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?
Saturday, April 05, 2008
Thursday, March 20, 2008
Financial sector reforms need to deepen
According to Percy Mistry, one of the champions of Mumbai International Financial Centre, India's financial sector reforms have to accelerate. In particular, Mistry in an article in Business Standard has mentioned the folowing :
Reduce micro management by RBI and SEBI.
Dismantle the license control raj.
Liberalise derivatives and commodity markets.
Encourage more competition and innovation.
To be a global financial services player, Mistry argues, India needs :
An open capital account
Capable and efficient markets
World class institutions and responsive regulators
Less intervention by RBI and MOF.
Reduce micro management by RBI and SEBI.
Dismantle the license control raj.
Liberalise derivatives and commodity markets.
Encourage more competition and innovation.
To be a global financial services player, Mistry argues, India needs :
An open capital account
Capable and efficient markets
World class institutions and responsive regulators
Less intervention by RBI and MOF.
Should the Fiscal Responsibility and Budget Management (FRBM) Act be scrapped?
The Business Standard came out with a very insightful editorial recently. "Should the Fiscal Responsibility and Budget Management (FRBM) Act be scrapped? For this law seems to be having the perverse effect of making the government hide more and more of its expenditure and not show it in the Budget. The finance minister can then claim that he is meeting FRBM targets, when in truth he is not. Scrapping the law might encourage more honest budgeting."
While Chidambaram claims that he has heroically slashed the deficit, the fact is that if all the "off balance sheet" items are considered including the oil pool deficit, farm loan waivers, the pay commission recommendations and last but not the least, the deficits of state governments, the deficit may cross 7.5-8.0% of the GDP.
While Chidambaram claims that he has heroically slashed the deficit, the fact is that if all the "off balance sheet" items are considered including the oil pool deficit, farm loan waivers, the pay commission recommendations and last but not the least, the deficits of state governments, the deficit may cross 7.5-8.0% of the GDP.
Three main barriers to growth of the indian economy
According to a McKinsey report prepared about 7 years back, three factors reduced growth by as much as 4%. Little seems to have changed since then.
The factors are :
Multiplicity of regulations governing product markets.
Unfairness and ambiguity
Uneven enforcement
Reservation for SSIs
FDI restrictions
Licensing
Distortions in the market for land.
Unclear ownership
Counterproductive taxation
Inflexible zoning, rent and tenancy laws
Widespread government ownership.
The factors are :
Multiplicity of regulations governing product markets.
Unfairness and ambiguity
Uneven enforcement
Reservation for SSIs
FDI restrictions
Licensing
Distortions in the market for land.
Unclear ownership
Counterproductive taxation
Inflexible zoning, rent and tenancy laws
Widespread government ownership.
Little progress on Pensions front
The government is not making much progress in the crucial area of pensions. The existing formal pension channels don’t cover unorganised sector workers.
Given the dismal levels of penetration of financial services, most Indian people are not contributing towards their old-age security.
The PFRDA Bill could bridge that gap, and give people greater control over their retirement benefits, but the Left has held it hostage.
Contrast this with the US. In 1981, Ronald Reagan launched the 401K plan in the US. The US pension industry, which was $60 billion then, is today a $9 trillion industry, with most of the money invested in equities.
Under the shadow of the Left, the government has hestitated to increase FDI limits from 26% to 49% in insurance. What a great pity.
Given the dismal levels of penetration of financial services, most Indian people are not contributing towards their old-age security.
The PFRDA Bill could bridge that gap, and give people greater control over their retirement benefits, but the Left has held it hostage.
Contrast this with the US. In 1981, Ronald Reagan launched the 401K plan in the US. The US pension industry, which was $60 billion then, is today a $9 trillion industry, with most of the money invested in equities.
Under the shadow of the Left, the government has hestitated to increase FDI limits from 26% to 49% in insurance. What a great pity.
India's rigid labour markets continue to create problems
The absence of a bankruptcy law and labour reforms, especially the difficulty in retrenching workers, has reduced the competitiveness of Indian firms.
The Industrial Disputes Act, 1947—particularly, Chapter 5B—bars manufacturing companies that employ more than 100 workers from firing employees without state government approval.
According to Amit Mitra, Secretary-General of the Federation of Indian Chambers of Commerce and Industry, employers have been reluctant to add extra staff during peak seasons because they cannot be laid off during lull periods.
