THE GREAT FINANCIAL CRISIS OF 2008-09 / WHAT WENT WRONG ?

A special report on financial risk in context of the financial crisis.
Source : The Economist.


THE revolutionary idea that defines the boundary between modern times and the past is the mastery of risk: the notion that the future is more than a whim of the gods and that men and women are not passive before nature.” So wrote Peter Bernstein in his seminal history of risk, “Against the Gods”, published in 1996. And so it seemed, to all but a few Cassandras, for much of the decade that followed. Finance enjoyed a golden period, with low interest rates, low volatility and high returns. Risk seemed to have been reduced to a permanently lower level.

This purported new paradigm hinged, in large part, on three closely linked developments: the huge growth of derivatives; the decomposition and distribution of credit risk through securitisation; and the formidable combination of mathematics and computing power in risk management that had its roots in academic work of the mid-20th century. It blossomed in the 1990s at firms such as Bankers Trust and JPMorgan, which developed “value-at-risk” (VAR), a way for banks to calculate how much they could expect to lose when things got really rough.

Suddenly it seemed possible for any financial risk to be measured to five decimal places, and for expected returns to be adjusted accordingly. Banks hired hordes of PhD-wielding “quants” to fine-tune ever more complex risk models. The belief took hold that, even as profits were being boosted by larger balance sheets and greater leverage (borrowing), risk was being capped by a technological shift.

There was something self-serving about this. The more that risk could be calibrated, the greater the opportunity to turn debt into securities that could be sold or held in trading books, with lower capital charges than regular loans. Regulators accepted this, arguing that the “great moderation” had subdued macroeconomic dangers and that securitisation had chopped up individual firms’ risks into manageable lumps. This faith in the new, technology-driven order was reflected in the Basel 2 bank-capital rules, which relied heavily on the banks’ internal models.

There were bumps along the way, such as the near-collapse of Long-Term Capital Management (LTCM), a hedge fund, and the dotcom bust, but each time markets recovered relatively quickly. Banks grew cocky. But that sense of security was destroyed by the meltdown of 2007-09, which as much as anything was a crisis of modern metrics-based risk management. The idea that markets can be left to police themselves turned out to be the world’s most expensive mistake, requiring $15 trillion in capital injections and other forms of support. “It has cost a lot to learn how little we really knew,” says a senior central banker. Another lesson was that managing risk is as much about judgment as about numbers. Trying ever harder to capture risk in mathematical formulae can be counterproductive if such a degree of accuracy is intrinsically unattainable.
For now, the hubris of spurious precision has given way to humility. It turns out that in financial markets “black swans”, or extreme events, occur much more often than the usual probability models suggest. Worse, finance is becoming more fragile: these days blow-ups are twice as frequent as they were before the first world war, according to Barry Eichengreen of the University of California at Berkeley and Michael Bordo of Rutgers University. Benoit Mandelbrot, the father of fractal theory and a pioneer in the study of market swings, argues that finance is prone to a “wild” randomness not usually seen in nature. In markets, “rare big changes can be more significant than the sum of many small changes,” he says. If financial markets followed the normal bell-shaped distribution curve, in which meltdowns are very rare, the stockmarket crash of 1987, the interest-rate turmoil of 1992 and the 2008 crash would each be expected only once in the lifetime of the universe.

This is changing the way many financial firms think about risk, says Greg Case, chief executive of Aon, an insurance broker. Before the crisis they were looking at things like pandemics, cyber-security and terrorism as possible causes of black swans. Now they are turning to risks from within the system, and how they can become amplified in combination.

It would, though, be simplistic to blame the crisis solely, or even mainly, on sloppy risk managers or wild-eyed quants. Cheap money led to the wholesale underpricing of risk; America ran negative real interest rates in 2002-05, even though consumer-price inflation was quiescent. Plenty of economists disagree with the recent assertion by Ben Bernanke, chairman of the Federal Reserve, that the crisis had more to do with lax regulation of mortgage products than loose monetary policy.

Equally damaging were policies to promote home ownership in America using Fannie Mae and Freddie Mac, the country’s two mortgage giants. They led the duo to binge on securities backed by shoddily underwritten loans.

In the absence of strict limits, higher leverage followed naturally from low interest rates. The debt of America’s financial firms ballooned relative to the overall economy (see chart 1). At the peak of the madness, the median large bank had borrowings of 37 times its equity, meaning it could be wiped out by a loss of just 2-3% of its assets. Borrowed money allowed investors to fake “alpha”, or above-market returns, says Benn Steil of the Council on Foreign Relations.

The agony was compounded by the proliferation of short-term debt to support illiquid long-term assets, much of it issued beneath the regulatory radar in highly leveraged “shadow” banks, such as structured investment vehicles. When markets froze, sponsoring entities, usually banks, felt morally obliged to absorb their losses. “Reputation risk was shown to have a very real financial price,” says Doug Roeder of the Office of the Comptroller of the Currency, an American regulator.

