2009

Indian economic growth slowed to just 5.3 per cent in the last three months of 2008, its lowest growth rate in the last six years. India’s economy seems to have been hit by the global crisis far harder than our ruling politicians have thus far admitted.

The turn of events suggests that a sustained period of 9%+ growth will not be easy for India. Just because China did it for decades does not mean that we are already there.

Even though we are different from China in that we are not so heavily dependent on global trade, the parts of the economy which have generated rapid growth in the past decade, namely the IT and BPO sector are global. At the same time, in the last three months of 2008, other sectors too have not done well. Manufacturing declined 0.2 per cent, owing to insuficient domestic and global demand. Agricultural output also shrank by 2.2 per cent.


The sharp slowdown will increase pressure on the RBI to cut interest rates. Although the RBI has lowered its benchmark rate by 350 basis points in the last few months, falling inflation means real interest rates are realtively high.


But for higher government spending, growth would have been even slower. But this is not a sustainable solution. We know that government spending in our country is highly inefficient. Moreover, the government has little room for further stimulus given its already large fiscal deficit, estimated at 11.4 per cent of GDP. And even this could be an understated figure as our politicians and bureaucrats are adept at playing with numbers.

The pitfalls of low volatility

Ref The Economist, Jan 15, 2009

Volatility refers to the standard deviation of the returns of a portfolio. Volatility contributes to risk. Prudence demands that volatility is monitored and controlled.
But low-volatility should also ring alarm bells. Is the volatility low because the fund manager is buying illiquid assets. Because such assets are traded rarely, prices do not move much.

Or has the manager adopted a strategy with highly skewed returns; lots of small gains but the occasional catastrophic loss. Nicholas Nassem Taleb, the proponent of the Black Swan is famous for this argument. For example, the manager could be selling insurance against a big stockmarket fall. Most of the time such falls do not happen. But when the market falls, the insurer may have to pay out all his previous gains. Such strategies have been described as “picking up nickels in front of steamrollers”. Recall what happened to the monoline insurers last year.

Low volatility may also be the result of fraud. Many firms try to beat profits estimates by a small amount every quarter. Indeed one of the motivations of creative accounting is to reduce the volatility of earnings.

What we need is a change in attitude among investors. Life is volatile. Economies do not grow at a steady rate for ever. Markets do not rise at a steady pace and business conditions do not allow for a smooth rise in profits. So we must acccept volatility as a given in business. A portfolio manager who is committing high returns with low volatility may well be running a Ponzi scheme.

Debt is no longer chic

Ref The Economist, Feb 19, 2009

In 1980, more than 60 American non-financial companies qualified for the AAA rating from Standard & Poor’s (S&P). Now there are just six. In 1987 just 38.1% of issuers in the American bond market were rated as speculative, or “junk”. In 2007 junk-bond issuers made up most of the market for the first time.

Traditionally, debt has scored over equity in the sense that it reduces the cost of capital, creates tax benefits and most importantly imposes discipline. When managers know they have to pay back the capital they have raised, they will be careful. With equity, this pressure to pay back does not exist.

But as the Economist article explains, managers’ self-interest seems to have taken over at some point. Managers started using cash to buy back equity to boost earnings per share. They also favoured debt over equity to make the share price more volatile, and thereby make the option more valuable. Debt was also often used to finance acquisitions as part of empire building, a rtrend encouraged by investment banks, which had an incentive to recommend debt issuance and acquisitions, to earn fees. While all this was happening, activist shareholders such as hedge funds put pressure on companies to pay out surplus cash.

It is only in the current recession that the dangers of debt are becoming more apparent. The default rate is now rising rapidly. S&P believes that nearly 14% of bond issuers will fail to meet their obligations this year. It is difficult to roll over new debt, given the credit crunch. Meanwhile, suppliers are insisting on instant payment from companies with weak balance-sheets.

The problem for companies is there may not be much they can do right now to rectify the situation. A depressed market is hardly the time to issue equity. Also if an equity issue is announced, the share price tends to fall. For many American companies, the share price is in single digits. And any further fall may have catastrpohic consequences. After all the share price itself is a proxy for default risk as per the well known Merton Model.

The Citi bailout

On February 27th, Citigroup and the Treasury reached a deal that took a big step towards partial nationalisation. Through conversions of preferred stock, the government will own 36% of Citi, though the final figure will depend on how many preferred shares private holders agree to swap.
As the Economist mentioned today, the latest bail-out will give the government real control of Citi. The government does not need to own a majority of the shares in a bank to wield whatever influence it likes. With somewhere near 36% of Citi, control of decision-making will be complete—if it is not already. Citi already has to clear strategic decisions with regulators.
Citi approached regulators about the conversion, worried that further losses would as the recession and housing crisis deepen. Citi will need more capital in the coming months. And its current market cap of about $ 14 billion looks really puny indeed.