"It has resulted in a paradoxical situation. Despite having surplus labour in the country, many large employers are expanding output through capital investment wherever possible."
The Industrial Disputes Act, 1947—particularly, Chapter 5B—bars manufacturing companies that employ more than 100 workers from firing employees without state government approval.
According to Amit Mitra, Secretary-General of the Federation of Indian Chambers of Commerce and Industry, employers have been reluctant to add extra staff during peak seasons because they cannot be laid off during lull periods.
"It has resulted in a paradoxical situation. Despite having surplus labour in the country, many large employers are expanding output through capital investment wherever possible."
India's business investment climate continues to be bad
It takes 71 days to get all requisite clearances for starting an enterprise in India. The same requires just five days in the US, six days in Singapore and 48 days in China.
It takes 425 days to enforce a contract in India, compared to 69 days in Singapore and 241 days in China.
In fact, according to a World Bank 2007 survey, ‘Ease of Doing Business’, India is ranked 177th out of 178 countries in enforcing business contracts.
Clearly nothing much to cheer for the Indian government despite its claims to be led by reformers like Manmohan Singh and Chidambaram.
It takes 425 days to enforce a contract in India, compared to 69 days in Singapore and 241 days in China.
In fact, according to a World Bank 2007 survey, ‘Ease of Doing Business’, India is ranked 177th out of 178 countries in enforcing business contracts.
Clearly nothing much to cheer for the Indian government despite its claims to be led by reformers like Manmohan Singh and Chidambaram.
Little in the 2008 budget for education
Despite the claims by the Finance Minister, nothing much is being done by the current government for education as the following statment by Nandan Nilekani of Infosys suggests. The statment by our Prime Minister on the other hand clearly suggests that for the government, education has a lower priority than giving away loan waivers ( Rs 60000 crores) to farmers.
"Higher education is a dark spot. Though FM has enhanced allocation for education, he hasn’t done much for higher education. Starting a few IITs is not going to make much difference to the country. Bold steps are called for to open the sector. While steps have been announced to invest in skills development and education, clearly they are timid.” Nandan Nilekani, Economic Times, March 1
“We are very keen to do more in these areas but we have our resource constraints. So we cannot do everything at one go.” Manmohan Singh, Economic Times, March
"Higher education is a dark spot. Though FM has enhanced allocation for education, he hasn’t done much for higher education. Starting a few IITs is not going to make much difference to the country. Bold steps are called for to open the sector. While steps have been announced to invest in skills development and education, clearly they are timid.” Nandan Nilekani, Economic Times, March 1
“We are very keen to do more in these areas but we have our resource constraints. So we cannot do everything at one go.” Manmohan Singh, Economic Times, March
The fiscal deficit : India vs China
The Economist recently mentioned that according to official estimates, China's government ran a budget deficit of around 1%last year. But some economists reckon that the cautious government is understating its true fiscal health: it probably had a small surplus. If the profits of state-owned firms are also added in, the government could have a surplus of around 3% of GDP. China's public debt has also fallen to only 17% of GDP, well below the average ratio of 77% in OECD economies. Indeed, China has the best fiscal position of any big country.
By contrast, India, though improving, has one of the worst fiscal positions in the world. The government has tried hard to conceal this fact, boasting that it has reduced its deficit to an estimated 3.3% of GDP in the year ending March, from 6.5% in 2001-02 However, in a recent report the IMF argued that the true total deficit is closer to 7% of GDP once we add in the state governments' deficits and various off-budget items. If the losses of state electricity companies are also added in, the total deficit could top an alarming 8% of GDP. India's public debt is also uncomfortably high at about 75% of GDP.
Clearly, our Finance Minister should be more honest and transparent while presenting facts and figures.
By contrast, India, though improving, has one of the worst fiscal positions in the world. The government has tried hard to conceal this fact, boasting that it has reduced its deficit to an estimated 3.3% of GDP in the year ending March, from 6.5% in 2001-02 However, in a recent report the IMF argued that the true total deficit is closer to 7% of GDP once we add in the state governments' deficits and various off-budget items. If the losses of state electricity companies are also added in, the total deficit could top an alarming 8% of GDP. India's public debt is also uncomfortably high at about 75% of GDP.
