Tuesday, March 16, 2010

Is the infrastructure allocaton adequate?

Vinayak Chatterjee, an infrastructure expert, writing in the Business Standard ( March 15, 2010) mentions that the total size of the Union Budget is about Rs 11.09 lakh crore. The infrastructure allocation is thus 16 per cent of the Union Budget. Of the Rs 373,000 crore of Plan expenditure, the infrastructure allocation is Rs 1.73 lakh crore or 46 per cent of Plan allocation. So it would seem that the government is taking infrastructure very seriously indeed.

But how much of these allocations actually result in the creation of infrastructure assets? For example, the allocation of Rs 40,100 crore for the National Rural Employment Guarantee Scheme (NREGS) in the Rural Development Section, does not all go towards creating infrastructure. Probably only a very small proportion does. But as Chatterjee mentions, this is the way the finance ministry currently "defines" infrastructure!

As per the 11th Plan, the nation needs $500 billion (Rs 22.5 lakh crore), or $100 billion per annum. This translates into a requirement of Rs 450,000 crore per annum. Of this, the Union Budget is able to provide for Rs 173,000 crore, or roughly 38 per cent. Chatterjee argues that this is very much in order, considering 30 per cent is slated to come from public private partnerships (PPP), and the balance of 32 per cent from states and off-Budget resources. I tend to disagree. Much of the so called budget allocation will not lead to capital formation but will go into revenue spending or in a worst case scenario, end up as leakages.

I have a simple question. Why does it need someone like Chatterjee to do all these calculations and figure out what is going on? If Pranab Mukherjee is truly convinced that what he is doing for infrastructure is enough and far more than any other budget in recent years, why could he not give us all the relevant facts? The very fact that we still do not know for sure what are the tangible outcomes of a flagship program like NREGS shows that the government has no accountability whatsoever. It can keep rattling off figures and we would never know what is the ground reality.

Friday, March 12, 2010

The Non Operating Income Trap

Writing in Business Standard (March 11, 2010), the reputed economist, Shankar Acharya has reiterated a basic flaw in the government’s approach to fiscal consolidation. The 1.4 % reduction in the fiscal deficit in the coming year will rely heavily on a few items: an additional Rs 15,000 crore of PSU disinvestment proceeds, Rs 35,000 crore of the much-postponed 3G telecom auction proceeds, about Rs 20,000 crore saved on account of no Pay Commission arrears, about Rs 15,000 crore saved on account of no loan waiver payments and Rs 10,000 crore saved on account of no oil/fertiliser bonds. Together, these five items add up to Rs 95,000 crore or 1.4 per cent of fiscal deficit ratio improvement claimed by the Finance Minister!

But many of these items are one-off in nature. And in corporate language they would be called non operating income. In other words, the worry is how will further deficit cuts be achieved?

The bond market is usually a powerful judge of government policies. In the second week of March, the 10-year benchmark interest rate crossed 8 per cent, reflecting the concerns of that market. The hardening of yields is also a sign that markets are anticipating higher inflation.

Meanwhile, the government has sought to assure industry that there will be no crowding out effect due to government borrowing. But Acharya mentions that unlike last year, excess liquidity may not remain as the RBI will most likely continue its exit from its expansionary policy introduced at the peak of the global meltdown in 2008. At the same time, commercial banks are already holding almost 30 per cent of their assets in the form of government bonds. They may have little appetite for more such assets, especially when there is a risk of capital losses due to higher interest rates. So, the only way to offload government paper may be to offer higher interest rates. This will drive up interest expenses for the government adding up to the structural deficit. More importantly, by increasing the cost of funds, investment and growth may also be affected.

In other words, the budget has painted a far more optimistic scenario than would be justified if we take into account the ground realities.

More about PSU disinvestment

John Samuel Raja of Outlook Business (March 20, 2010) has provided a comprehensive picture of PSU disinvestments in our country. Currently there are about 808 PSUs. Their revenues add up to about Rs. 20,55,000 crores and their net profit to about Rs. 107,000 crores. Their assets are currently valued at about 103% of GDP. But their overall financial performance is disappointing. As many as 360 of them posted a loss in 2008-09. Some 212 PSUs posted profits of below Rs. 10 crores. The net profit was only 1.68% of assets for the PSUs as a whole. The corresponding figure for the BSE Sensex companies is 4.2%.