Everywhere you looked, moreover, incentives were misaligned. Firms deemed “too big to fail” nestled under implicit guarantees. Sensitivity to risk was dulled by the “Greenspan put”, a belief that America’s Federal Reserve would ride to the rescue with lower rates and liquidity support if needed. Scrutiny of borrowers was delegated to rating agencies, who were paid by the debt-issuers. Some products were so complex, and the chains from borrower to end-investor so long, that thorough due diligence was impossible. A proper understanding of a typical collateralised debt obligation (CDO), a structured bundle of debt securities, would have required reading 30,000 pages of documentation.

Fees for securitisers were paid largely upfront, increasing the temptation to originate, flog and forget. The problems with bankers’ pay went much wider, meaning that it was much better to be an employee than a shareholder (or, eventually, a taxpayer picking up the bail-out tab). The role of top executives’ pay has been overblown. Top brass at Lehman Brothers and American International Group (AIG) suffered massive losses when share prices tumbled. A recent study found that banks where chief executives had more of their wealth tied up in the firm performed worse, not better, than those with apparently less strong incentives. One explanation is that they took risks they thought were in shareholders’ best interests, but were proved wrong. Motives lower down the chain were more suspect. It was too easy for traders to cash in on short-term gains and skirt responsibility for any time-bombs they had set ticking.

Asymmetries wreaked havoc in the vast over-the-counter derivatives market, too, where even large dealing firms lacked the information to determine the consequences of others failing. Losses on contracts linked to Lehman turned out to be modest, but nobody knew that when it collapsed in September 2008, causing panic. Likewise, it was hard to gauge the exposures to “tail” risks built up by sellers of swaps on CDOs such as AIG and bond insurers. These were essentially put options, with limited upside and a low but real probability of catastrophic losses.

Another factor in the build-up of excessive risk was what Andy Haldane, head of financial stability at the Bank of England, has described as “disaster myopia”. Like drivers who slow down after seeing a crash but soon speed up again, investors exercise greater caution after a disaster, but these days it takes less than a decade to make them reckless again. Not having seen a debt-market crash since 1998, investors piled into ever riskier securities in 2003-07 to maintain yield at a time of low interest rates. Risk-management models reinforced this myopia by relying too heavily on recent data samples with a narrow distribution of outcomes, especially in subprime mortgages.

A further hazard was summed up by the assertion in 2007 by Chuck Prince, then Citigroup’s boss, that “as long as the music is playing, you’ve got to get up and dance.” Performance is usually judged relative to rivals or to an industry benchmark, encouraging banks to mimic each other’s risk-taking, even if in the long run it benefits no one. In mortgages, bad lenders drove out good ones, keeping up with aggressive competitors for fear of losing market share. A few held back, but it was not easy: when JPMorgan sacrificed five percentage points of return on equity in the short run, it was lambasted by shareholders who wanted it to “catch up” with zippier-looking rivals.

An overarching worry is that the complexity of today’s global financial network makes occasional catastrophic failure inevitable. For example, the market for credit derivatives galloped far ahead of its supporting infrastructure. Only now are serious moves being made to push these contracts through central clearing-houses which ensure that trades are properly collateralised and guarantee their completion if one party defaults.

The push to allocate capital ever more efficiently over the past 20 years created what Till Guldimann, the father of VAR and vice-chairman of SunGard, a technology firm, calls “capitalism on steroids”. Banks got to depend on the modelling of prices in esoteric markets to gauge risks and became adept at gaming the rules. As a result, capital was not being spread around as efficiently as everyone believed.

Big banks had also grown increasingly interdependent through the boom in derivatives, computer-driven equities trading and so on. Another bond was cross-ownership: at the start of the crisis, financial firms held big dollops of each other’s common and hybrid equity. Such tight coupling of components increases the danger of “non-linear” outcomes, where a small change has a big impact. “Financial markets are not only vulnerable to black swans but have become the perfect breeding ground for them,” says Mr Guldimann. In such a network a firm’s troubles can have an exaggerated effect on the perceived riskiness of its trading partners. When Lehman’s credit-default spreads rose to distressed levels, AIG’s jumped by twice what would have been expected on its own, according to the International Monetary Fund.

Mr Haldane has suggested that these knife-edge dynamics were caused not only by complexity but also—paradoxically—by homogeneity. Banks, insurers, hedge funds and others bought smorgasbords of debt securities to try to reduce risk through diversification, but the ingredients were similar: leveraged loans, American mortgages and the like. From the individual firm’s perspective this looked sensible. But for the system as a whole it put everyone’s eggs in the same few baskets, as reflected in their returns (see chart 2).

Efforts are now under way to deal with these risks. The Financial Stability Board, an international group of regulators, is trying to co-ordinate global reforms in areas such as capital, liquidity and mechanisms for rescuing or dismantling troubled banks. Its biggest challenge will be to make the system more resilient to the failure of giants. There are deep divisions over how to set about this, with some favouring tougher capital requirements, others break-ups, still others—including America—a combination of remedies.

