Vedpuriswar's Blog

Is the infrastructure allocaton adequate?

2010-03-16T21:27:00.004+05:30

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.

The Non Operating Income Trap

2010-03-12T20:52:00.003+05:30

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

2010-03-12T20:35:00.005+05:30

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

2010-03-12T20:22:00.005+05:30

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.

The need for a new approach to budgeting

2010-03-10T20:46:00.004+05:30

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.

Inadequate allocation for Infrastructure in India's budget

2010-03-08T20:01:00.009+05:30

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.

The fallacy of public sector disinvestment

2010-03-02T21:57:00.012+05:30

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.

How non plan expenditure is wasteful

2010-03-01T22:03:00.002+05:30

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

2010-03-01T21:59:00.002+05:30

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

2010-03-01T21:56:00.002+05:30

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

2010-03-01T21:54:00.000+05:30

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

2010-03-01T09:20:00.007+05:30

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.

Understanding the real meaning of economic reforms

2010-02-28T19:30:00.006+05:30

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

2010-02-28T18:52:00.006+05:30

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

2010-02-28T18:38:00.004+05:30

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?

2010-02-28T09:48:00.005+05:30

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.

2010-02-28T09:21:00.004+05:30

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

2010-02-28T08:35:00.007+05:30

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.

A quick glance at India's 2010 budget

2010-02-27T20:42:00.005+05:30

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.

India's bad budget

2009-07-09T13:29:00.003+05:30

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.

Prospects for the US Dollar

2009-03-26T16:22:00.001+05:30

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

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

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

Central and eastern European currencies

2009-03-06T21:07:00.002+05:30

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

2009-03-06T20:39:00.001+05:30

Ref Gillian Tett, Financial Times March 5 2009

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

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

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

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

Will the dollar remain strong?

2009-03-05T21:58:00.001+05:30

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%

2009-03-05T21:46:00.001+05:30

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

2009-03-05T21:35:00.002+05:30

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%

2009-03-05T21:04:00.001+05:30

Ref Ralph Atkins, Financial Times March 5 2009

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

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

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

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

AIG's huge losses.

2009-03-04T22:13:00.001+05:30

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

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

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

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

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

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

Land acquisition in India

2009-03-03T21:21:00.001+05:30

Ref Leader, Business Standard March 3, 2009

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

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

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

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

Explaining the role of central banks in the sub prime crisis

2009-03-02T15:34:00.000+05:30

Ref The Economist dt Sep 11, 2008

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

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

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

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

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

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

India's growth story at a cross roads

2009-03-01T13:40:00.001+05:30

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?

2009-03-01T13:27:00.000+05:30

Ref : The Economist dt December 13, 2008

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

India’s GDP growth slows sharply to 5.3%

2009-02-28T21:40:00.001+05:30

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

2009-02-28T21:22:00.000+05:30

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

2009-02-28T20:48:00.000+05:30

Ref The Economist, Feb 19, 2009

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

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

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

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

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

The Citi bailout

2009-02-27T22:14:00.000+05:30

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

2009-02-27T14:54:00.000+05:30

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

2009-02-27T09:19:00.000+05:30

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

2009-02-27T09:06:00.000+05:30

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

2009-02-27T05:58:00.000+05:30

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

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

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

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

Was the Citigroup merger wrong?

2008-04-05T20:45:00.000+05:30

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

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

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

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

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

Financial sector reforms need to deepen

2008-03-20T21:56:00.000+05:30

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?

2008-03-20T21:49:00.001+05:30

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

2008-03-20T21:43:00.001+05:30

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

Little progress on Pensions front

2008-03-20T21:37:00.000+05:30

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

2008-03-20T21:33:00.000+05:30

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

2008-03-20T21:29:00.000+05:30

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

2008-03-20T21:23:00.000+05:30

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

2008-03-20T21:16:00.000+05:30

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

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

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

A dollar rebound?

2008-02-24T19:19:00.000+05:30

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

2008-02-24T19:16:00.000+05:30

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 ?

2008-02-24T19:15:00.000+05:30

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?

2008-02-24T19:04:00.000+05:30

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

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

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

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

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

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

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

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

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

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

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

The Indo American Nuclear Deal

2007-08-30T21:52:00.000+05:30

Why the Communists are barking up the wrong tree

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

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

The essence of the India-US nuclear deal

2007-08-30T21:48:00.000+05:30

(Ref: The Economist, August 25, 2007)

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

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

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

2007-08-30T21:39:00.000+05:30

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

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

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

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

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

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

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

2007-08-24T14:14:00.000+05:30

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

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

The Sub Prime Crisis: Some investors see an opportunity

2007-08-24T14:10:00.001+05:30

(Ref: The Financial times dt August 21)

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

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

The structural reasons behind the Sub Prime Crisis

2007-08-24T14:06:00.000+05:30

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

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

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

The Sub Prime Crisis: The dollar as a safe haven

2007-08-24T14:05:00.000+05:30

(Ref: Wall Street Journal, August 20)

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

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

The Sub Prime Crisis: The impact on Asia

2007-08-24T14:03:00.000+05:30

(Ref: Wall Street Journal, August 20)

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

The Sub Prime Crisis: Strange developments in Asian currency markets

2007-08-24T14:01:00.000+05:30

(Ref: Wall Street Journal, August 20)

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

The puzzling ways of the left in India

2007-08-24T13:58:00.001+05:30

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

The Sub Prime crisis : Impact on the real economy

2007-08-22T17:20:00.000+05:30

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

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

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

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

The Sub Prime Crisis: What next from Fed?

2007-08-22T17:17:00.000+05:30

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

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

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

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

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

The Sub Prime Crisis: Hedge funds in trouble

2007-08-22T17:09:00.000+05:30

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

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

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

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

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

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

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

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

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

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

The Sub Prime Crisis: Trouble at banks

2007-08-22T17:05:00.000+05:30

(Ref: The Economist, dt. 18 August)

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

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

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

The Sub Prime Crisis: Trouble in the inter bank market

2007-08-22T17:02:00.000+05:30

(Ref: The Economist, dt. 18 August)

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

The Sub Prime Crisis: Dispersed risk becomes dispersed mistrust

2007-08-22T16:59:00.000+05:30

(Ref: The Economist, dt. 18 August)

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

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

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

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

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

2007-08-22T16:57:00.000+05:30

(Ref: The Economist, dt. 18 August)

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

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

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

A primer on the Sub Prime crisis

2007-08-22T13:46:00.000+05:30

(Ref: Time, August 27, 2007)

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

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

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

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

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

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

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

2007-08-22T13:34:00.000+05:30

(Ref: Gillian Tett, Financial Times August 17)

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

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

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

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

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

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

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

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

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

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

The Rupee

2007-08-22T13:20:00.000+05:30

Some observations on RBI's exchange rate management

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

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

Meanwhile, intervention does involve costs. Rupees have to be sold and dollars bought. These dollars have to be invested in risk free instruments. The risk free interest rate on dollar assets is currently about 3% less than that on rupee assets. But as well known economist Surjit Bhalla recently mentioned in a Business Standard article, this cost is not all that high as it is made out to be. The amount in the currency stabilization scheme is currently around $ 22 billion or Rs. 88,000 crores. The loss due to lower interest costs on dollar assets is only around $ 660 million or Rs. 2600 crores, fairly small for an economy of our size.