Clearly, our Finance Minister should be more honest and transparent while presenting facts and figures.
Sunday, February 24, 2008
A dollar rebound?
Will the US dollar fall further or will it stage a smart recovery? That is the big question for currency strategists as 2008 gains momentum and banks look beyond sub prime. There is still no consensus.
One is a bullish view on the greenback, despite the huge US trade deficit and the imminent slowdown of the world’s largest economy. The dollar bulls are hoping that investor expectations over the state of the US economy may have already stabilized. Although disappointing data will likely continue to come as the economy slows down, by its bold actions, the Fed has already inspired confidence in the markets and the US slowdown may have already been built into expectations. The 125 basis points cut towards the end of January in two tranches clearly signaled the Fed’s commitment to bold policy moves in order to get the US economy back on track. The Fed’s efforts to contain the fallout from any recession puts it ahead of the other G10 (Japan, Euro, UK, Switzerland, Norway, Sweden, Canada, Australia, New Zealand) central banks.
The prospects for a currency cannot be considered in isolation of other currencies. The bullish view on the dollar is supported by the disappointment of analysts with the ECB’s exclusive focus on inflation. In its most recent meeting held on February 8, the ECB did not change rates but admitted that there could be a slowdown. The dollar bulls argue that direction is clearly lacking from the ECB at present. So policy expectations will remain volatile, markets may feel uncomfortable and funds may flow out of the Euro zone. Jean Claude Trichet the ECB president did soften his stance at the most recent meeting last week and admitted that unusually high uncertainty was prevailing in the global financial environment. But the ECB’s stance towards inflation remains far more rigid than that of the Fed.
Meanwhile, the Bank of England, though not as aggressive as the Fed, last week, cut interest rates by 0.25% to 5.25%, citing deteriorating global growth outlook. But the bank did not completely shift its focus away from inflation as the Fed seems to have done. Unlike the Euro, there is little policy instability, especially since Mervyn King’s reappointment as BoE governor. However, there is weakness in the UK economy marked by slow growth and instability in the mortgage markets.
What about emerging market currencies? One reason for the greenback’s weakness in recent years is that US investors looking for higher returns have moved heavily into emerging market equities, assets and commodities. The latest data on US mutual funds, however, show that in December the share of foreign equities in American investors’ portfolios fell for only the second month of 2007 and only the fifth month in the last two years. The other times this occurred were during months of increased risk aversion. The last occasion was in August last year at the onset of the sub prime crisis. This increased risk aversion may well result in a further reduction of US investor appetite for overseas assets and thus reduce the downward pressure on the dollar.
What about the carry trade? That means borrowing low interest rate currencies like yen, selling them and investing in high interest rate currencies like the Aussie Dollar. Emerging data seem to indicate that arbitraging possibilities through carry trade are disappearing for the truly convertible currencies. The markets may well be coming around to the view that it is time to bet on low interest rate currencies (and the dollar is now one of them) as they have better fundamentals.
In January, the low-yielding yen and Swiss Franc were the two strongest currencies. Sharp sell offs in global equity markets on January 21 put “decoupling” further in doubt, and rating downgrades of bond insurers put credit concerns back in the spotlight. Historically, a rising level of risk aversion has helped safe-haven currencies such as the JPY and CHF and hurt “growth” currencies such as the Australian Dollar and New Zealand Dollar. Confidence in the carry trade collapsed in January. Indeed, the JPY outperformed all of the other G10 currencies in January, and ended the month up 5.3% versus the USD.
The medium term outlook for the dollar does seem bright, especially against the Euro. The dollar has held ground in the last 3 months against the Euro despite the steep cuts in interest rates. (See graph)The more the Fed eases now, the more it will remove these cuts, likely later this year when the US economy recovers. As long as the dollar holds up as the Fed cuts rates now, the dollar will have a good chance of rallying in the second half of the year when the Fed may start raising interest rates. When the Fed raises rates in a more upbeat environment, there might be a lot of support coming from the markets for the dollar.