In January President Barack Obama shocked big banks by proposing a tax on their liabilities and a plan to cap their size, ban “proprietary” trading and limit their involvement in hedge funds and private equity. The proposals still need congressional approval. They were seen as energising the debate about how to tackle dangerously large firms, though the reaction in Europe was mixed.

Regulators are also inching towards a more “systemic” approach to risk. The old supervisory framework assumed that if the 100 largest banks were individually safe, then the system was too. But the crisis showed that even well-managed firms, acting prudently in a downturn, can undermine the strength of all.

The banks themselves will have to find a middle ground in risk management, somewhere between gut feeling and number fetishism. Much of the progress made in quantitative finance was real enough, but a firm that does not understand the flaws in its models is destined for trouble. This special report will argue that rules will have to be both tightened and better enforced to avoid future crises—but that all the reforms in the world will never guarantee total safety.

The need to re-write Economics text-books.

The crisis is changing how macroeconomics is taught....
An insightful article from THE ECONOMIST.


Mar 31st 2010
From The Economist print edition

IN MORE than 30 years of teaching introductory macroeconomics, says Alan Blinder of Princeton University, he has never seen interest as high as it was last year. At Harvard, says David Laibson, students in his undergraduate macroeconomics course are “chomping at the bit”. At elite American universities, where endowments have shrivelled and hiring is down, increased interest in economics is among the most benign of the recession’s effects.

Yet the crisis has also highlighted flaws in the existing macroeconomics curriculum. Greg Mankiw, a Harvard economist and the author of a bestselling textbook, points out that students can hardly be expected to make sense of the crisis if they know virtually nothing about things like the role of financial institutions. Yet if there is a “financial system” in most introductory texts, Mr Blinder observes, it usually focuses on the demand and supply functions for money. “The current curriculum fails to give students even imperfect answers” to their legitimate questions about recent economic events, he says.

Changes are coming. Mr Blinder is one of the authors of another popular undergraduate textbook, which he is now revising. In the process, he is having to think long and hard about how to balance the need for more detail about things like finance with the constraints under which introductory macroeconomic courses are taught. The new edition is likely to have a prominent place for the idea of leverage and how it contributed to the crisis. That is fairly simply explained. But some additional complexity will be unavoidable.

For instance, the convenient fiction of a model of the economy with a single interest rate was defensible as long as different rates moved in concert. This, Mr Blinder says, is no longer something that students can be told “with a straight face”. Some discussion of the role of securitisation and systemic risk is essential, even if it feels like a lot of detail for beginners to grasp. Mr Blinder, with a nod to Albert Einstein, says that economists need to remember that things should be made as simple as possible, but no simpler.

Revised textbooks will soon find their way into bookshops. Charles Jones of Stanford University has put out an update of his textbook with two new chapters designed to help students think through the crisis, and is now working on incorporating these ideas into the body of the book. A new edition of Mr Mankiw’s book should be out in about a year. And Mr Blinder’s publishers aim to have his revised text on sale by June.

Courses in many leading universities are already being amended. Mr Laibson says he has chosen to teach his course without leaning on any standard texts. Francesco Giavazzi of the Massachusetts Institute of Technology is now devoting about two-fifths of the semester’s classes to talking about how things are different during a crisis, and how the effects of policy differ when the economy hits boundaries like zero interest rates. Discussion of the “liquidity trap”, in which standard easing of monetary policy may cease to have any effect, had fallen out of vogue in undergraduate courses but seems to be back with a vengeance. Asset-price bubbles are also gaining more prominence.

Inflation Kills !!!

An excellent article on Inflation. It relates inflation to investments and personal finances.
Which decade witnessed the largest stock market decline in U.S. history? The

decade starting with the Great Depression? The Panic of 1987? The most recent

decade with its two crashes? After adjusting for inflation, it turns out that the

1970s was the worst. While the Great Depression produced the largest nominal

percent point drop, it also generated a period of deflation. So there were fewer

dollars to spend, but each dollar retained bought you more bananas. Total real

purchasing power was "only" reduced by about 45%. In contrast, the OPEC

crisis during the 1970s, along with its double-digit inflation, reduced purchasing

power by almost 50%.

Indeed, one of the biggest threats to your portfolio's performance over time is

inflation. For every additional point of inflation, your portfolio will lose about 20% of its purchasing

power over the next 25 years. In addition, taxes are levied on your portfolio's nominal return, even if it

does not experience a real increase in purchasing power. All combined, you can easily lose a third or more

of the value of your portfolio over time with just a tiny bit of extra inflation.

Moreover, unlike jarring market crashes -- such as the Great Depression or the recent crisis -- inflation

lurks in the shadows. It destroys value by gradually eroding real returns over time. It is financial death by

a thousand cuts. Investors too often look at "the numbers" in their portfolio without asking what those

numbers can actually buy over time. It's a classic mistake that John Maynard Keynes termed "money

illusion."

But there are two good reasons to now start paying close attention to inflation again. First, the expansion

of the Federal Reserve's money supply during the past 18 months has been enormous and unprecedented.