Bhalla further argues that the Asian countries from Japan to China have all prospered and grown by keeping their currencies undervalued. His research reveals that on a long term basis, each 10% initial undervaluation of a currency allows the country to gain an extra 0.2% growth per annum.

Bhalla’s argument is well taken. But I would argue that an even better course of action is not to spend too much time arguing about what is the “correct” exchange rate or what is the “correct” policy. Corporates should be competitive even when the currency appreciates. The Germans and the Japanese are good examples. Take Japan. The Yen was fixed at 360 to the dollar till 1971. It touched 80 in 1995. Yet Japanese companies like Toyota did not lose their competitiveness. That is because they worked hard, when the currency was undervalued and made their operations learner and meaner. They also invested in overseas manufacturing facilities to insulate themselves from the fluctuation of the Yen.

Indeed, keeping the currency undervalued amounts effectively to the infant industry argument, a hot topic for discussion a couple of decades back. An infant industry must be protected by tariffs. But after it grows into an adult, the protection must be withdrawn. Alas, many of our infants protected by the license raj and import restrictions did not show any strong desire, leave alone capability, to grow. Only after 1991, when the economy started to open up and competition increased, the men were separated from the boys. Similarly, if we allow the rupee to find its own level and if there is some appreciation, the better companies will come up with innovative solutions.

And in any case, it is wrong to assume that the rupee will continue to appreciate. Currently we are on a high, thanks to the IT and BPO industries. But there are serious structural problems underlying our economy. These include the poor education system, pathetic infrastructure, lack of innovation and a very weak political leadership. As our economy comes under the closer scrutiny of more and more foreign investors, we can expect these problems to receive as much attention as the stellar performance of blue chip companies like Infosys and TCS. Then our third world inadequacies will be factored along with our first world capabilities by the markets while valuing the currency. After all, the foreign exchange rate is not so much about interest rates and inflation as it is about the bets people are making on the country’s future.

The US Sub Prime crisis

2007-08-22T12:57:00.000+05:30

(Ref Financial Times dt August 17)

An insightful article by Chris Giles, Gillian Tett and Paul Davies in the Financial Times dt. August 17, has given a detailed account of the US sub prime crisis which has affected markets all over the world.

First the basic facts. The crisis surfaced in February when two specialist lenders to the subprime segment, Novostar and New Century Financial reported losses. New century filed for bankruptcy protection on April 12. In May, another hedge fund Dillon Read Capital Management ran into problems. On June 19, Bear Stearns announced two of its hedge funds had run into trouble. Many other funds reported losses. The common thread running through these troubled entities was exposure to supposedly very safe, highly rated complex debt products, which in turn had exposure to bonds backed by sub prime mortgage debt.

Since then the crisis seems to have hit other sectors. On July 25, financing for two major LBO deals, Alliance Boots and Chrysler ran into problems amidst fears of a credit crunch. Stock markets were hit as a consequence. Money market funds were later hit. A German bank IKB had to be bailed out. Sentinel, a large American investment house recently stopped investors from withdrawing their money. Most recently Countrywide Financial, traditionally considered as one of the most solid mortgage companies lost access to the market for commercial paper and had to draw down an entire $11.5 billion line of credit to boost its cash position. The venerable US government backed Fannie Mae recently announced that it expects higher delinquencies and credit losses this year in view of the credit market turmoil.

What these incidents confirm is that concerns about exposure to risky mortgages have virtually closed the market where mortgage providers resell their loans. At the same time, anxiety has seized the markets where companies raise short term cash. And this is happening not just in the US. In the UK, mortgage providers have come under pressure as wholesale borrowing costs have gone up.

Looking at the turn of events, there is no doubt that the quest for generating more returns has led to more leverage. And financial innovation has resulted in risks being repackaged and sold to entities that are not fully under the control of the regulatory authorities. What seems to be occurring now is deleveraging, i.e., the phenomenon of investors and financial institutions trying to cut their debt in a hurry by selling assets. History tells us that such deleveraging rarely occurs smoothly and usually has some impact on the wider economy. The big question now is whether the US sub prime crisis will spread to the wider US economy and indeed to other parts of the world.

There is no doubt that the contagion is spreading to the banks. One link between the banks and financial markets is the SIV, a vehicle that funds itself in the short term money markets and does not appear on the balance sheets of banks. Many of these vehicles have emergency credit lines with banks. There is a big concern that as normal sources of liquidity dry up, the banks’ balance sheets will come under huge strain as they are forced to bail out these vehicles.

Meanwhile, the “real” economy does look quite healthy. Corporate debt has been falling. The cost of borrowing for strong companies has been flat or falling. Creditworthy households have been enjoying a period of falling long term interest rates. Of course, the sub prime segment has been an exception. But even here, the net economic losses are estimated to be $50 - $100 billion, much smaller compared to the $500 billion savings and loan debate of the late 1980s. The losses will not exceed .05% of the world bond market. A few central bankers have even mentioned that some amount of correction will help in repricing of risk , which is quite desirable.

Meanwhile, the longer the turmoil continues, the more the potential risks to business and consumer sentiment. A serious crisis at a bank or rise in borrowing costs can affect the real economy. If people start saving more, anticipating slower growth or fall in house prices, that too could affect the real economy. This in turn would depend no how households and companies perceive the current events and anticipate the impact.

At the moment, central banks are not showing any panic reaction. They are trying to smooth the process of adjustment to a more deleveraged world and trying to ensure that repricing of risk continues without any major disruption. They are hoping that growth will continue without the need for any major bail out. In case this happens, it would speak volumes for the resilience and maturity of the global financial system.

In a recent interview with the Wall Street Journal, Henry Paulson, the US Treasury secretary and former Goldman Sachs CEO mentioned that the current strength of the global economy is the big difference been 2007 and 1998. The other differences, Paulson pointed out, were the global integration of economies and markets during the past ten years and the large increase in the number and size of hedge funds and other private pools of capital. If what Paulson says is indeed true, there is no doubt that we would have come a long way indeed since the 1998 Long Term Capital Management (LTCM) crisis.

Heathrow in a mess

2007-08-20T21:36:00.000+05:30

India is not the only country whose airports are in a mess. London’s Heathrow airport has also been attracting a lot of negative publicity in recent months. As the Economist recently reported, the qeues are getting longer, tempers shorter, a third of the departing flights are getting delayed and thousands of bags are being misplaced each day. The threat of terrorism has put the airport on a state of high alert. As a result, the security checks have become a real ordeal. I passed through Heathrow recently and can endorse this wholeheartedly.

Heathrow’s mess is a result of inadequate investments even as traffic volume has gone up significantly. The aircraft handles 67 million passengers a year even through its facilities are designed for only 45 million. Heathrow has several shops to keep customers engaged, but they are overpriced. No wonder, the airport consistently finds a place in the bottom in customer surveys.