One is a bullish view on the greenback, despite the huge US trade deficit and the imminent slowdown of the world’s largest economy. The dollar bulls are hoping that investor expectations over the state of the US economy may have already stabilized. Although disappointing data will likely continue to come as the economy slows down, by its bold actions, the Fed has already inspired confidence in the markets and the US slowdown may have already been built into expectations. The 125 basis points cut towards the end of January in two tranches clearly signaled the Fed’s commitment to bold policy moves in order to get the US economy back on track. The Fed’s efforts to contain the fallout from any recession puts it ahead of the other G10 (Japan, Euro, UK, Switzerland, Norway, Sweden, Canada, Australia, New Zealand) central banks.
The prospects for a currency cannot be considered in isolation of other currencies. The bullish view on the dollar is supported by the disappointment of analysts with the ECB’s exclusive focus on inflation. In its most recent meeting held on February 8, the ECB did not change rates but admitted that there could be a slowdown. The dollar bulls argue that direction is clearly lacking from the ECB at present. So policy expectations will remain volatile, markets may feel uncomfortable and funds may flow out of the Euro zone. Jean Claude Trichet the ECB president did soften his stance at the most recent meeting last week and admitted that unusually high uncertainty was prevailing in the global financial environment. But the ECB’s stance towards inflation remains far more rigid than that of the Fed.
Meanwhile, the Bank of England, though not as aggressive as the Fed, last week, cut interest rates by 0.25% to 5.25%, citing deteriorating global growth outlook. But the bank did not completely shift its focus away from inflation as the Fed seems to have done. Unlike the Euro, there is little policy instability, especially since Mervyn King’s reappointment as BoE governor. However, there is weakness in the UK economy marked by slow growth and instability in the mortgage markets.
What about emerging market currencies? One reason for the greenback’s weakness in recent years is that US investors looking for higher returns have moved heavily into emerging market equities, assets and commodities. The latest data on US mutual funds, however, show that in December the share of foreign equities in American investors’ portfolios fell for only the second month of 2007 and only the fifth month in the last two years. The other times this occurred were during months of increased risk aversion. The last occasion was in August last year at the onset of the sub prime crisis. This increased risk aversion may well result in a further reduction of US investor appetite for overseas assets and thus reduce the downward pressure on the dollar.
What about the carry trade? That means borrowing low interest rate currencies like yen, selling them and investing in high interest rate currencies like the Aussie Dollar. Emerging data seem to indicate that arbitraging possibilities through carry trade are disappearing for the truly convertible currencies. The markets may well be coming around to the view that it is time to bet on low interest rate currencies (and the dollar is now one of them) as they have better fundamentals.
In January, the low-yielding yen and Swiss Franc were the two strongest currencies. Sharp sell offs in global equity markets on January 21 put “decoupling” further in doubt, and rating downgrades of bond insurers put credit concerns back in the spotlight. Historically, a rising level of risk aversion has helped safe-haven currencies such as the JPY and CHF and hurt “growth” currencies such as the Australian Dollar and New Zealand Dollar. Confidence in the carry trade collapsed in January. Indeed, the JPY outperformed all of the other G10 currencies in January, and ended the month up 5.3% versus the USD.
The medium term outlook for the dollar does seem bright, especially against the Euro. The dollar has held ground in the last 3 months against the Euro despite the steep cuts in interest rates. (See graph)The more the Fed eases now, the more it will remove these cuts, likely later this year when the US economy recovers. As long as the dollar holds up as the Fed cuts rates now, the dollar will have a good chance of rallying in the second half of the year when the Fed may start raising interest rates. When the Fed raises rates in a more upbeat environment, there might be a lot of support coming from the markets for the dollar.
The Fed rate cuts and their implications
These are truly exciting times provided you are an analyst or academic and you do not have any major exposure to the market! On January 30, the Federal Open Market Committee (FOMC), the monetary policy making authority of the US Federal reserve (Fed) decided to lower its target for the benchmark federal funds rate by 50 basis points to 3 percent. The Fed also cut its discount rate by 50 bp. (The Fed funds rate is the overnight interbank lending rate while the discount rate is the rate at which the Fed is prepared to lend short term to eligible banks.) The Fed explained: “Financial markets remain under considerable stress, and credit has tightened further for some businesses and households. Moreover, recent information indicates a deepening of the housing contraction as well as some softening in labor markets.” The Fed mentioned that it expected moderate inflation in the coming quarters, but it would continue to monitor inflation carefully. It hoped that the 50 bp cut would help to promote moderate growth over time and to “mitigate the risks to economic activity.”