The PSUs which have been privatized seem to be doing well. Balco and Hindustan Zinc have been turned around by Sterlite. Maruti has also done well after the government offloaded its stake. The same goes for CMC, IPCL, VSNL and Jessop. In contrast, where small stakes have been sold and the government retains control, the functioning has become more transparent and accountable but the improvement has been less spectacular.

Outlook Business quoted Vijay Kelkar, Chairman of the 13th Finance Commission: “The motivation for disinvestment or privatization should not be narrowly seen as being only about maximizing proceeds from the sale of assets. The real big gains come from the full picture. We gain when the private sector attains higher productivity. And this happens even with mere disinvestment, but it happens much more strongly with privatization.”

It is estimated that a 10% stake sale in all the listed PSUs alone could result in revenues of Rs. 180,000 crores. That would help bridge almost two thirds of the revenue deficit. More importantly, by disinvestment, the government can free up resources that can be better utilized for education, health care and various items of physical infrastructure.

Clearly we need a much bolder vision than what the finance minister has articulated in the recent budget.

Beyond the Budget 2010

Bibek Debroy one of my favourite economists (Business Today, March 21, 2010.) has come out with a wish list of items which should get implemented by the government in the next 4 years. I am listing below a few of them.

a) Budget speeches should be restricted to 500 words and seven minutes.

b) The fiscal deficit should come down to 3 percent of GDP and revenue deficits should come down to 0 per cent.

c) All off-Budget items must form a part of deficit calculations. All personal and corporate tax rates must be standardized, with no exemptions. All exemptions must go for indirect taxes too.

d) Subsidies must be replaced by direct, but conditional cash transfers. Using UID numbers and based on individual socio-economic criteria, below poverty line (BPL) households must be unambiguously identified. Non BPL households must not receive subsidies.

e) Over time, the secrecy surrounding the budget must go. The budget must be placed in the public domain even before it is placed before Parliament.

I am adding to Debroy’s list.

a) From now on, the finance minister must spend less time on grandiose promises and instead talk about what happened during the year that passed, what was achieved, what could not be completed and so on.

b) The finance minister should not throw up numbers that by themselves are prone to misinterpretation. Thus he must not just say that he is allocating say Rs 30,000 crores for roads. He must also indicate how much of road construction the country needs, how many kilometers of road can be constructed with Rs 30,000 crores, how much China is spending on roads every year, etc. Then the public can make an informed judgment about whether the allocation is adequate or justified.

c)The government is spending the tax payer’s money. So we have every right to know how our money is being spent. Which means fiscal discipline is crucial. The non plan expenditure must be subject to stringent controls. The minister should not just mention that the revenue deficit has been cut to 4% of GDP. He must indicate what items have been cut, what items remain. Then the public can understand whether fiscal discipline is being implemented cosmetically or by cutting unproductive expenditure.

d) The Finance Minister himself need not present the budget if there is a danger of putting people to sleep. A smart bureaucrat who is an excellent communicator can be chosen for the task. The budget should be presented in such a way that it is inspiring and impactful even if it does not throw up surprises. So I would probably suggest about 20-25 minutes may be given to make the presentation.

Wednesday, March 10, 2010

The need for a new approach to budgeting

The problems in Greece have alerted us to a fundamental problem with government accounting. It lacks transparency. The Greeks fudged their way through the process of meeting the Maastricht deficit/ debt criteria in order to gain entry into the Eurozone. Finally they have been caught.

What about India? How transparent are the Government accounts? Take the recent budget. Not a word about what was promised last year , what has been delivered during the year that has passed, why there were shortfalls and so on. In many cases such as infrastructure, highly aggregated figures have been provided that make it quite difficult to understand and assess the quality of spending. And the fact that the unproductive revenue deficit remains as stubborn as ever has been conveniently brushed under the carpet. Year after year, we hear the Finance Minister making pompous statements about the future. Each year, the Finance Minister talks about how he has put in place a budget that will promote inclusive growth and so on. As though his grandiose statements by themselves will generate growth.