The main lesson for us in India is that infrastructure has to be created ahead of demand. Look at the Kuala Lampur airport. What a joy it is to be at that airport. Large open spaces, comfortable seating arrangements and plentiful avenues for shopping. And of course friendly staff.

While on the subject of airports, I may add that Frankfurt does not seem to be too much better off. When I passed through the airport a couple of months back, it was crowded and the aerobridge facility was not available. The airport may be less crowded than Heathrow but the layout is bad and the staff are not all that cordial.

Heathrow has many lessons to offer to us. If Mumbai has any dreams of becoming a leading financial centre in the region, it had better invest sufficiently in its airport.

Hierarchy will not go away

2007-08-20T21:35:00.000+05:30

We have kept hearing again and again about the importance of talent management, empowering people to be creative, encouraging individualism, and so on. But as Peter Coy mentions in a recent BusinessWeek article, even in an innovation driven economy, hierarchy will remain indispensable for getting things done. The author quotes a reputed organizational behaviour expert, Harold J Leavitt, “You still have to do what the boss expects you to do. There is a veil of humanism. We call each other by our first names. But when the chips are down, the boss says you are fired.” While individual initiative and creativity cannot be undermined, systems and processes will continue to be important. Indeed that is what companies like TCS, Infosys and Wipro have mastered as they have scaled up their operations. If we take a larger perspective, we will see that a system centric approach and strong people orientation are not totally inconsistent. When systems and processes are strong, talented individuals are freed from the drudgery of routine jobs and can do more creative tasks.

Bernanke’s performance

2007-08-20T21:20:00.001+05:30

Ben Bernanke took over from Alan Greenspan as Fed Chairman in February 2006. Since then he has slowly but surely demonstrated that he is coming to grips with his job.
The most important quality of a central banker in my opinion is focus. A central banker must focus on a few key issues and forget everything else. Bernanke has not allowed himself to be distracted by the US sub prime mortgage crisis. He has refused to respond to calls for easier money. He realizes that lowering interest rates in a bid to rescue this troubled market might lead to excess borrowing and inflationary pressures in other sectors of the economy.
Endorsing Bernanke’s stand, Prof. Allan Meltzer of Carnegic Mellon recently mentioned in a Businessweek report: “The people on Wall Street are making a lot of noise because they do not like to lose money… it would be a huge mistake to change policy to rescue a bench of people who made stupid mistakes. Capitalism without failure is like religion without sin. It doesn’t work.”

At the same time, Bernanke has shown flexibility when needed. Just a couple of days back (on August 17) the Federal Reserve cut the discount rate by 0.5% to 5.75%. The Fed admitted market conditions and increased uncertainty could slow down growth in the months to come. The move came amidst worries that problems in the mortgage sector could affect the real economy.

Bernanke’s general philosophy seems to be that in the long run, low inflation promotes stable, job generating growth. He is quite happy to keep interest rates high to check inflation, even if some people are unhappy. As Business week concluded: “Clearly this is one soft spoken professor who knows how to say no.” (Bernanke had taught at Princeton from 1985 to 2002.)
The growing stature of Bernanke is also a tribute to the strength of the Fed as an institution. The Fed has produced three top class leaders in a row- Paul Volcker followed by Greenspan and now Bernanke. Clearly the Fed knows how to choose its leaders and give them a free hand to run the place according to their discretion.

What contributes to enduring success?

2007-08-20T16:46:00.002+05:30

A recent article by Christian Stadler, an Austrian professor, in the Harvard Business Review ( July-August 2007) explains the reasons behind the strong performance of some companies over long periods of time. Measured by total returns for shareholders, these companies fared 62 times better than the general market. The comparison companies which were also good but not “great” beat the market only by a factor of eight. Stadler’s research has through up four key findings:
 The great companies emphasise exploiting existing assets and capabilities over exploring for new ones.
 These companies diversify their business portfolio, taking care to maintain a wide range of suppliers and customers.
 Such companies tell and retell stories of past failures to make sure these mistakes are not repeated.
 They seldom make radical changes and take great care in their planning and implementation.

Kakushin vs Kaizen

2007-08-20T16:41:00.000+05:30

Toyota's quest for perfection

Toyota, the Japanese car maker is well known for its commitment to Kaizen or continuous improvement. Now it seems as though Toyota is embracing the mantra of Kakushin or radical innovation. Toyota’s president, Katsuaki Watanabe mentions in a recent interview with Harvard Business Review ( July-August 2007) that while Kaizen will continue as in the past, Kaikaku , drastic change or reform, will be equally important. At its new manufacturing facility in Takaoka, Toyota will change completely the way it makes cars. The processes at Takaoka will be simple, making it easier for people to observe abnormalities immediately. Robots, a new painting process and high-precision quality monitoring instruments, will help Toyota to strengthen its competitive position. The Takaoka lines will also have tremendous flexibility. As many as 16 models can be produced on two lines as against 4 or 5 on three lines earlier. Toyota’s relentless quest for perfection continues!

Forecasting is not the same as prediction

2007-08-20T16:32:00.000+05:30

A brilliant article by Paul Saffo in a recent edition of Harvard Business Review (July-August 2007) brings out the differences between prediction and forecasting. Prediction is possible only in a world in which events are preordained and current actions will not influence future outcomes. As Saffo mentions: “Prediction is concerned with future certainty; forecasting looks at how hidden currents in the present signal possible changes in direction for companies, societies or the world at large.”

The key function of forecasting is to identify a full range of possibilities based on a set of reasonable assumptions. A forecast must have a strong logic. And people who use the forecast must understand the logic and evaluate for themselves the quality of the forecast. As Saffo mentions: “The wise consumer of a forecast is not a trusting bystander but a participant and above all, a critic.”

This is a great article for people who want to know more about forecasting and how to be intelligent users of forecasts.

Reaping the demographic dividend

2007-08-20T16:26:00.000+05:30

Can India do it?

India’s population is expected to increase from 1.02 billion in 2001 to 1.4 billion by 2026. The country remains one of the youngest nations in the world today, with 54% being 24 years and below. Approximately 371 million will be added to the population between 2001 and 2026. It is expected that people in the age group 15-59, will account for about 83% of this increase. The big question is what proportion of this segment will be sufficiently educated and skilled to be meaningfully employed.
Nearly 50% of the demographic bulge will come from seven backward and generally badly governed states – Bihar, Uttar Pradesh, Jharkand, Chattisgarh, Uttaranchal, Rajasthan and Orissa. Neither are jobs being created in these states nor is the educational infrastructure anything to rejoice about.
Meanwhile, primary enrolment is going up, leading to rising expectations among our youngsters. Unless enough investments are made in education in general and skill building in particular, there may be frustration at the mildest level and social unrest in a worst case scenario.
Another big concern is that the country’s health indicators are not looking particularly good. India has the largest number of underfed children in the world, very high rates of tuberculosis incidence and one of the highest rates of maternal mortality. So clearly, along with investments in education, we also need to spend more on health care.
As Latha Jishnu mentions in a recent Business World article, “Young and raring to go,” “If India begins in earnest to provide the right environment for the army of its young people, then it can expect to reap the demographic dividend and become a prosperous nation. If not, it will remain a poor country of ageing people.”