As Milton Friedman most clearly articulated decades ago, more money chasing the same number of

goods usually generates higher prices. In fact, had the recent monetary explosion happened during

"normal" times, prices would have likely doubled. Second, projected federal deficits are ballooning out of

control. According to the Congressional Budget Office, the new Obama Budget will add almost $9.8

trillion to the national debt over the next decade. Astonishingly, the market has even recently priced some corporate bonds corporate bonds as safer than government securities. Eventually, it will be too tempting to reduce the

value of this snowballing debt simply by printing more money.

Inflation hawks have now begun circling. Some investment advisors are urging their clients to buy gold

and other commodities in order to maintain purchasing power as the value of the dollar shrinks. But these

hawks are no longer just located in the outer circles. At a recent FOMC meeting, the Kansas City Federal

Reserve's president broke ranks with the rest of the members by voting against the continued era of cheap

money. Even the Chinese government, who now holds almost 10% of U.S. debt, has expressed a desire

for a new currency to replace the U.S. dollar as the world's benchmark, although concerns about a massive

Chinese selloff of dollars are likely overblown.

To be sure, recent core inflation numbers (that exclude volatile food and energy) have been well below

expectations. Given the severity of the economic slump, many experts believe that low inflation will

continue for a while. In March, the presidents of the regional Federal Reserve banks in Chicago and St.


Louis called for continued "accommodative" monetary policy, which is just code language for more of the

same loose controls on the money supply. Opinion pieces in the Wall Street Journal and New York Times

have even argued that the deficit hawks should simply go away.

For investors, however, the current debate over the inflation outlook is incomplete and misleading.

Diversified investors hold many types of assets. Some of these investments are more sensitive to inflation

over the short run while some are more sensitive over the long run. Both time horizons should matter to

investors.

In the short run -- say over the next three years -- inflation is likely to continue to be quite low. One

reason is that explosive growth in the Federal Reserve's balance sheet has been mostly matched by

enormous increases in excess reserves held by commercial banks despite a very steep yield curve. In

other words, the banks are "hoarding the cash," preventing it from becoming part of everyday

transactions. Why? One reason that is the Federal Reserve now pays banks interest to encourage them to

hold additional reserves. Some banks also fear that rising short-term interest rates will increase their costs

over the life of the loan. (Their fears are indeed reflected in prices of one-year futures contracts for Fed

Funds.) More importantly, the banking sector is just in "Phase One" of the residential real estate mortgage

crisis, the so-called "subprime" mess. Phase Two -- defaults of "Alt A" types of residential loans that were

often issued to sole proprietors with less formal income documentation -- will begin later this year. Phase

Three -- defaults of "Option ARM" loans in which interest rates sharply increase a few years after the

loans start -- will begin to increase next year. Banks need to reserve against all of these potential losses.

Of course, if banks happen to be over-reserving for these losses, then inflation might come sooner if the

Fed can't quickly yank money out of the banking system. But that scenario is unlikely. Indeed, "Phase

Four" of the mortgage crisis -- this one stemming from the commercial lending side -- has received very

little attention this far. If anything, banks are probably still not reserving enough for these defaults.

Combined with the recent economic slowdown in Europe, it is likely that inflation will be held in check

for a while.

But longer-run inflation (beyond five years) should be on everyone's radar screen. In fact, it is unlikely

that the current yields on 30-year Treasury securities will be enough to cover inflation over time, much

less provide a real return. Present value shortfalls in Social Security and Medicare are in excess of $70

trillion and will likely lead to an "inflation tax." Yields on 10-year Treasury securities -- which

policymakers try to keep low because of their indirect relationship to mortgages -- may not be high

enough to cover inflation.

So what is an investor to do about inflation? The traditional choice is to invest in commodities, metals, oil

and the like. The broadest investible measure of commodities is almost 85% correlated with the

Consumer Price Index (CPI) on an annual basis, meaning that the value of commodities tends to move in

the same direction as inflation. Gold is almost 60% correlated, oil stands at 21%, and real estate and

natural gas are both at 5%.

But, contrary to conventional wisdom, none of these asset classes are actually good inflation hedges

anymore. They are already too popular.

Indeed, don't be fooled by correlation. Two data series can appear to be highly correlated even though one

of them consistently underperforms the other. In fact, commodities are about the only major asset class

that actually underperforms the CPI over time. More targeted sector plays -- such as gold, oil and natural

gas -- tend to beat the CPI, but not by nearly enough to compensate for their enormous risks (they are

about twice as risky as the S&P 500). In fact, corporate bonds and equities actually appear to do a better

job of "keeping up" with the CPI over time on a risk-adjusted basis, despite their low mathematical

correlation.

A few specific investment recommendations, starting with the lowest hanging fruit:

Increase your exposure to Treasury Inflation Protected Securities (TIPS) inside of your tax

advantaged retirement accounts. Put a quarter or more of your retirement stash into TIPS.