And when all this happens, our media and business with some rare exceptions keep applauding from the sidelines. One well known personality even described the latest budget as the first non populist budget after independence.I have seen few articles in the media that have pressed for more information from the Finance Minister.

There is a saying that the people get the government they deserve. India is a shining example.

Monday, March 08, 2010

Inadequate allocation for Infrastructure in India's budget

T N Ninan writing in Business Standard, 6-7 March 2010 ( Mamata's China tour) has nicely captured a fundamental flaw in the recent budget: the inadequate allocation for Railways. I mentioned in an earlier blog that too much has been made out of the allocation of about Rs 173,000 crores for infrastructure. Ninan has given useful comparative figures about China to drive home the point that the allocation is indeed puny.

China has connected Beijing / Shanghai, by high speed rail to Guangzhou, Wuhan, Zhengzhou, Tianjin, Nanjing, Xian, Taiyuan and other cities in China.These high-speed rail services operate at 350 km to 400 km per hour and extend over 3,300 km of track. The Middle Kingdom plans to offer some 40 such inter-city train services (including a new Beijing-Shanghai link), stretching over a total of 13,000 km of track, by 2012 — almost twice the distance of India’s “golden quadrilateral”. Even China's non-high speed trains now run at 200 km per hour or more.

In contrast, the best speed on Indian Railways has remained unchanged at about 130 km per hour for four decades. Some years back the Indian rail system was bigger than China’s. But now the Chinese rail system carries four times as much freight as Indian railways do. The gap will increase further. In 2009, China increased its investment in its railways by a staggering 80 per cent to about Rs 400,000 crore. Further increases in capital outlay are coming (Rs 550,000 crore in 2010).

Now compare these outlays with India's allocation of Rs 173,000 crores for total infrastructure. We can understand how our politicians make misleading statements and get away with them.

Tuesday, March 02, 2010

The fallacy of public sector disinvestment

In his recent budget, Mr Pranab Mukherjee announced that through disinvestment of public sector undertakings ( PSUs) , he would be able to cut down the fiscal deficit significantly. The Finance Minister has projected that he will raise about Rs 40,000 crores through disinvestment in the coming fiscal year.

Immediately after he made the announcement there was an intense debate in the media about whether the estimate was too optimistic. I would suspect the projection is indeed too optimistic for a government which in the recent past has been tentative when it comes to bold economic reforms.

But I have a more basic objection to the money from disinvestment being used to reduce the fiscal deficit. As I mentioned in an earlier blog, almost 73 % of the fiscal deficit is made up by the revenue deficit. And revenue expenditure items are bad for the economy as they do not create long term income generating assets. So what the finance minister is telling us is that he will sell the family silver to meet current consumption needs.

Let me explain this point with an analogy. When we middle class people sell a property, it is usually to buy another property. if we do not buy another property, we would at least put the money in a long term investment that will yield good returns over a period of time. We don't sell our property to land up in the pub or shopping mall everyday! Nor do we do so to go on an expensive foreign holiday.

Another misleading argument given by a leading business magazine in the country is that disinvestment of PSUs will lead to wealth transfer from the government to the public. That can happen only if the Government starts selling its stake in PSUs at artificially low prices. Why should anyone sell the family silver at distressed prices? When divesting, the Government's concern should not be with wealth transfer. It should be with getting the best possible price. After all, the wealth of the PSUs belongs to the entire nation. if the Government sells off its stake at unrealistically low prices, the people who benefit will be the top 5% of the income group. Whereas if the Government gets a good price, it will have more money available to eliminate unproductive expenses and also deploy in schemes which can help the poor.

What should the Government actually do with the disinvestment proceeds? I think the best thing it could do is to reduce the debt burden which has grown to humongous proportions over time. Reducing the debt burden will bring down the interest outflows which today constitute the biggest expenditure item in the budget.In contrast, using the disinvestment proceeds to fund the revenue deficit would be unethical and bad for the economy. It would violate the basic principles of fiscal discipline.

Monday, March 01, 2010

How non plan expenditure is wasteful

In my earlier blogs, I have mentioned that non plan expenditure is wasteful. Let us examine a few figures to understand this point.