The 50 bp cut has come on top of a 75 bp emergency cut on January 22. The FOMC’s justification then was the weak economic outlook and “increasing downside risks to growth.” The Fed added that while strains in short-term funding markets had eased, the general financial market conditions continued to deteriorate and credit had tightened further for some businesses and households. The Fed also anticipated the possibility of a deeper contraction of the housing sector as well as some softening in labor markets.
The aggressive stance of the Fed was earlier preceded by two 25 bp cuts on December 11 and October 31 and a 50 bp cut on September 18. In short, the Fed has cut interest rates by 2.25 % (from 5.25% to 3%) in a span of about 3 months. After being overshadowed briefly by the European Central Bank which led a major concerted effort by central banks to increase liquidity in the markets in December, the Fed has come back to centre stage.
The Fed clearly believes that more than anything else, it is interest rates which send the clearest and least confusing signals to the market. Some analysts have argued recently that instead of cutting interest rates in small doses and continuing the state of uncertainty in the markets, it is best to administer one major dose. The Fed’s actions seem to be aligned with this philosophy.
Some like the Economist have criticized the Fed for being influenced by short term movements on Wall Street. But this view is probably harsh. In a crisis situation such as this, action is usually preferable to analysis. Talk of rising headline inflation and hence the need to maintain status quo on interest rates is fine but the fact is investor confidence must be protected. We should also not bet too heavily on the emerging markets to bail out the global economy. The events of the last week have clearly demonstrated that the concept of “decoupling” can be taken too far. People are again talking about recoupling !
One of the widely cited reasons for the Great Depression of the 1930s was the lethargy on the part of the Fed to loosen monetary policy. The famous economist, Nouriel Roubini of Stern Business School recently argued in Newsweek that the current crisis is worse than the 1987 stock market crash. It is also worse than the Savings & Loan crisis of the late 1980s when only savings and loan thrifts and the commercial real estate sector were affected. And unlike the 1998 LTCM (Long Term Capital Management) crisis, today we seem to be facing both insolvency and liquidity problems. Today’s scenario is also different from the 2000-2001 US slow down when only the tech sector was affected. Roubini actually concluded: “We are of course far short of a Great Depression now but in terms of systemic risk and the risks of a financial meltdown, you almost have to go back that far to find a good analogy.”
Roubini’s views may be somewhat pessimistic. But at a time when we are still not clear about what is the extent of the sub prime losses and to what other sectors (like credit cards ) the contagion may spread, the Fed has not lacked in boldness and vision. The”Bernanke put” may be criticized by some intellectuals but will probably bring some cheer to the markets. And the animal spirits (a term coined by the famous economist Keynes) should not be allowed to flag. If they start flagging, restoring investor confidence will prove to be a monumental task.
The 50 bp cut has come on top of a 75 bp emergency cut on January 22. The FOMC’s justification then was the weak economic outlook and “increasing downside risks to growth.” The Fed added that while strains in short-term funding markets had eased, the general financial market conditions continued to deteriorate and credit had tightened further for some businesses and households. The Fed also anticipated the possibility of a deeper contraction of the housing sector as well as some softening in labor markets.
The aggressive stance of the Fed was earlier preceded by two 25 bp cuts on December 11 and October 31 and a 50 bp cut on September 18. In short, the Fed has cut interest rates by 2.25 % (from 5.25% to 3%) in a span of about 3 months. After being overshadowed briefly by the European Central Bank which led a major concerted effort by central banks to increase liquidity in the markets in December, the Fed has come back to centre stage.
The Fed clearly believes that more than anything else, it is interest rates which send the clearest and least confusing signals to the market. Some analysts have argued recently that instead of cutting interest rates in small doses and continuing the state of uncertainty in the markets, it is best to administer one major dose. The Fed’s actions seem to be aligned with this philosophy.
Some like the Economist have criticized the Fed for being influenced by short term movements on Wall Street. But this view is probably harsh. In a crisis situation such as this, action is usually preferable to analysis. Talk of rising headline inflation and hence the need to maintain status quo on interest rates is fine but the fact is investor confidence must be protected. We should also not bet too heavily on the emerging markets to bail out the global economy. The events of the last week have clearly demonstrated that the concept of “decoupling” can be taken too far. People are again talking about recoupling !