Even Manual workers can become knowledge workers

2007-08-17T16:30:00.000+05:30

Empowerment holds the key to job enrichment

In his book, “The 8th Habit,” Stephen Covey narrates a true story about a group of janitors.

An instructor in a training program was explaining to a group of first-level supervisors how to enrich the job of the janitors working under them. One of the foremen, involved in maintenance, felt the idea was too idealistic and unrelated to most of the work a janitor did. All the supervisors being trained agreed that there was a problem with the janitors. They were uneducated and were there because they couldn’t get a better job. Essentially their only desire was to clock in and clock out.

Knowing the maintenance foreman was sincere, the instructor abandoned his prepared discussion and began to deal with the janitorial problem directly. He wrote three words on the blackboard: Plan, Do, and Evaluate – three major elements of job enrichment. He than asked the participants to list the maintenance duties and activities associated with these three words.

Under the “planning” part of the job were: establishing schedules for maintenance, selecting and purchasing waxes and polishes, and determining which janitor covered which areas of the plant. During the discussion, the maintenance foreman said that he was about to purchase several new floor polishing and scrubbing machines. All of these planning activities were carried out by the maintenance foreman.

Listed under the “doing” section were the normal activities of janitors – sweeping, scrubbing, waxing, and removing the rubbish and refuse.

The “evaluating” part of the job included such activities as routine daily checks on the cleanliness of the plant, evaluation of the effectiveness of different soaps, waxes and polishers, identifying ways of improving and ensuring that the cleaning schedules were maintained. Additionally, the maintenance foreman also contacted vendors to determine the type of new machine he could purchase.

When the various activities had been listed, the instructor asked, which of these activities could be done by the janitors. For example, why did the foreman determine which soaps to buy? Why not let the janitors decide? How about having the salesmen give the demonstration of the new machine to the janitors and let them decide which of the machines was best? How about having the janitors identify parts of the job they would be interested in taking on?”

The maintenance supervisor started giving the janitors more responsibility for planning, doing and evaluating their work. The janitors tested out new machines and made the final recommendations for purchase. They experimented with different waxes to determine which stood up the best under normal usage. They began examining the cleaning schedule to determine how much attention should be given to each area. The janitors developed their own criteria for determining plant cleanliness and began to exert peer pressure on janitors who did not meet the norms.

Gradually, quality went up, job turnover and discipline problems went way down, social norms developed around initiative, cooperation, diligence and quality, and job satisfaction increased significantly. The janitors no longer needed supervision because they supervised and managed themselves according to the criteria they helped develop.

Soon other foremen began thinking about how they could apply the same principles in their own areas, especially since they could begin to see for themselves the results of the maintenance foreman’s work with the janitors.

Balancing priorities

2007-08-17T15:47:00.001+05:30

When we are serious and sincere, we can find time for everything.

In his book, “The 8th Habit,” Stephen Covey narrates another powerful story. A friend was quite attached to his mother. At one time in his life, he got caught up in his own commitments. His life got so busy that weeks would go by before he would make even a quick phone call to his mother. And when he did manage to make a visit, it would be very hurriedly done. Another meeting to go to, another deadline to meet. The meeting with his mother became a chore.

The mother never complained to her son. But the son wasn’t happy with the situation. He was dejected that he couldn’t consistently spend time with his mother. So, he discussed it with his wife. She suggested scheduling a time each week or so that would work for both his family and his mother. When they looked at the calendar, they saw the wife had choir practice every Wednesday evening. That night became his night to spend with his mom.

Now the visits became scheduled and regular. The son did not run off within the first ten minutes, and there were few interruptions. If the mother wanted to get some exercise, the two would go for a walk together. On other occcasions the mother would cook a meal for her son. Sometimes the son would take her to do shopping at the mall, which was a bit too far away for her to drive to. And they kept talking about family, about current events, about old memories. Every evening the son spent with his mother gave him peace which he had not previously enjoyed.

Rediscovering your passion

2007-08-17T15:44:00.000+05:30

The key lies in finding a larger purpose.

In his book “The 8th Habit,” Stephen Covey narrates a powerful, true story involving an Englishman who had spent his childhood as a street urchin but had gone on to become a reasonably successful writer. At the time of the story, however, he had developed the “writer’s block.” It seemed his creativity had completely dried up. His debts were mounting. He was under tremendous pressure from the publisher to meet the deadline. He was becoming more and more depressed. He began to fear that his own children would end up on the streets.

The writer, finding it difficult to sleep, began to spend his nights walking the streets of London. He saw the poverty, the inhumane conditions of children working nights in the factories, the terrible struggle of parents trying to eke out a living for their families. Soon, he forgot his own problem. He wanted to do something that would make a difference!

He no longer felt doubt or discouragement. He didn’t worry about his own financial concerns. He returned to his writing with an energy level he had never known. The desire to contribute became his passion. He wanted to make the story quickly available and affordable to as many people as possible. His whole life had changed. He’d truly found his voice.

India’s rise

2007-08-17T15:12:00.001+05:30

A time to celebrate or to reflect?

A recent article by historian, William Dalrymple in a special isue of Time Magazine, to commemorate 60 years of the country’s independence mentions: “The idea that India is a poor country is a relatively recent one. South Asia was always famous as the richest region of the globe.”
Dalrymple mentions that at the height of the Mughal empire, our country was rivalled only by China. By the 17th Century, Lahore had grown larger and richer than Constantinople and with some two million inhabitants, dwarfed London and Paris.
In 1600, when the British East India company was founded, Britain was generating 1.8% of world’s GDP while India was producing as much as 22.5%. By 1870, Britain contributed 9.1% of the world’s GDP while India had been reduced to a third world nation. After this period of set back, Dalrymple argues that India is well on the way to making a strong comeback.
He concludes: “Extraordinary as it is, the rise of India and China is nothing more than a return to the ancient equilibrium of world trade, with Europeans no longer appearing as gunboat riding colonial masters but instead reverting to their traditional role: that of eager consumers of the much celebrated manufactures, luxuries and services of the East.”

I wish I could share Dalrymple’s optimism. Pardon me for my cynicism which it seems is also shared by a few others. A report in a recent issue of Newsweek,which covers global trends in education, mentions that the country’s educational system is in a mess. The report quotes opinion leaders like Kiran Karnik of Nasscom and TV Mohandas Pai of Infosys who mention that developing and growing India’s skilled workforce will be the biggest challenge the country faces in the years to come. Meanwhile, there seems to be a severe dilution of our basic values. Indiscipline, corruption, religious violence and child labour show no signs of declining. Our traditional strengths, thrift and saving for the rainy day are eroding rapidly in an age of consumerism, easy loans and credit cards. The manner in which the current president of India was elected or the way a high performer like Dayanidhi Maran was asked to quita few months back, reflects the lack of integrity, leave alone vision, in our political leaders. And the manner in which the Indian cricket team lost a golden opportunity to score a comprehensive 2 – 0 win over England in the recently concluded test series, is a strong indication that even for the people who are widely perceived as role models, self preservation triumphs over national pride.