The recent budget has earmarked Rs 735,657 towards non plan expenditure. Debt servicing accounts for Rs 248,664 crores , defence (revenue expenditure) for Rs 87,344 crores, subsidies for Rs 116,224 crores and pensions for Rs 42,840 crores. These are all expenses that do not really contribute to the creation of long term income generating assets. There are many other non productive items but I have only mentioned some of the more important ones. If our government is serious about fiscal discipline, it should make some efforts to control them. True in the recent budget, some effort has been to cut subsidies ( by about Rs 15,000 crores ) and defence services (by about Rs 1000 crores). But this is not enough. Meanwhile, the debt servicing burden has increased by about Rs 30,000 crores over the past year. Over the same period, the total non plan expenditure has increased by about Rs 30,000 crores.

These figures show that a lot more has to be done to bring back fiscal discipline.

Non Plan and Plan expenditure

In an earlier blog, I mentioned that the quality of spending is as important as the quantum. In the recent budget, the total plan expenditure is only Rs 373,092 crores. Out of this Rs 315,125 crores come under revenue spending and only Rs 57,967 crores come under capital spending.The non plan expenditure is as high as Rs 735,657 crores of which only Rs 92,508 crores come under capital spending. In general, non pan expenditure is wasteful stuff. Similarly revenue expenditure does not lead to long term income generating assets. In short, of the total expenditure of about Rs 11,08,749 crores, only about Rs 57,967 crores can be considered value adding. If this is the meaning of fiscal discipline, then there must be something wrong somewhere.

The Revenue deficit problem

Mythili Bhusnurmath, writing in The Economic Times, 1 Mar 2010,has come up with what looks to me to be one of the most incisive pieces of analysis on the Union Budget, 2010. While Finance Minister Mr Pranab Mukherjee has given the impression that the fiscal deficit is under control, what has been overlooked by most analysts is that the more dangerous revenue deficit is still far too high.

Revenue deficit as the name suggests is the gap between revenue receipts and revenue expenditure. By definition, revenue items do not lead to the creation of long term income generating assets.

As a proportion of the fiscal deficit, the revenue deficit has increased from just 41% in 2007-08 to 79% in the revised estimates for 2009-10 , and is expected to go down only marginally to 73% in 2010-11. So during the current year, out of every Rs 100 borrowed by the government, Rs 73 will be spent on consumption. Assuming an average interest rate of 8% on government borrowing , ie an interest outlay of Rs 8 ( on the borrowed amount of Rs 100), the government must earn a return of 8/27 or almost 30% on the remaining amount to be able to just meet its interest costs.

This kind of return would be a dream for even the most efficient private sector company. So, it is quite absurd to think that the government will be able to generate this kind of return. In short, the government will fall into a debt trap having no option but to borrow more and more simply to repay its loans.

As Ms Bhusnurmath has put it aptly, “ When a private party does this, we call it a Ponzi scheme and are quick to condemn it. But when the government does it, we fail to sit up and take notice.”

Projected revenues may not materialise

After the budget weekend, people have started analyzing the various proposals more deeply. It seems the revenues on account of the sale of 3G licenses may be less than projected to the extent of Rs 5000-10,000 crores or more. These doubts have risen because only three licenses are being auctioned instead of the original plan for four. The auction for the fourth slot has been postponed as the defence ministry has still not released the spectrum/radio frequencies. This may happen only in 2013.

The quality of Government spending is also important

Fisal discipline does not only mean reducing the gap between revenues and expenses. It also means cutting unproductive spending and raising productive spending. A good example of productive expenditure is infrastructure. It is estimated that a Rupee invested in highways can create Rs 7 of economic value.

Much has been made out of the fact that the Finance Minister has allocated about Rs 173,000 crores for infrastructure in the recent budget. But is this such a big deal? We are probably 40,000 - 50,000 km of highways short today, according to recent indications given by the Highways Minister, Mr Kamal Nath. To build a km of four lane highway it costs around Rs 8-9 crores. And to build a six lane highway, the amount would be about Rs 14 crores. Let us take an average of Rs 10 crores per km. So buiding highways itself calls for about Rs 400,000-500,000 crores of spending.