One of the widely cited reasons for the Great Depression of the 1930s was the lethargy on the part of the Fed to loosen monetary policy. The famous economist, Nouriel Roubini of Stern Business School recently argued in Newsweek that the current crisis is worse than the 1987 stock market crash. It is also worse than the Savings & Loan crisis of the late 1980s when only savings and loan thrifts and the commercial real estate sector were affected. And unlike the 1998 LTCM (Long Term Capital Management) crisis, today we seem to be facing both insolvency and liquidity problems. Today’s scenario is also different from the 2000-2001 US slow down when only the tech sector was affected. Roubini actually concluded: “We are of course far short of a Great Depression now but in terms of systemic risk and the risks of a financial meltdown, you almost have to go back that far to find a good analogy.”
Roubini’s views may be somewhat pessimistic. But at a time when we are still not clear about what is the extent of the sub prime losses and to what other sectors (like credit cards ) the contagion may spread, the Fed has not lacked in boldness and vision. The”Bernanke put” may be criticized by some intellectuals but will probably bring some cheer to the markets. And the animal spirits (a term coined by the famous economist Keynes) should not be allowed to flag. If they start flagging, restoring investor confidence will prove to be a monumental task.
From decoupling to recoupling ?
In recent months, analysts have been hotly discussing the concept of decoupling. Have the emerging markets finally broken free of their shackles and reduced their dependence on the US economy? And unlike the past when the US acted as the bellwhether and continued to come to the rescue of the global economy from time to time (Recall the Latin American debt crisis (1980s), Mexican(1994), Asian(1997-98 ) and Russian currency crises(1998) ) have the tables been turned at last? With emerging economies accounting for bulk of the growth in global GDP in recent moths, has the world reached another turning point?
Recent wild swings in the emerging markets seem to indicate that the theory of decoupling has been taken too far. While the world may not catch cold if America sneezes, it may not be that easy for the emerging markets to cure America if the largest economy in t he world does indeed catch cold.
As leading economist Stephen Roach of Morgan Stanley recently mentioned in Newsweek magazine, (Feb 4, 2008) we cannot talk of globalization and decoupling in the same breath. Interinkages between markets and economies across the world cannot be wished away, even if as Harvard Business School professor, Pankaj Ghemawat mentions in his recently released book, Redefining Global Strategy, we are living in a semi global world.
A second point is that the US is still a giant compared to India and China. American consumers spent an estimated $ 9.5 trillion last year compared to $ 1 trillion by the Chinese and about $ 650 billion by the Indians. As Roach mentioned, if the US does go into recession, “It is mathematically impossible to see a major decrease in US consumption being made up by the Chinese and Indians.” Clearly, despite their dynamism and their much higher growth rates, China and India are still small if we put things in perspective.
A third point , related to the second is that the emerging markets may be able to compensate for a slight slowdown in the US but they hardly have the firepower to reverse the impact of a deep recession on the global economy. As Jim O’ Neill of Goldman Sachs and a great believer in the emerging markets, has mentioned in the same issue of Newsweek, the US is 30% of the global economy whereas China is only 7%.” For now, I’m betting on recoupling. The world cannot ignore a US recession.”
A fourth point to note is that China and India are hardly “thought leaders” in the global economy. They get most if not all the ideas for doing business from the Americans. Most of the innovations by the Indian and Chinese companies have been process improvements. True, we have innovations like the Nano once in a while ( and we should be justifiably proud of these breakthroughs) but it will be quite sometime before India actually produces the kind of stuff which the Silicon Valley(California) or Route 21(outside Boston) clusters in the US produce. And many of our blue chips are heavily dependent on the US market for bulk of their revenues. They can hardly claim with any justifiable optimism that they will be able to make up for any loss in revenues due to a US slowdown by increasing their domestic business. Indeed the big bet, our IT services and outsourcing companies are making is that the Americans, driven by the pressure to cut costs, will further increase the quantum of outsourcing.
A fifth point is that our markets still take the cue from the US, not vice versa. After the terrorising fall in the Sensex on January 21 and 22, the markets recovered only after the US Federal Reserve made that bold 75 basis points cut. A few days later, when our RBI decided not to do anything about interest rates (and instead preferred to do what it seems to enjoy doing most, giving free advice to commercial banks on how much they should charge their customers!), the US markets did not panic. And let us remember that our blue chip companies are still doing well. Some have even shown smart increases in net income in the last quarter. On the other hand, billions of dollars have been lost by the Citis and Morgan Stanleys thanks to the sub prime crisis. If decoupling were really true, we should have seen funds arriving in hoardes in the developing countries just as in the past they would have moved out from emerging markets and taken refuge in US treasury bills.