There is an old English proverb: “One swallow does not make a summer.” Similarly, a few IT or pharma companies cannot be equated with a prosperous country. or for than matter an enlightened society.

The tale of two cities

2007-08-17T15:09:00.001+05:30

London vs New York
With some $100 billion in foreign investment pouring in annually from countries like Russia, India, China and the US, London is challenging New York very seriously in the race to become the financial capital of the world. British PM Gordon Brown recently pointed out that over 40% of the world’s foreign equities are traded here as also 30% of foreign exchange. And unlike New York and Tokyo which are backed by large domestic markets, London’s business is truly global.

In contrast, as Fortune magazine recently reported, New York seems to be plagued by self doubt. Too much litigation and heavy handed regulation are factors cited behind this phenomenon. US Treasury secretary, Henry Paulson and Christopher Cox, Chairman of the SEC have called for reforms to revitalize the US capital markets. While the US is weighed down by Sarbanes Oxley, London seems to have been quite successful in putting together a new, more flexible regulatory approach that makes it easy to do business, regardless of nationality, currency or accounting system.

London has become a magnet for firms from emerging economies looking to raise capital. In fields like OTC derivatives, foreign exchange and metals trading, it has taken a worldwide lead. About 21% of global hedge fund assets are handled from London. The city has also been successful in attracting hundreds of smaller firms from around the world, including the US to its less prestigious markets, especially the AIM exchange.

New York is trying to stage a comeback. NYSE and Nasdaq are trying to merge with London’s European rivals. The SEC has recently accepted the International Financial Reporting Standards that differ from the US GAAP. The SEC has also relaxed Section 404 of SOX which stipulates that outside auditors must monitor internal controls.

Ironically enough, much of the expertise fuelling London’s boom is American. Four of the top five deal makers in the US last year, were American. Meanwhile, both London and New York cannot overlook competition from other centres like Mumbai, Shanghai, Warsaw, Dubai and Sao Paulo. Looks as if the days when one or two cities dominated international finance are over.

Lessons from Henry Cavendish

2007-08-16T12:03:00.000+05:30

The remarkable story of a truly great scientist

The great British scientist Henry Cavendish has a lot to teach us about achieving professional excellence through complete dedication and commitment to the task at hand.

Born into a rich family, Cavendish was the most gifted English scientist of his age, but suffered from shyness to a ‘degree bordering on disease’. Any human contact was for him a source of the deepest discomfort.

Once he opened his door to find an Austrian admirer standing outside. Words of praise flew out of the excited Austrian. For a few moments Cavendish listened to the visitor. Then, unable to take any more, he ran out of his house. It was some hours before he would be coaxed back to his home.

Although Cavendish did sometimes attend social events, the other guests were clearly informed that he was on no account to be approached or even looked at. Those who sought his views were advised to wander into his vicinity as if by accident and to ‘talk as it were into vacancy’. If these remarks were scientifically worthy they might receive a mumbled reply, but more often than not they would hear a peeved squeak and turn to find the place was actually vacant. Cavendish would be seen retreating towards a more peaceful corner!

In the course of a long life, Cavendish made a series of important discoveries. He was the first person to isolate hydrogen and the first to combine hydrogen and oxygen to form water. His experiments with electrical conductivity were a century ahead of their time, but unfortunately remained undiscovered until that century had passed.

Without telling anyone, Cavendish discovered or anticipated the law of the conservation of energy, Ohm’s Law, Dalton’s Law of Partial Pressures, Richter’s Law of Reciprocal Proportions, Charles’s Law of Gases, and the principles of electrical conductivity. He also foreshadowed the work of Kelvin and G H Darwin on the effect of tidal friction on slowing the rotation of the earth, the work of Pickering on freezing mixtures, and some of the work of Rooseboom on heterogeneous equilibria. Finally, he left clues that led directly to the discovery of the noble gases, some of which are so elusive that the last of them wasn’t found until 1962.

What an amazing man Cavendish was. He devoted his entire life to the pursuit of scientific discovery in a range of fields. He fully shut himself off from all distractions. He did not work to gain recognition. He worked for the joy of finding out new things. A man who truly achieved flow.

Adapted from “ A short history of nearly everything” by Bill Bryson

Management lessons through story telling-Sony Radio

2007-08-11T19:13:00.001+05:30

Commitment to core values
Morita came across an American buyer who looked at his radio and said he liked it very much. He said his chain had about 150 stores and he would need large quantities. He wanted a price quotation on quantities of 5000, then 10,000, 30,000, 50,000 and 100,000 radios. Morita was thrilled! But back in his hotel room, he began pondering the possible impact of such grand orders on the small facilities in Tokyo. Sony had expanded its plant a lot in recent years but did not have the capacity to produce 100,000 transistor radios a year and also make the other things in Sony’s small product line. Sony’s capacity was less than 10,000 radios a month. If the company got an order for 100,000 units it would have to hire and train new employees and expand its facilities even more. This would mean a major investment, a major expansion, and a gamble.

As Morita put it : “I was inexperienced and still a little naive, but I had my wits about me. I considered all the consequences I could think of, and then I sat down and drew a curve that looked something like lopsided letter U.”
The price for 5000 would be the regular price. That would be the beginning of the curve. For 10,000 there would be a discount, and that was at the bottom of the curve. For 30,000 the price would begin to climb. For 50,000 units, the price per unit would be higher than for 5000 and for 100,000 units the price would have to be much more per unit than for the first 5000.

He mentioned: “I know this sounds strange, but my reasoning was that if we had to double our production capacity to complete an order for one hundred thousand and if we could not get a repeat order the following year we would be in big trouble, perhaps bankrupt, because how could we employ all the added staff and pay for all the new and unused facilities in the case? It was a conservative and cautious approach, but I was convinced that if we took a huge order we should make enough profit on it to pay for the new facilities during the life of the order....... In Japan we cannot just hire people and fire them whenever our orders go up or down. We have a long-term commitment to our employees and they have a commitment to us.”

Adapted from “Made in Japan,” by Akio Morita

Management lessons through story telling-Sony’s transistor radio

2007-08-11T19:06:00.000+05:30

Understanding vision

Sony’s first transistor radio of 1955 was small and practical – Morita saw the United States as a natural market; business was booming, employment was high, the people were progressive and eager for new things, and international travel was becoming easier.

Morita took his little $29.95 radio to New York and made the rounds of possible retailers. Many of them were unimpressed. They said, “Why are you making such a tiny radio? Everybody in America wants big radios. We have big houses, plenty of room. Who needs these tiny things?”

The fidelity was not as good as a large unit, but it was excellent for its size. Many people saw the logic of this argument, and Morita was happy to be offered some tempting deals.

The following is Morita’s narrative:
“The people at Bulova liked the radio very much and their purchasing officer said very casually, “We definitely want some of these. We will take one hundred thousand units.” One hundred thousand units! I was stunned. It was an incredible order, worth several times the total capital of our company. We began to talk details, my mind working very fast, when he told me that there was one condition: we would have to put the Bulova name on the radios.