Mr Pranab Mukherjee's budget has allotted Rs 19,894 crores for road infrastructure. No doubt it is an increase of 13% over last year. But the amount will be sufficient to build only about 2000 km of highway. While the private sector will also chip in, we all know that the government has to lead the way in road construction. And our target is 50,000 km , not 2000km!

Similarly, an amount of Rs 16,752 crores ( increase of Rs 950 crores over the previous year) has been allotted for expansion of the railway network. This amount too looks grossly inadequate when we consider that the railways remain the lifeline for millions of people in the country. The Railways also remain the most cost effective mode of transporting cargo over large distances on land.

All this goes to show that the budget has serious lacunae. Unfortunately, the media has not bothered to drill deeper and do a rigorous analysis of the infrastructure proposals.

Sunday, February 28, 2010

Understanding the real meaning of economic reforms

It is quite clear that the recent budget presented by Mr Pranab Mukherjee had little by way of structural reforms. A few economists and businessmen had the courage and conviction to point this out while others, who valued their relationship with the finance minister more, made weak or no references to this aspect of the budget. It is about 20 years since India embarked on the path of economic reforms. So this is indeed a good time to take stock of the situation. But before we do that we need to understand he meaning of the word, " Reforms".

It would be too much to cover the topic exhaustively in a blog but I shall make an attempt to convey the essence. Reform means a new approach to doing things.For example, if the Government has been running certain businesses so far, where it is not really needed, it must gracefully withdraw and pave the way for the private sector to take over.

Reforms also mean that there is no free lunch. If we as consumers have been getting something free or at lower than the market prices, we need to start paying more so that over time the inbuilt subsidy is eliminated.

Reforms means that the Government gives up its powers in areas where it does not need to be a policeman so that businessmen can spend more time strategising and running the business instead of worrying about taking approvals from the government and complying with regulations.

Reforms mean that unproductive and wasteful activities that are a drain on our limited resources are stopped. This is turns means an easy exit route that enables companies to shut down operations which cannot be turned around.

Reforms means making the government's activities more transparent and imposing accountability on Government staff.

And now let us try understand what the word" Reforms" does not mean.

Reforms does not mean postponing price increases of items as justified by market trends.

Reforms does not mean giving lollipops to people by way of ad hoc tax reductions.

Reforms does not mean tinkering with excise and customs duties from time to time and thereby creating uncertainty in the minds of entrepreneurs.

Reforms does not making various futuristic statements of good intentions without the data to back them or the discipline and will power to implement them.

Reforms does not mean making grandiose announcements to spend more for the poor but without even bothering to check how much of this money will ever reach the poor.

Now examine the proposals in the recent budget. It will be amply clear how committed our Government is to structural economic reforms.

The real meaning of fiscal deficit. and why it should be under control

In the recent budget, the finance minister, Mr Pranab Mukherjee has sought to give the impression to the media and the general public that he has heroically cut the fiscal deficit even as he has handed out lollipops to the middle class in the form of widening of the income tax slabs. We need to understand why the deficit matters instead of getting lost in the numbers.

A huge fiscal deficit means the Government has to bridge the revenue expenditure either by borrowing from the market or by printing money. if the Government borrows, the private sector will be crowded out, ie it will be able to borrow less at the current interest rate. And we all know the Private sector, driven as it is by the profit motive, uses capital more efficiently than the government.

On the other hand, if the government prints money, it will lead to more rupees chasing the same quantity of goods, leading to inflationary pressures.

Sound principles of economic policy making dictate that during the good times, the Government should build budget surpluses that it can run down during recessions. This is exactly what is happening in the US where the deficit as a percentage of the GDP has reached double digits.

In our country, there was a minor slow down after the collapse of Lehman Brothers in September 2008. So there was probably a case for increasing the deficit in the last budget to make up for the reduced global demand. But today, there is little justification.

The developed countries have to be cautious about how they withdraw the fiscal stimulus because the recovery there is still fragile. However, this argument does not apply to India. We must also remember that notwithstanding the Finance Minister's claims of having the deficit well under control, if all the items like the shortfall on the oil account and the deficits of the states are considered, our country's deficit would also be running into double digits. That is why it is a little funny to see so much premature celebration over Mr Mukherjee's deficit cutting efforts.