That brings us to the sixth point. Indian and Chinese assets are rapidly becoming over valued. Anyone trying to buy a home today in one of our metros would need no further convincing about this point! At the same time, labour is also becoming expensive In India. As O’Neill mentioned, “ There’s been just a peristent, fantastic increase in emerging market assets , driving expectations of even more incredible gains. But assets in China and India aren’t cheap anymore. That means these countries are vulnerable to any kind of disappointing news.”
All this means that we need to be more cautious and get ready to tighten our belts. Clearly, the time has come to talk about recoupling and not decoupling.
Recent wild swings in the emerging markets seem to indicate that the theory of decoupling has been taken too far. While the world may not catch cold if America sneezes, it may not be that easy for the emerging markets to cure America if the largest economy in t he world does indeed catch cold.
As leading economist Stephen Roach of Morgan Stanley recently mentioned in Newsweek magazine, (Feb 4, 2008) we cannot talk of globalization and decoupling in the same breath. Interinkages between markets and economies across the world cannot be wished away, even if as Harvard Business School professor, Pankaj Ghemawat mentions in his recently released book, Redefining Global Strategy, we are living in a semi global world.
A second point is that the US is still a giant compared to India and China. American consumers spent an estimated $ 9.5 trillion last year compared to $ 1 trillion by the Chinese and about $ 650 billion by the Indians. As Roach mentioned, if the US does go into recession, “It is mathematically impossible to see a major decrease in US consumption being made up by the Chinese and Indians.” Clearly, despite their dynamism and their much higher growth rates, China and India are still small if we put things in perspective.
A third point , related to the second is that the emerging markets may be able to compensate for a slight slowdown in the US but they hardly have the firepower to reverse the impact of a deep recession on the global economy. As Jim O’ Neill of Goldman Sachs and a great believer in the emerging markets, has mentioned in the same issue of Newsweek, the US is 30% of the global economy whereas China is only 7%.” For now, I’m betting on recoupling. The world cannot ignore a US recession.”
A fourth point to note is that China and India are hardly “thought leaders” in the global economy. They get most if not all the ideas for doing business from the Americans. Most of the innovations by the Indian and Chinese companies have been process improvements. True, we have innovations like the Nano once in a while ( and we should be justifiably proud of these breakthroughs) but it will be quite sometime before India actually produces the kind of stuff which the Silicon Valley(California) or Route 21(outside Boston) clusters in the US produce. And many of our blue chips are heavily dependent on the US market for bulk of their revenues. They can hardly claim with any justifiable optimism that they will be able to make up for any loss in revenues due to a US slowdown by increasing their domestic business. Indeed the big bet, our IT services and outsourcing companies are making is that the Americans, driven by the pressure to cut costs, will further increase the quantum of outsourcing.
A fifth point is that our markets still take the cue from the US, not vice versa. After the terrorising fall in the Sensex on January 21 and 22, the markets recovered only after the US Federal Reserve made that bold 75 basis points cut. A few days later, when our RBI decided not to do anything about interest rates (and instead preferred to do what it seems to enjoy doing most, giving free advice to commercial banks on how much they should charge their customers!), the US markets did not panic. And let us remember that our blue chip companies are still doing well. Some have even shown smart increases in net income in the last quarter. On the other hand, billions of dollars have been lost by the Citis and Morgan Stanleys thanks to the sub prime crisis. If decoupling were really true, we should have seen funds arriving in hoardes in the developing countries just as in the past they would have moved out from emerging markets and taken refuge in US treasury bills.
That brings us to the sixth point. Indian and Chinese assets are rapidly becoming over valued. Anyone trying to buy a home today in one of our metros would need no further convincing about this point! At the same time, labour is also becoming expensive In India. As O’Neill mentioned, “ There’s been just a peristent, fantastic increase in emerging market assets , driving expectations of even more incredible gains. But assets in China and India aren’t cheap anymore. That means these countries are vulnerable to any kind of disappointing news.”