While TIPS are not tax efficient enough for taxable accounts, they provide a good inflation

hedge for retirement accounts where taxes are either deferred or already paid.

1.

For your taxable accounts, buy $10,000 per year in Treasury I Bonds. Like TIPS, I Bonds

provide solid protection against inflation. Unlike TIPS, you are not taxed on "phantom

income" along the way. Because I Bonds are such a "win-win", the government caps the

amount that you can purchase each year to $5,000 in paper form and $5,000 in electronic

form. So do both.

2.

Invest up to 15% of your portfolio in emerging market equities. To be sure, many of these

markets have already experienced large gains recently. But they still offer a "twofer" of

sorts: a hedge against U.S. currency depreciation as well as diversification into countries

that still have strong growth prospects.

3.

Move some of your lower yield government bond portfolio toward Ginnie Mae centric

mutual funds. Ginnie Mae's are the only mortgage-backed securities carrying the full faith

and credit of the federal government. They usually provide a yield between one half a

percent and one percent greater than comparable maturities.

Fasten Your Seat Belts - India Poised for 10% Growth !!!

Watch out for India during the next 5 years... Says Managing Director of the Boston Consulting Group, India. Read on to know the reasons.....

Many Indians firmly believe that their future is decided by the constellation of stars at the time of their birth. The moment a child is born, parents and grandparents rush to an astrologer to get the newborn baby’s horoscope made, and then spend their lives to fit into the foretold pattern. So what is the future foretold for India, which is no longer a newborn country but could be termed a youth in the recent history of nation states?

I was reminded of this in a recent discussion on the Indian economy with the chairman of a large US-based MNC who was visiting India. We discussed how India seemed to have come out of the economic crisis stronger than most nations, perhaps by a combination of luck (we had the right stars in our corner!) and design. But, more important was the simple question he posed to me: Was India’s remarkable growth story of this decade “capped out” or was it the beginning of the next wave of growth, a destiny perhaps foretold by the stars?

To set the context for this interesting question, let us first take a short historical tour of India’s GDP growth in the last 45 years. In the first decade of this period (1965-74), the average GDP growth was 3.1 per cent. The next 30 years saw the average GDP growth increase in each decade (1975-84, 1985-94, 1995-04) to 4.9 per cent, 5.5 per cent and 6.1 per cent, respectively. The first five years of the current decade (2005-14) saw the GDP growth increase further to 7.9 per cent despite one of the worst economic crises of our lifetime. India has emerged from the crisis remarkably unscathed and much stronger than many other countries, and this was reflected in the optimism of our finance minister’s recent Budget speech where he did mention the magic figure of 10 per cent-plus GDP growth. Of course, he did leave the timeline somewhat undefined as “within the next few years”.

We all know that many of the drivers of our economic growth are in place. The 11th Five Year Plan calls for more than doubling investments in infrastructure to over Rs 20,00, 000 crore as compared to the 10th Five Year Plan. The government proactively talks about the need to reduce transaction costs through policies like goods and services tax (GST), and achieve financial consolidation through implementation of the Finance Commission recommendations. Equally well-known is the fact that foreign direct investment (FDI) into India has been growing rapidly and we have seen the second wave of big overseas investments in the last three years. On this score, it is interesting to note that for the first time in 2008, FDI from Japan into India exceeded that into China.

Let me point out two interesting elements of our economy’s journey in next five years. We know that among many differences between Indian and China’s economy, a key difference is the fact that the Indian economy is much more consumption-driven while China’s is an investment-led economy. This difference will play a big role as we should see a big impact on the Indian economy because of dramatic growth in consumption in many products — this is called “hockey stick” growth — due to a historic combination of changing dependency ratio and growth in middle class. Dependency ratio, which gives the ratio of typical dependents in a society (age below 19 years and over 60 years) to working-age population (20 to 59 years), will see a historic shift in India from 1.04 to 0.76 in the next five years, with the largest part of our population entering the working age of 20 years. Combine this with growth of 15 per cent in the number of middle-class households in India in the same five-year period and a “consumption hot-spot” is created.

The other interesting element is the role of the manufacturing sector. Few years ago, I remember pointing out proudly to overseas visitors the fact that over 50 per cent of India’s GDP was contributed by the services sector, an economic structure similar to that of more developed economies. The unspoken implication was that India had perhaps jumped the traditional stage of economic development and was well on its way to a more mature economic structure. We now realise that view was erroneous. I was pleasantly surprised by the statement made by the finance minister in his Budget speech this year that manufacturing sector is the growth driver for the Indian economy. Clearly, there seems to be a significant change in the thinking of the government on the role of the manufacturing sector and its contribution to our economic development. This sector has to play the critical role in creating significant share of the 220 million new jobs that India needs in the next 15 years, which will be crucial to our economic growth.