No attempt to cut unproductive expenditure in India's Budget 2010

If the Government was serious about fiscal discipline, it would have done a lot to bring unproductive and wasteful expenses under control. Unfortunately, this has not happened. The total expenditure proposed in the budget is Rs 11,08,749 crores, an increase of 8.6% over the previous year. But more importantly, the unproductive non plan component works out to as much as Rs 735,657 crores. On the other hand, the Plan expenditure amounts to only Rs 373,092 crores.The non plan expenditure was only Rs 608,721 crores in 2008-09. In the next three years( including the forthcoming year), while non plan expenses would have gone up by about Rs 227,000 crores, the plan expenditure would have gone up by less than Rs 100,000 crores.The revenue deficit which is what really needs to be attacked, would have gone up by about Rs 23,000 crores over the same period. In short, the structural part of the deficit is only increasing year after year, notwithstanding the claims of the government.

Why are the country's top businessmen supporting India's budget 2010?

A quick glance at the leading dailies after Pranab Mukherjee presented the budget on February 26 reveals that most of our top businessmen are quite happy with the budget. It is quite clear that in the budget, there was not even a pretence of carrying out any structural economic reforms. Except for some tinkering with tax rates/ slabs, optimistic revenue projections and some lofty intentions, there was little really to suggest that the Finance Minister was on top of his job and knew what was needed to streamline the economy and boost the animal spirits. Very little ( if at all anything) has been done to bring the structural part of the budget deficit under control. Yet our leading industrialists are patting the Finance Minister on the back. Why is this so?

The answer lies in the mindset of the business class in the country. Right from the British days,our businessmen have believed in a marriage of convenience with the ruling class. People familiar with Indian History would know that the business class, though it always projected itself as a patriotic group, did not support Mahatma Gandhi in the freedom struggle throughout. When they realised that Gandhi was crossing the limits and their relations with the British Government might be severely damaged, these businessmen conveniently distanced themselves. At the same time, when their business interests were severely threatened, they came together and were quite vociferous in making various demands of the Government. The Bombay Plan is a good example.

Barring a few of our businessmen who have the courage and conviction to stand up to the politicians, most of the others are happy to allow the current state of affairs to continue. They are well aware that in an economy where the Government still plays such a central role, picking up fights with ministers, expecially the Finance Minister does not really make good business sense! The message of this blog is that let us not guage the quality of the budget from the reactions of our businessmen!

More about India's 2010 budget.

In the budget presented to the Parliament on Feb 26th, Mr Pranab Mukherjee projected revenues in the coming year from disinvestment of PSUs to be around Rs 40,000 crores and from auctioning of 3G licenses to be around Rs 35,000 crores. Together they add up to Rs 75,000 crores or about 1.1% of the GDP. These are very optimistic projections indeed and are based on a favourable economic and political climate, abundant risk taking by industrialists and strong foreign investment inflows.

It is quite possible that Mr Mukherjee's optimism is justified and may well turn out to be true. But the global economic recovery certainly looks fragile at the moment, expecially in view of the huge budget deficits in many developed countries and pressure to bring them under control quickly if not immediately. Look at what is happening in Europe. And it is quite evident that the global economy has still not returned to normal. India as we saw towards the end of 2008, is very much a part of the global economy. Under the circumstances, what is really inexplcable on the part of the Finance Minister is to give away about Rs 26,000 crores to the middle class by widening the income tax slabs. In my earlier blogs, I mentioned that salaried professionals like us have benefited from this move. But is it really good for the economy? Could Mr Mukherjee have not maintained the status quo if he was so serious about fiscal discipline?

Clearly Mr Mukherjee was more intent on playing to the galleries than on taking tough measures that would be good for the economy in the long term.

Why India's budget is misleading

The key theme of this year's budget was supposed to be fiscal consolidation. We indians are good at making simple things complicated. So let us start by understanding the meaning of this term. The word fiscal consolidation is bombastic and misleading. A better and simpler term would be cutting the deficit.

Very broadly speaking, the deficit can be reduced in two ways: by cutting expenses and by increasing revenues. In general, a combination of the two approaches is needed to bring down the deficit. One approach alone may not be enough.