All this means that we need to be more cautious and get ready to tighten our belts. Clearly, the time has come to talk about recoupling and not decoupling.
Is more capital the solution to the banking crisis?
Two insightful pieces in Business Standard dt January 29, one an editorial and another an article by well known economist Lawrence Summers, explained at length the implications arising out of the sub prime crisis. Because of securitization, it has become difficult to pinpoint where risks lie and how to measure them. Financial institutions are holding various credit instruments that are impaired but difficult to value. This is creating uncertainty and freezing new lending.
Under the current circumstances, investors have become extremely risk averse, except for a few vulture investors like Wilbur Ross, who are on the prowl for distressed assets. So the valuations of asset backed securities are likely to be understated. During such times of panic, capital can give banks more staying power. As Summers put it “More capital permits more recognition of impairments and makes asset transfers easier by increasing the number of potential purchasers. It is preferable for the economy that banks bloster their capital positions by diluting current owners than by shrinking their lending activities.”
How valid are these arguments? To start with, we must appreciate that there are broadly speaking, three ways to deal with risk. One is to revamp internal systems and processes. That means strengthening risk measurement and control mechanisms. Unfortunately, in today’s situation, it has become difficult to identify tainted assets, leave alone measure risk accurately. Moreover, if banks swing to the other extreme and auditors start taking control of banks, lending and trading may be further discouraged. That is the last thing the financial system needs today.
A second method is to use derivatives and transfer risk quickly, ie avoid warehousing. If the bank does not understand the risk well or is uncomfortable managing it actively, it should be transferred through a derivative or insurance contract. Indeed, this is what Goldman Sachs, the player virtually unaffected by the sub prime crisis seems to have done.
The last is to have more equity, another name for capital. When risks are very difficult to identify or measure and we are in a situation where we do not know what we do not know, capital is the only credible alternative. Citi, UBS and other leading banks have all tried to recapitalise themselves in recent months, approaching sovereign wealth funds in the middle east and Asia.
There is no doubt that capital is critically important for a bank. Richard Brealey, an eminent academic ( from London Business School) writing in the Journal of Applied Corporate Finance( Fall 2006 ) observed that If the value of bank assets evolved smoothly and could be observed continuously then a bank would need only a minimal amount of equity capital. But to deal with “jump” risks, extra capital is required . Moreover, many asset values are observed only at discrete intervals. The greater the time between valuations of the bank’s assets, and the more volatile those assets, the more capital that would be needed. Finally, capital provides a safeguard against errors in valuing the bank’s assets.
But as the Americans say, there is no free lunch. Capital comes at a price. So banks should not hold too much capital. Otherwise they will not be able to meet the expectations of shareholders. Moreover, capital may be of little help if there is a run on banks. After all, the amounts raised by the global banks from the sovereign wealth funds, despite the media publicity and political reactions it has attracted, is only a small fraction of the estimated total exposure of banks to asset backed securities.
If prudent risk management demands that banks should only hold those risks which they should hold, this is a great opportunity for soul searching and financial restructuring. In an insightful article in the Harvard Business Review, (Nov 2005), the Nobel prize winning Robert Merton had mentioned: “ In most large companies, equity capital is used to cushion against a great many risks that the firm is no better at bearing than anyone else. If it can strip out the non value adding or passive risk, a company will be able to use its existing equity capital to finance a lot more value adding assets and activities than competitors and its shares will be worth far more.”
Equity is also an expensive source of capital. It does not enjoy tax benefits. Moreover, there are agency costs associated with equity that favor managers over shareholders. Unlike debt, where there are mandatory cash outflows, equity can make managers complacent.
To avoid these agency costs, some economists have argued that banks should be obliged to make regular issues of subordinated debt. The holders of this subordinated debt would have the incentive to monitor the bank. At the same time, the prices at which the debt is issued will reflect the bank’s creditworthiness. True subordinated debt will not solve all corporate governance problems. But there is no doubt that higher discipline will result if banks have to go to the market to raise debt from time to time. And we must remember that market discipline is one of the three pillars of Basle II, the others being supervisory review and minimum capital requirements.
As the banking system finds itself at a cross roads, there is little doubt that regulators today face the onerous burden of coming up with the right policy response. Merely raising the capital adequacy ratio may not be enough.
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.
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