The crisis in Iceland

Ref The Economist dt Dec 13, 2008

The collapse of the krona and nationalisation of the country’s three largest banks in early October, 2008 have left Iceland facing a huge financial crisis.This is probably the biggest banking failure in history relative to the size of an economy. How did this happen?
Iceland ilustrates the dangers of a large globalised banking system in a small domestic economy. In 2007 Iceland’s three main banks made loans equivalent to about nine times the size of the booming economy, up from about 200% of GDP after privatisation in 2003. Only about one-fifth of those loans were in kronur; interest rates on these were very high. SO many Icelanders instead borrowed from their banks in cheaper currencies such as yen and Swiss francs.
But after the banks collapsed in early October, the currency slumped and domestic interest rates rose sharply. Exchange controls imposed in the heat of the crisis have severely restricted access to hard currency.
The IMF forecasts that the economy will contract by 9.6% next year. Many workers have been laid off. Many young Icelanders, who have never known unemployment, are expected to lose their jobs.
With unemployment rising, citizens talk openly about defaulting on their home and car loans. Principal payments on local-currency mortgages are indexed to inflation, which is expected to be 20% this year. This and their foreign-currency exposure means many households’ debts have roughly doubled in krona terms.
The failure of the banks may cost taxpayers more than 80% of GDP. Relative to the economy’s size, that would be about 20 times the Swedish government's banking rescue act in the early 1990s. The cost would also be several times that of Japan’s serious banking crisis a decade ago.
The crisis was fulelled by the aggressive business model of Iceland’s two largest banks, Landsbanki and Kaupthing Bank. These banks could attract only paltry sums in the domestic market. In 2006, they decided to use the internet to attract foreign deposits, using the cost savings from online banking to offer higher interest rates to savers. These banks were soon sucking deposits away from bricks-and-mortar banks across Europe. When Landsbanki collapsed in October, the country ended up owing $8.2 billion to foreign internet depositors of its banks, or about half of Iceland’s entire GDP.
Now the debate has intensified whether Iceland should join the Euro. Here opinion is divided among Icelanders. And even if the country decides to join the Euro zone, it will take quite sometime.

Tensions in the Eurozone

Spreads on the ten-year government debt of Greece, Ireland, Italy, Portugal and Spain over that of Germany have widened sharply. Rating agencies are closely watching the fiscal positions of the five countries.

The recession in the early 1990s saw various currency crises within Europe’s exchange-rate mechanism (ERM) , particularly in 1992, when Britain had to leave the ERM. One motive for creating the euro was precisely to avert such crises. Members of the Eurozone have at least been spared pressure from the foreign-exchange market.

But there is a price to pay for stable exchange rates. That is taking the shape of lost competitiveness, big current-account and budget deficits, and increasing concerns about creditworthiness.

In the 1990s the weaker economies in the euro zone made strenuous efforts, through fiscal tightening, wage restraint and product- and labour-market reforms, to satisfy various criteria and qualify for euro membership. But once they passed the test they relaxed, lulled into a sense of complacence that membership of the single currency would be enough to solve their economic problems. At the same time they enjoyed the benefits of a boom due to the euro’s lower interest rates. Once in the euro, and deprived of the chance to devalue again, they should have pursued structural reforms at home to make their economies more competitive. They should have emphasised fiscal discipline to offset the euro’s easier monetary policy. But they did not.

Now as these countires are entering a period of deep recession, the hidden costs are being exposed. In Spain and Ireland property bubbles that were inflated in part by the switch to low euro interest rates have burst spectacularly. In Greece, Italy and Portugal a steady loss of wage and price competitiveness is eroding growth. and in all these countries, public finances seem to be in a mess.
The bond markets are especially concerned about Greece and Ireland; but fears are growing even over such big countries as Italy (where public debt stands at over 100% of GDP) and Spain.

Argentina on the Danube

This is the title of an article which recently appeared in The Economist.
Many East European countries seem likely to default on their debt. At least the markets think so. The financial system in this region has combined badly run local banks with loosely overseen subsidiaries of Western ones. During the boom years, this system absorbed credit from abroad, leading to big current-account deficits. Because of reckless lending, often in foreign currencies, bad debts are likely to increase. Some local banks have failed; many of the foreign-owned ones now depend on their parents’ willingness to keep financing them. Unfortunately for them, those parents have plenty of problems at home.

All the countries are not facing the same problem. Poland and the Czech Republic have cut interest rates to cope with the slowdown but this has sent their currencies tumbling. This has increased the burden on households that have mortgages in Swiss francs or euros. Some countries like Hungary ( 100% of GDP) have a big external government debt. For Latvia, Estonia, Lithuania and Bulgaria, the strong euro is a problem. They have pegged their currencies to it.

All in all, this seems to be the most turbulent period for Eastern Europe since the collapse of the Soviet Union.

Swiss private banking at a cross roads

The core of Swiss banking, namely client confidentiality and privacy is being challenged. In the rich world, the mood against all big banks has turned nasty. The US has already taken a belligerent stand. At the G20 meeting in April, European leaders may discuss potential sanctions against tax havens that refuse to hand over information held by their banks.

As the Economist recently mentioned , at risk is up to $2 trillion in offshore assets held in Swiss private banks. There are also important questions at stake about the reach of the state and a citizen’s right to privacy.

Those who press for an end to banking secrecy argue that people who hide their assets want to evade taxes probably as much as $255 billion a year around the world. However, private banking is not just about tax planning. Clients have other fears too - divorce settlements, expropriation by fickle governments and thieving criminals. Also much of the new money that flowed into Switzerland in recent years may have come from countries with low or no personal income taxes, such as the Gulf. Moeover, a rapidly increasing share of money coming from European countries with high rates of tax is declared to the authorities.

Whatever be the case, the Swiss private banking industry is fighting a grim battle for survival.

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.