I was hoping that Mr Pranab Mukherjee would tell us how he was going to eliminate wasteful expenses incurred by the Government year after year. But it is quite obvious that he did not even make a semblance of an effort in this regard.

Instead, Mr Mukherjee chose the easy way out. He tried to increase the excise duty and brought more services under the tax net. At least, if he had remained focused on additional tax revenue mobilisation, we could have given him the benefit of doubt. Instead, he has actually reduced income tax for many people by widening the slabs. This is a gesture which benefits the richer members of the middle class ( including people like me) but is of questionable merit as far as the economy is concerned.

Mr Mukherjee has also further complicated things by announcing more tax exemptions. This is something clearly unwarranted when the Government has already committed itself in public to a new and completely overhauled direct tax code in about a year's time.

Last but not the least, the finance minister has made convenient assumptions that he will be able to raise plenty of non tax revenue through public sector disinvestment and auctioning 3G telecom licenses. Imagine a CEO of a loss making company at the Annual General meeting announcing to the assembled shareholders nothing whatsoever about how he will cut overheads and improve efficiencies. Only that he will cut losses next year by selling off the company's real estate/office space. What kind of reaction can he expect from the shareholders? It would be very surprising indeed if paper rockets were not thrown at him.

The puzzling point is that the stock markets have reacted favourably to the budget. And market reactions are often correct. There is only one explanation for this phenomenon. Those segments of the society who are active stock market investors seem to have benefited handsomely through the widening of the income tax slabs. An equally probable reason is that the stock markets had such low expectations from Mukherjee that they were relieved when they saw the budget proposals.

Watch out for more in my forthcoming posts.

Saturday, February 27, 2010

A quick glance at India's 2010 budget

With a few lollipops here and there and some clever jugglery of numbers, our finance minister seems to have made a favourable impression on the media and the general public. True I myself have benefited from the budget through the rise in the peak income tax slab. But if fiscal prudence was the theme of the budget, Mr Mukherjee should not have cut income tax. He should have raised it. And if tax rationalisation was what he was trying to achieve, he should have removed, not added exemptions. He should also have shown more commitment to the GST( Goods and Services Tax) framework.

Mr Mukherjee has tried to paint a rosy fiscal picture by making some unrealistic and convenient assumptions such as heavy inflows due to disinvestment of PSUs and also cellphone license revenues. But if the opposition politicians could make such a hue and cry in Parliament about a small hike in the price of petrol/diesel, will the Congress Party really have the stomach to push through PSU divestment? And will license revenues be all that much as projected?

Watch out for more in my blogs starting from tomorrow.

Thursday, July 09, 2009

India's bad budget

Many economists/ media persons have tried to make the best out of Mr Pranab Mukherjee's budget. Unfortunately, their arguments are weak and unconvincing . Here is a government which had an opportunity to break free from the left. As we all know, the Left had consistently been stonewalling the reform initiatives for the past few years. Yet by sending out such confusing signals, the Congress has made it abundantly clear that the left was ( as Percy Mistry recently put it) " a convenient fig leaf for obscuring the inconvenient truth". The real opposition to reforms lies within the Congress. The party remains as socialist as ever. The way Mukherjee sang praises about Indira Gandhi's nationalisation of the banking system in the 1960s is a case in point.

Once we separate out the rhetoric from the substance, we see that the key messages from the finance minister/government are :

A) We will continue to waste the exchequer's money.

B) We know more than the markets.

C) We will continue to micromanage and meddle in the economy.

D) Accelerating the reforms process ( thereby encouraging entrepeneurship) is not a priority for us.

E) We can make any statements we like without substantiating data and get away with it.

F) Public memory is short and any commitments we make ( on fiscal discipline) can be conveniently overlooked at a later date.

Thursday, March 26, 2009

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!

Friday, March 06, 2009

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.

Thursday, March 05, 2009

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.

Wednesday, March 04, 2009

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.

Tuesday, March 03, 2009

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.

Monday, March 02, 2009

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.

Sunday, March 01, 2009

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.

Saturday, February 28, 2009

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.

Friday, February 27, 2009

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.

Saturday, April 05, 2008

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?

Thursday, March 20, 2008

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
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.

Sunday, February 24, 2008

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.

Thursday, August 30, 2007

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.