That stopped me. I had vowed that we would not be an original equipment maker for other companies. We wanted to make a name for our company on the strength of our own products. I told him I would check with my company, and in fact I did send a message back to Tokyo outlining the deal. The reply was, “Take the order.” I didn’t like the idea, and I didn’t like the reply. After thinking it over and over, I decided I had to say no, we would not produce radios under another name. When I returned to call on the man from Bulova he didn’t seem to take me seriously at first. How could I turn down such an order? He was convinced I would accept. When I would not budge, he got short with me.

“Our company name is a famous brand name that has taken over fifty years to establish,” he said. “Nobody has ever heard of your brand name. Why not take advantage of ours?”

I understood what he was saying, but I had my own view. “Fifty years ago,” I said, “your brand name must have been just as unknown as our name is today. I am here with a new product, and I am now taking the first step for the next fifty years of my company. Fifty years from now I promise you that our name will be just as famous as your company name is today.”

Adapted from “Made in Japan,” by Akio Morita

Management lessons through story telling-The Sony Walkman

2007-08-11T18:58:00.000+05:30

Leading by intuition
The idea took shape when Ibuka came into Akio Morita’s office one day with one of the portable stereo tape recorders and a pair of standard-size headphones. He looked unhappy and complained about the weight of the system. Morita asked him what was on his mind and then he explained, “I like to listen to music, but I don’t want to disturb others. I can’t sit there by my stereo all day. This is my solution – I take the music with me. But it’s too heavy.”

The following is Morita’s account: “Ibuka’s complaint set me into motion. I ordered our engineers to take one of our reliable small cassette tape recorders we called Pressman, strip out the recording circuit and the speaker, and replace them with a stereo amplifier. I outlined the other details I wanted, which included very light-weight headphones that turned out to be one of the most difficult parts of the Walkman project.

Everybody gave me a hard time. It seemed as though nobody liked the idea. At one of our product planning meetings, one of the engineers said, “It sounds like a good idea, but will people, but it if it doesn’t have recording capability? I don’t think so.”

I said, “Millions of people have bought car stereo without recording capability and I think millions will buy this machine.”

Nobody openly laughed at me, but I didn’t seem to be convincing my own project team, although they reluctantly went along. I even dictated the selling price to suit a young person’s pocketbook, even before we made the first machine.

The tape recorder was a relatively expensive unit, selling for 49,000 yen in Japan, Morita wanted the first models of our new stereo experiment to retail for no more than thirty thousand yen. The accountants protested but Morita persisted. Morita told them he was confident about making the new product in very large numbers and the cost would come down as volume climbed. Morita chose the basic configuration of the Pressman because many parts for the Pressman were available worldwide at service centers, and Sony knew the unit was reliable. Therefore Sony could start out without worrying about any mechanical failure.

Morita continues his narrative: “In a short time the first experimental unit with new, miniature headphones was delivered to me, and I was delighted with the small size of it and the high-quality sound the headphones produced. In conventional stereo with large loudspeakers, most of the energy used to produce the sound is wasted, because only a fraction of it goes to the listeners’ ears. The rest of the sound vibrates off the walls and the windows. Our tiny unit needed only a small tricky of battery power to the amplifier to drive the tiny lightweight headphones. The fidelity that came through the small headphones was as good or better than I expected.

I thought we had produced a terrific item, and I was full of enthusiasm for it, but our marketing people were unenthusiastic. They said it wouldn’t sell, and it embarrassed me to be so excited about a product most others thought would be a dud. But I was so confident the product was viable that I said I would take personal responsibility for the project. I never had reason to regret it. The idea took hold and from the very beginning the Walkman was a runaway success.”

Adapted from “Made in Japan,” by Akio Morita

Management lessons through story telling-The Boeing 707

2007-08-11T18:49:00.000+05:30

Setting Big Hairy Ambitious Goals

Until the early 1950s, Boeing focused on building huge flying machines for the military. However, Boeing had virtually no presence in the commercial aircraft market. McDonnell Douglas had vastly superior abilities in the smaller, propeller-driven planes that composed the commercial fleet.
In the early 1950s, however, Boeing saw an opportunity to take on McDonnell Douglas by marrying its experience with large aircraft to its understanding of jet engines. Led by Bill Allen, Boeing executives debated the wisdom of moving into the commercial sphere. They concluded that, whereas Boeing could not have been the best in the commercial plane market a decade earlier, the cumulative experience in jets and big planes they had gained from military contracts now made such a dream possible. They also realised that the economics of commercial aircraft would be vastly superior to the military market. They were just flat-out turned on by the whole idea of building a commercial jet.

So, in 1952 Allen and his team made the decision to spend a quarter of the company’s entire net worth to build a prototype jet that could be used for commercial aviation. They built the 707 and launched Boeing in a bid to become the leading commercial aviation company in the world. Three decades later, after producing five of the most successful commercial jets in history (the 707, 727, 737, 747, 757), Boeing stood as the greatest company in the commercial airplane industry, worldwide.

Adapted from “Good to Great” by Jim Collins.

Management lessons through story telling-The hedgehog and the fox

2007-08-11T18:44:00.000+05:30

What the hedgehog teaches us about focus

In his famous essay, “The Hedgehog and the Fox,” Isaiah Berlin divided the world into hedgehogs and foxes, based on an ancient Greek parable.
The fox, a cunning creature, can devise several complex strategies for sneak attacks upon the hedgehog. Day in and day out, the fox circles, around the hedgehog’s den, waiting for the perfect moment to pounce. Fast, sleek, and crafty – the fox looks like the sure winner.
The hedgehog, on the other hand, waddles along, searching for lunch and taking care of his home. Minding his own business, the hedgehog wanders right into the path of the fox.
“Aha, I’ve got your now!” thinks the fox,. He leaps out, bounding across the ground, lightning fast. The little hedgehog, sensing danger, looks up and thinks, “Here we go again. Will he ever learn?” Rolling up into a perfect little ball the hedgehog becomes a sphere of sharp spikes, pointing outward in all directions. The fox bounding toward his prey, sees the hedgehog defense and calls off the attack.

Retreating back to the forest, the fox begins to calculate a new line of attack. Each day, some version of this battle between the hedgehogs and the fox takes place, and despite the greater cunning of the fox, the hedgehog always wins.

Adapted from “Good to Great” by Jim Collins.

Management lessons through story telling-The Stockdale paradox

2007-08-11T18:37:00.000+05:30

Lessons from a Vietnam War survivor

The story of Admiral Jim Stockdale offers some great lessons in leadership. Stockdale was the highest ranking United States military officer in the “Hanoi Hilton” prisoner-of-war camp during the height of the Vietnam War. He was tortured over twenty times during his eight-year imprisonment from 1965 to 1973. He shouldered the burden of command, doing everything he could to create conditions that would increase the number of survivors, while fighting an internal war against his captors and their attempts to use the prisoners for propaganda. At one point, he beat himself with a stool and cut himself with a razor, deliberately disfiguring himself, so that he could not be put on videotape as an example of a “well-treated prisoner.” He exchanged secret intelligence information with his wife through their letters, knowing that discovery would mean more torture and perhaps death. He instituted rules that would help people to deal with torture. He instituted an elaborate internal communications systems to reduce the sense of isolation that their captors tried to create, which used a five-by-five matrix of tap codes for alpha characters. Once the prisoners mopped and swept the central yard using the code, signalling “We love you” to Stockdale.