So, what has this economic discourse got to do with astrology and stars, and with the question posed by the MNC CEO on the GDP growth? I am not an astrologer, though at the prodding of my wife I must admit I have been to see some of them and, to just please my wife, tend to agree with her when she says confidently that some event in our lives was predestined. Despite the natural instinct of a rationalist, let me don the hat of an “economic astrologer” and say that whatever we do (or don’t do), India’s stars are so arranged in their constellation that we are destined to achieve an average GDP growth rate of over 10 per cent in the next five years!

Let me explain why. In recent years, the only country that has delivered a consistent 10 per cent-plus GDP growth rate is China. So, to answer the question about what will take India to 10-per cent GDP growth, I looked at China for some pointers. If you look at its performance in the last 10 years, it had been growing at about 7-8 per cent till about 2002 when it switched gears to a growth trajectory of 10 per cent-plus GDP (the highest was 13 per cent in 2007). I looked at its economic characteristics in 2002-03 when this change happened and compared these with India in 2010 to draw any parallels. I was quite astonished to see the parallels — India today is exactly where China was six-seven years ago when it moved to the 10 per cent growth trajectory. Let me share four key data points to illustrate this.

China’s average income level in public purchasing power parity (PPP) terms in 2002 was close to $3,000 — this is same as India’s per capita income in PPP terms today.

China’s FDI in 2002 of around $39 billion is very close to India’s FDI levels today. India’s investment as a percentage of GDP, which used to be around 23-24 per cent for many years, has grown to about 38-39 per cent in 2009. Guess what China’s investment was as a percentage of GDP in 2002? It was 38 per cent!

The final parallel is on exports. China’s exports, which have been one of the key drivers of its GDP growth, are around 36 per cent of its GDP today. When it took off in 2001, it was just 23 per cent. Guess what India’s exports were in 2009? They were 23 per cent of its GDP!

Sceptics will claim that these are just numbers, and coincidences occur in only reel life, not in real life. The believers will see this as signs from heaven that India’s future destiny is written in the stars, and despite all the challenges we face (and I am sure China faced its own set of challenges in 2002), we are on our way to the 10 per cent growth trajectory. So, are we going to fulfil our destiny or let the challenges steal our future away?

You decide.

Today's Article - 27th March 2010

Bimal Jalan: The working of India's democracy

An excellent article on challenges faced by Indian Political system by Dr. Bimal Jalan. The author was formerly the Governor of the Reserve Bank of India.

Not so long ago, in 2008, when Barack Obama was elected president of the US, all of us — in India and the rest of the world — hailed it as the triumph of American democracy. For the first time, after the adoption of the US Constitution in 1787, a person of African origin was elected to the highest office of the state with a sizeable majority.
However, the universal feeling of triumph about the working of American democracy soon yielded place to a sense of despondency. The fate of a popular health Bill proposed by President Obama for approval by the US Congress in 2009 became highly uncertain in view of the power of business lobbies and the ideologies of a few legislators. Fortunately, a few days ago, the Bill was approved by a very narrow margin.
This is not all. In the context of a deep financial crisis and bailout of banks by the government, the US Congress has been considering some legislative proposals to put in place a more efficient regulatory system. The legislative process to introduce such a system has not yet been completed because of a handful of Senators.


In the words of Nobel laureate Paul Krugman, in a recent article, “The US is paralysed in the face of mass unemployment and out-of-control health-care costs. Don’t blame Obama. There’s only so much one man can do, even if he sits in the White House. Blame our political culture instead, a culture that rewards hypocrisy and irresponsibility rather than serious efforts to solve America’s problems.” (“March of the Peacocks”, Business Standard, January 30).
Among large democracies, the US is not alone in facing a crisis in delivering what people want. The UK is another example, where the government is getting bigger, with the state’s share of GDP rising from 37 per cent in 2000 to 52 per cent in 2009. The average citizen, on the other hand, has become poorer with a higher level of unemployment. The same is the case with Japan, and countries in the European Union (Portugal, Ireland, Greece and Spain, the so-called PIGS !).
In the midst of all this “darkness”, as it were, where does India stand? The short answer is that our position is not any better. In addition to “systemic” problems, like erosion of collective responsibility, excessive centralisation and widespread political corruption, the faith of the ordinary citizen in the working of their elected government has been further shaken by two landmark events in the last three months.

In December 2009, there was a sudden announcement in favour of a separate state of Telangana, followed by an equally abrupt decision to postpone it. And now, a few days ago, we had the spectacle of some MPs being forcibly carried out of the Rajya Sabha so that the landmark legislation on women’s reservation could be approved the same day. And then, the pause — and announcement that this Bill will be introduced in the Lok Sabha later after consultations with all parties !

What are we to make of all this? There is no straight or unequivocal answer. I, however, believe that in the light of recent events, it is even more urgent now to take some relatively simple measures to strengthen the working of India’s politics. In view of constraints of space, let me just mention a few such measures that can be introduced if there is a consensus among three leading party formations in Parliament (the Congress party, the NDA and the Left). The emergence of such a consensus was the most gratifying development in respect of the Women’s Reservation Bill.