The famous author Jim Collins eagerly looked forward to the prospect of spending an afternoon with Stockdale. As they got talking, Stockdale remarked, “I never lost faith in the end of the story, I never doubted not only that I would get out, but also that I would prevail in the end and turn the experience into the defining event of my life, which, in retrospect, I would not trade.”

After a period of silence, Collins asked, “Who didn’t make it out?”

“Oh, that’s easy,” he said, “The optimists.” Collins was completely confused.

Stockdale explained, “The optimists, Oh, they were the ones who said, “We’re going to be out by Christmas.” And Christmas would come, and Christmas would go. Then they’d say, ‘We’re going to be out by Easter.’ And Easter would come, and Easter would go. And then Thanksgiving, and then it would be Christmas again. And they died of a broken heart.”

Adapted from “Good to Great” by Jim Collins.

Management lessons through story telling-Circuit City

2007-08-11T18:32:00.000+05:30

Lead with questions, not answers

In 1973, one year after he became CEO, Alan Wurtzel’s company stood at the brink of bankruptcy. At the time, the company was a hodgepodge of appliance and hi-fi stores with no unifying concept. Over the next ten years, Wurtzel and his team not only turned the company around, but also created the Circuit City concept and laid the foundation for a stunning record of results.

When Wurtzel started the long turnaround, he began with the question of where to take the company. Unlike many CEOs, Wurtzel resisted the urge to walk in with the answer. Instead, he began with questions. Wurtzel stands as one of the few CEOs in a large corporation who put more questions to his board members than they put to him.

He used the same approach with his executive team, constantly pushing and probing and prodding with questions. Each step along the way, Wurtzel would keep asking questions until he had a clear picture of reality and its implications. “They used to call me the prosecutor, because I would home in on a question,” said Wurtzel. “You know, like a bulldog, I wouldn’t let go until I understood. Why, why, why?
Adapted from “Good to Great” by Jim Collins.

The strange paradox that India is

2007-08-05T18:52:00.000+05:30

First world capabilities and third world inadequacies

India is a strange paradox. As the leading social activist , Jayaprakash Narayan of Lok Satta recently mentioned in a public gathering, our country combines first world capabilities in some areas with third world inadequacies in others.
We have business leaders like N.R.Naraynamurthy and Azim Premji who are second to none in terms of their vision and statesmanship and commitment to the highest standards of corporate governance.We have companies like TCS, Infosys and Wipro who have demonstrated consistently their ability to execute large IT outsourcing contracts. We have some public servants like Kiran Bedi who can match the Rudi Gullianis of the world in terms of their go getting capabilities. We have some of the most hard working people in the world in the corporate sector, toiling very long hours in their offices.
But we also have some of the most incompetent and dishonest politicians in the world. And the few who are competent and honest are not the greatest communicators. That includes our current prime minister. Recently, I watched a video of Al Gore the former vice president. He could bring the crowd on its feet by his impassioned appeal to save the earth from global warming. And recall Ronald Reagan when he was the US president. Or more recently Tony Blair, former prime minister of England. I can think of few Indian politicians who have that kind of an oratorial capability, people who can combine substance with style and deep conviction.
Even more of greater concern is the concentration of power in the hands of a few individuals and the complete subversion of the democratic process. Indeed, there are few checks and balances on some Indian politicians. Recall the way in which the current president was selected. And that too when the previous president (who most people accept as one of India's most popular presidents ever) was available for a second term and was a clearly better candidate.
We also have some of the most in disciplined people in the world- who drive rashly on the roads throwing all traffic rules to the wind, who do not like to stand in the queue and who talk loudly in public places without caring about the inconvenience caused to the people around. Not to talk about the Diwali crowd who seem to draw sadistic pleasure bursting crackers which can damage the ear drums of people around, especially the senior citizens.
And while we do have some great companies, none of them find a place among the world's 100 most corporate brands published by Business Week recently.
Our legal system is pathetic. Judgments relating to some of our most celebrated cases like the Coimbatore and Bombay blasts have been delayed for years and are only now coming close to delivery.
And I need not mention our pathetic infrastructure which is choking many of our cities including Bangalore.
Clearly, notwithstanding the hype created by a few intellectuals and columnists,our current rate of economic growth cannot be sustained if we are not able to develop first world capabilities in many more areas where our current standards are shameful to say the least.

BLINK: The Power of Thinking without Thinking

2007-07-28T21:23:00.000+05:30

The Power of Thinking without Thinking
By Malcolm Gladwell
Little, Brown & Company, 2005

Human beings make sense of a situation in two different ways. The first is the conscious approach. They think about what they have learned, and eventually come up with an answer. This strategy is logical and deliberate. The second strategy does not weigh all the evidence. It considers only what can be gathered at a glance. Recall the old proverb,"First impression is the best impression."

This book by Malcolm Gladwell, one of the most influential writers of our times is all about when each approach works best. It is about what we can do to ensure that the first impression does not lead to a hasty or wrong conclusion. It is about the kind of expertise and skills we need to develop to ensure that we become good at split second decision making. Gladwell’s books are always unique and insightful. This book is no exception.

We tend to assume that the quality of a decision is directly related to the time and effort that goes into making it. But in many situations, decisions made very quickly can be every bit as good as decisions made cautiously and deliberately. The part of our brain that leaps to conclusions at a glance is called the adaptive unconscious. It acts as a giant computer that quickly and quietly processes a lot of the data we need in order to keep functioning as human beings. Come to think of it, this ability has played a significant role in the shaping of human civilization. Human beings have survived as a species for so long because they have developed the capability to make very quick judgments based on very little information.

"Thin-slicing" refers to the ability of our unconscious to find patterns in situations and behavior based on very narrow slices of experience. Thin-slicing can be a very useful competence for managers. At the same time, the unconscious though a powerful force,can be fallible. It can be thrown off, distracted, and disabled. So, when should we trust our instincts, and when should we be wary of them? This book is about how snap judgments and first impressions can be educated and controlled.

Social Intelligence-The new science of human relationships

2007-07-27T22:08:00.000+05:30

Social Intelligence-The new science of human relationships
By Daniel Goleman, Hutchinson, 2006

In this book, Daniel Goleman, explores an emerging new science with major implications for our interpersonal world. Human beings are designed for sociability and are constantly engaged in a neural ballet that connects them brain-to-brain with those around. Goleman points out that human beings have a built in bias towards empathy, cooperation and altruism. Social intelligence can help them to nurture and develop these capacities.

This book deals with the social aspects of intelligence, i.e. how our brains work when we are in groups. The social brain refers to the neural mechanisms that coordinate our interactions as well as thoughts and feelings about people and our relationships. The social brain is the only biological system in our bodies that continually influences and in turn becomes influenced by the internal state of the people we are with. All other biological systems mainly regulate their activity in response to signals emerging from within our body.

Social intelligence has two components:

A) Social awareness
B) Social facility

Social awareness includes:

1) Primal empathy : Feeling with others , sensing emotional signals.
2) Attunement : Listening with full receptivity
3) Empathic accuracy : Understanding another person’s thoughts, feelings and intentions
4) Social cognition : Knowing how the social world works.

Social facility includes:

1) Synchrony : Interacting smoothly at the verbal level
2) Self presentation : Presenting ourselves effectively
3) Influence : Shaping the outcome of social interactions
4) Concern : Caring about others’ needs and acting accordingly.

Read this book to know more about social intelligence.

THE MEDICI EFFECT

2007-07-27T22:02:00.001+05:30

THE MEDICI EFFECT
Breakthrough Insights at the Intersection of Ideas, Concepts & Cultures
Frans Johansson
Harvard Business School Press, 2004

This fascinating book tells us about working at the intersection of different fields to generate and implement creative ideas. Opportunities to innovate may be limited within a field. But they multiply when different fields are combined. That is the key message in this book.

The key difference between a field and an intersection of fields lies in how concepts within them are combined. When we operate within a field, we can combine concepts within that particular field, generating ideas that evolve along a particular direction. The author calls them directional ideas. When we work at the intersection, we combine concepts between multiple fields, generating ideas that leap in new directions. The author calls them intersectional ideas.

Directional innovation improves a product in fairly predictable steps, along a well-defined dimension. The goal is to evolve an established idea by using refinements and adjustments. The rewards are reasonably predictable and attained without a long gestation period.

Intersectional innovations, on the other hand, pave the way for a new field. They often make it possible for the people who originated them to become the leaders in the fields they created. Intersectional innovations do not require as much depth of expertise as directional innovation and can be executed by seemingly ordinary people.

For most of us, the best chance to innovate lies at the intersection. Not only is the probability of finding remarkable idea combinations greater there, we will also find many more of them.

There are three distinct forces behind the rise of intersections.
The movement of people is on the rise everywhere. This is facilitating cultural intersections in fields such as cinema, literature, music, and art. Businesses, too, are increasingly able to innovate in different regions of the world. They can arbitrage ideas between different cultures by understanding how those cultures connect.

The second reason is that in field after field, our basic understanding of the world is reaching a point of saturation. We have a pretty good understanding of the individual components of the world. In the near future, the chances of making a radical discovery are slim. So the emphasis will be less on understanding each component and more on how those components interact.

Last but not the least, computing power has been doubling every eighteen months and continues to do so. This exponential leap in computation will generate more intersections for two reasons. First, it will not merely let us do the same things faster (which enables directional innovation). It will also allow us to do different things, generating possible intersections between traditionally separate fields. The leap in computation has also led to advances in communication, making our world smaller. Individuals, groups, and organizations that were once separate can now easily come together to find intersections between their backgrounds and expertise.

Read this fascinating book to know more about intersectional innovations.

CREATIVITY

2007-07-27T21:45:00.000+05:30

CREATIVITY - Flow and the psychology of discovery and invention by Mihaly Csikszentmihalyi

This fascinating book by Mihaly Csikszentmihalyi brings out the importance of creativity, outlines its building blocks and explains how we can all become more creative.

Without creativity, it would be difficult to distinguish humans from other animals. Creativity leads to a fuller, more satisfying life. Without creativity, mankind would not progress.

Csikszentmihalyi points out that creativity cannot be understood by looking only at the people who appear to make it happen. Creative ideas need a receptive audience to record and implement them. And without the assessment of competent outsiders, we cannot decide whether the claims of a self-styled creative person are valid.

Creativity results from the interaction of a system consisting of three elements: a culture that contains symbolic rules, a person who brings novelty into the symbolic domain, and a field of experts who recognize and validate the innovation.

Creativity is the process by which a symbolic domain in the culture is changed. So we must learn the domain well. To master a domain, we must pay attention to the information to be assimilated. Bulk of our attention is committed to the tasks of surviving from one day to the next. And we do not do much with the small amount of attention left over because of the lack of focus. Diffused thinking leads to lack of concentration. Creativity is possible only when we are able to focus attention on the problem at hand.

Creativity, as mentioned before, consists of three main parts. The first of these is the domain, which consists of a set of symbolic rules and procedures.

The second component of creativity is the field, which includes all the individuals who act as gatekeepers to the domain. They decide whether a new idea or product can be accepted. For example, in the visual arts, the field consists of art teachers, curators of museums, collectors of art, critics, and administrators of foundations and government agencies that deal with culture. These people decide what new works of art must be recognised, preserved, and remembered.

The third component is the individual, who using symbols of a given domain, comes up with a new idea or sees a new pattern. His or her thoughts or actions change a domain, or establish a new domain.

Read this book to get a deeper understanding of creativity and how creative people go about doing their work and leading their lives.

The Mystery of Capital

2007-07-26T22:22:00.000+05:30

Why does capitalism thrive in the west but not in many developing countries? Global capitalism has been tried before in various parts of the world. In Latin America, for example, reforms have been tried at least four times since independence from Spain in the 1820s. Each time, after the initial euphoria, Latin America swung back from capitalist and market economy policies.

Westerners rationalise these setbacks by blaming people in the poor countries for their lack of entrepreneurial spirit or market orientation. Other popular explanations are lack of Protestant ethic, the legacy of colonialism and low IQ.

According to Hernando De Soto, the major stumbling block that keeps the rest of the world from benefiting from capitalism is its inability to produce capital. Capital is the force that raises the productivity of labour and creates the wealth of nations. It is the lifeblood of the capitalist system, the foundation of progress, and the one thing that the poor countries of the world cannot seem to produce enough for themselves.

De Soto argues in this seminal book that the poor cannot produce capital not because they do not possess assets. But they hold these assets in defective forms: houses built on land whose ownership rights are not adequately recorded, or unincorporated businesses with undefined liability. Because the rights to these possessions are not adequately documented, these assets cannot readily be turned into capital, cannot be traded outside narrow local circles where people know and trust each other and cannot be used as collateral for a loan.

In the West, by contrast, land, building and equipment are represented in a property document that connects all these assets to the rest of the economy. Thanks to this representational process, land can be used as collateral for raising loans. Third World and former community nations do not have this representational process. The enterprises of the poor are very much like corporations that cannot issue shares or bonds to obtain new investments and finance.

In poor countries, although people frequently break the law, their entrepreneurial ingenuity has created wealth on a vast scale. These assets far exceed the holdings of the government, the local stock exchanges and foreign direct investment. According to the author, the total value of the “illegal” real estate held by the poor of the Third World and former communist nations is at least $9.3 trillion, about twice as much as the total circulating US money supply. But in the absence of a suitable representational process, the value of these assets remains locked up.

Read this great book to know more.