An unintended consequence of some recent amendments to the Constitution (i.e. the 52nd Amendment of 1985 and the 91st Amendment of 2003), combined with the power of parties to issue whips, has been to make individual members of Parliament fully subordinate to their leaders. The power of party leaders vis-a-vis elected members has been further compounded by an amendment in 2003 in the Representation of the People’s Act which removed the domicile requirement for election to the so-called Council of States (Rajya Sabha). An immediate priority is to revoke all amendments, which are designed to “dis-empower” elected members.

Cutting across political parties — in power and in Opposition — nearly 25 per cent of elected members in the Lok Sabha have criminal antecedents. An important reason for the attractiveness of politics as a career of choice by persons with criminal records is the enormous judicial delay in deciding such cases, and the power of political leaders to further delay the investigation and prosecution.

This incentive may be completely reversed by a relatively simple measure — by providing that elected candidates with pending criminal cases cannot take the “oath of office” until their cases have been heard by courts, and that such cases would have priority over other pending cases. Just consider the impact of this “reverse incentive” — in order to avoid immediate hearing of cases, the incentive would be to avoid getting elected to Parliament or state legislatures!

A related measure to make politics less remunerative is to reduce the power of ministries to “allocate” public resources, such as mineral rights, spectrum, gas etc. If an autonomous Election Commission, appointed by the government, can organise free and fair elections in the largest democracy in the world, similar agencies can be established to allocate public resources as per policies approved by the Cabinet.

Finally, the prevailing practice of passing several Bills at the end of the day at the discretion of the executive branch, without discussion or actual voting, has to be simply abolished — except in an emergency — to enable Parliament to perform its assigned role under the Constitution.

I believe that if the above measures are taken, or at least considered by Parliament, the working of Indian democracy by the people would become less oligarchic and more accountable

Today's Article - 26 March 2010

An interesting article from Business Standard -

The equity markets have rebounded strongly following the presentation of the Union Budget, rising by more than 10 per cent from their lows. This surge has been caused by a combination of strong global markets as Greece has seemingly bought itself some more time, and a generally favourable response by investors to the Budget and its fiscal targets. Inflows from foreign institutional investors (FIIs) have resumed as many of the large, long-only funds have received significant inflows, and we are in that part of the year when domestic insurance flows are at their maximum. The markets are trading well and seemingly want to go up. The recent move of the ratings agencies to take India off the credit watch status has been a further boost to market sentiments.

However, in my opinion, the next six months is going to be a difficult time, full of risk and an environment where one must exercise caution and not get carried away.

First of all, we are by no means over with these sovereign risk issues. Greece is still in trouble, and the EU is seemingly split as to how to bail out the country. Germany and France are opposite ends of the spectrum on using the International Monetary Fund (IMF) to help a bailout, and Greece has over 20 billion euros of funding needs in April and May. The country is running a fiscal deficit of close to 16 per cent, and not 12 per cent as commonly reported. And, to get this deficit down to a manageable number will involve huge economic and social costs. It is not clear if the country has the stomach and maturity to implement a double-digit fiscal correction. Post-Greece, we have similar issues with Spain, Portugal, Ireland and eventually Italy as well. All this will come to a head over the coming six months. Given the size of funding needs, the quantum of sovereign debt held by the EU financial system, and general political unease over sovereign bail-outs, risk aversion could reassert itself anytime. The euro remains weak and clearly headed lower.

Back home in India, the obvious problem is inflation. The Reserve Bank of India (RBI) governor has probably the toughest job in the country trying to calibrate monetary tightening so as to promote growth, stifle inflation and simultaneously still put through the huge borrowing programme of the government at a reasonable cost. India probably needs higher interest rates to prevent the current food-based inflation from spilling over into a more generalised price spiral, but higher interest rates will hurt the growth transition currently underway. We need to move away from government stimulus being a driver of growth towards private investment demand, and a spike in rates will hurt this transition meaningfully. A 300 basis points higher cost of debt affects project IRRs materially.

India has another problem in that at high rates of growth, anything over 8.5 per cent on a sustained basis, and everything starts falling apart in the country. From power, ports, airports, skilled manpower to railway wagons, everything goes into short supply, and inflation starts to spike higher. Remember, the last inflation scare in 2007 was not driven by food prices at all, but by surges in commodity prices and a general overheating of the economy. We are a fundamentally under-invested country, and to address the structural issues of an economy which cannot handle sustained growth of over 8.5 per cent without overheating, we need large-scale investments to improve the supply side response to growth in numerous areas of soft and hard infrastructure. To improve the supply side, we need huge investments. These investments are sensitive to rates, and will not be made in an environment of high and rising interest rates. Thus, ironically, one can argue that to tackle inflation on a more structural basis, we actually need low interest rates, not tight monetary policy.

The RBI governor thus has a thankless job, having to make a very delicate balance between growth and inflation. He cannot let the country move into an era of generally higher inflation and interest rates, as once out of the bottle, that genie is very difficult to control. But he cannot use a sledgehammer approach either. He anyway has to handle the inevitable crowding out issues as private sector credit demand picks up.

Interlinked with the above, the biggest risks on the horizon for India are the monsoons and oil prices. Another monsoon failure (God forbid) will throw the whole food price situation out of control, besides seriously damaging consumption, growth and the fiscal. We dodged the bullet of a poor monsoon in 2009 (in terms of economic impact), but two poor years back to back will put a huge strain on the economy. RBI will be forced to act, as no government will be able to withstand the political pressure that will be mounted following a second year of double-digit food price rise. Agriculture will dip by a lot more than the 2 per cent the government statisticians project for 2009, and rural consumption will slump with food subsidies spiralling out of control.

India is also extremely vulnerable to higher oil prices. There is a worrying tendency recently on the part of many global oil analysts to become more bullish and raise their price forecasts, which is a clear red flag.

High oil prices have a huge impact on the fiscal side in India through petroleum product subsidies and higher fertiliser subsidies, or on inflation in case prices are allowed to adjust. We can only hope that prices behave. Whether the impact is through the fiscal or inflation, the end outcome is the same — higher rates.

The next six months are also critical in that the government will have to demonstrate progress on tax reform through the direct tax code and goods and services tax. As pointed out before, both these reforms are absolutely critical to achieving the fiscal deficit targets outlined in the Budget. We will know within the next six months whether the government has been able to withstand the lobbyists and special interest groups, and deliver on these landmark legislations.

The markets, to my mind, should be stuck in a broad trading zone till such time as we get better visibility on the monsoons and oil prices. Normally, the rains do not have such importance, but given the inflationary and fiscal challenges already confronting the country and the policy-makers, we need to cross this hurdle for the markets to break out of their current range.

Markets can handle a 125-150 basis points rate hike over the coming 12 months, that is baked in the cake, but anything higher than that will be corrosive for PE multiples and market performance.

If the rain gods are kind, and the government does deliver on tax reform, then we are looking at a very positive market outlook in the second half of 2010.

Today's Article - 20 March 2010

T N Ninan: The post-Lehman world
This is not a moment for Indians to crow about their expected arrival on the world stage, because success brings with it responsibility

T N Ninan / New Delhi March 20, 2010, 0:59 IST / Business Standard
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When is a new generation born? The cheeky answer is, around 10 pm. To a similar question (when was the new world order born?), the answer would be: September 2008, when Lehman Brothers collapsed. It has been customary in the year-and-a-half since then to talk of the global financial crisis. In truth, it was no such thing, because the crisis engulfed only a couple of dozen countries around the North Atlantic. Countries elsewhere were affected too, but not in the same way — and the speed with which China and India have regained their footing underlines the point. In comparison, many of the advanced industrial countries look forward to two decades of slow growth at best, and relative stagnation at worst. The “re-balancing” of the world economy has well and truly begun.



It will take the rich countries all the way to 2030 before they get back to the pre-crisis fiscal situation, according to a paper presented at a seminar last month in Seoul, organised by the International Monetary Fund and the Korean Development Institute. During this period, pressures to expand government spending will grow, as countries with ageing populations struggle with mounting health care and pension bills. And yet, budgets will have to be squeezed to deliver a surplus, so that the surge in debt-GDP ratios (a result of the stimulus packages of the last 18 months) can be rolled back. That could mean higher taxes, but how do you collect more taxes when the revenue base gets chipped away, as a consequence of the very re-balancing of the global economy? Bear in mind that the Brics scenario spelt out by Goldman Sachs in 2003 has already come to pass; in fact, Goldman has been compelled to repeatedly update its forecasts of the global shift of economic power as India and China have continuously done better than the original Brics report had predicted. This shift in the economic balance has now got accentuated in the post-Lehman world.



Martin Wolf, of the Financial Times, refers to India and China as “premature superpowers”, countries that have low living standards but huge economies. Premature or not, he suggests that Britain should give up its permanent seat in the Security Council to India. That is not about to happen, but Wen Jiabao’s defence of the indefensible, namely China’s currency policy, underlines the ineffectiveness of American pressure on the rising power, even as an article in the current issue of Foreign Affairs debates how to deal with a post-nuclear Iran (thus looking forward to the US failure to prevent such a denouement). Even more abject is America’s apparent willingness to let Pakistan and the Taliban take over Afghanistan, after having fought a war for over eight years to prevent just such an outcome.



This is not a moment for Indians to crow about their expected arrival on the world stage, because success brings with it responsibility. For all its imperfections, the world of the last two decades was an ordered world, with generally-accepted rules and a global policeman. India has gained in this ordered world, even though it has complained constantly about not getting its rightful due. In contrast, a post-Lehman world will see many rising powers that do not automatically play by the rules, and so the challenges are likely to be more complex — the matrix could involve zones of influence, regional power balances and fluid coalitions, even sudden convulsions (think China). If India counts itself as a “great power” in the new world that is being born, it will be expected to play a role in framing and enforcing new rules. Are enough people thinking strategically in New Delhi?