Sunday, March 30, 2008

Commodities market anomalies

The NYT reports that economists are baffled by the ever-widening disparity between the actual cash market prices of foodgrains like corn, soyabeans and wheat, and their prices in the derivatives market. The anomalies are occurring between the price of a bushel of grain in the cash market and the price of that same bushel of grain, as determined by the expiration price of a futures contract traded in Chicago. This gives the illusion of two prices for the same good at the same place and time.

The problem is something like this. Futures contracts are important hedging tools for farmers, grain elevators, commodity processors and anyone with a stake in future grain prices. A futures contract that calls for delivery of wheat in July may trade for more or less for each bushel than today’s cash market price. But as each day goes by, its price should move a bit closer to that day’s cash price. And on expiration day, when the bushels of wheat covered by that futures contract are due for delivery, their price should very nearly match the price in the cash market, allowing for a little market friction or major delivery disruptions like Hurricane Katrina. But on dozens of occasions since early 2006, the futures contracts for corn, wheat and soybeans have expired at a price that was much higher than that day’s cash price for those grains.

The most credible explanation for these anomalies relate to the role of hedge funds, pension funds and index funds, who are distorting futures prices by pouring in so much money without regard to market fundamentals.

Commodity prices world wide have been surging to unprecedented levels. Speculative investors see commodities as a safer and high return investment opportunity and accordingly a bubble has been building up in commodities based derivatives. An irrational exuberance in commodities have also bidded up the prices of these derivative contracts, way beyond even the actual market prices. Many of these speculative investors are holding huge quantities of long positions on these contracts, in anticipation of further rise prices.

As has been well documented by behavioural literature, these holders of long positions are often reluctant to wind down their holdings, even in the face of lower actual market prices. This maintains a disparity in the derivatives market and cash market prices of the same commodity. This disparity may thus be a reflection of the under-developed nature of the arbitrage or carry trade market, which takes advantage of this mis-pricing. My guess is that once this market becomes more liquid and more players get in, the mis-pricings will get arbitraged away and disappear.

Another interesting phenomenon, brought out by the NYT in this article relates to the rising price of rice. This is in direct contrast to the aforementioned two price phenomenon, and is a testimony to the power of globalization in ushering in a global market place.

About the reasons for the steep rice in global rice prices, it writes, "Rising affluence in India and China has increased demand. At the same time, drought and other bad weather have reduced output in Australia and elsewhere. Many rice farmers are turning to more lucrative cash crops, reducing the amount of land devoted to the grain. And urbanization and industrialization have cut into the land devoted to rice cultivation... Until the last few years, the potential for rapid price swings was damped by the tendency of many governments to hold very large rice stockpiles to ensure food security. But those stockpiles were costly to maintain. So governments have been drawing them down as world rice consumption has outstripped production for most of the last decade."

Unlike many other food grains, rice consuming countries are mostly self sufficient, and only 7% of the global rice production is traded across international borders each year. The sharp increase in prices, despite the relatively small quantities traded clearly indicates two things - a tight market, and more importantly, a fairly integrated global market in rice trade.

From the price rises across the world, it is obvious that the domestic rice market has become closely integrated with each other and with the market in global trade. Further, the relatively small quantities traded across borders, combined with small stockpiles, now mean that prices can move quickly in response to supply disruptions. The commodity contract speculators may have exacerbated the problems by artificially boosting the demand.

Interestingly, in both cases, one where the arbitrage market was not fully developed, and another where the market had become closely integrated, the impact has been extreme - lower prices for farmers in the former and higher price for consumers in the later.

Update 1
NYT has an article explaining the drought triggered shift away from water intensive rice to more profitable wine grapes. The six long years of drought has reduced Australian rice production by 98%. Even in normal times, little of the world’s rice is actually exported — more than 90 percent is consumed in the countries where it is grown. In the last quarter-century, rice consumption has outpaced production, with global reserves plunging by half just since 2000. A plant disease is hurting harvests in Vietnam, reducing supply. And economic uncertainty has led producers to hoard rice and speculators and investors to see it as a lucrative or at least safe bet.

Thursday, March 27, 2008

Incentives in Elections

The logic in this post is slightly vague at at a few places. Though I am still searching for a few answers, I am convinced there are ways out. But it flags off an important dimension to future electoral reform policies.

It is commonplace in even informed circles to attribute all the ills facing our country to politicians. The middle class see the ubiquitous politician as the embodiment of all that is bad about our political system. They are perceived as corrupt, venal, rapacious in their plunder of the public resources, prevent honest officers from discharging their duties, and so on. My very firm belief is that this may be a very simplified and uncharitable judgement, which overlooks the incentives and disincentives facing a politician.

I shall assume that a politician is a rational economic agent, out to maximize his objectives. Edmund Burke famously said, "The duty of a politician is to win elections". A politician is therefore driven by the ultimate objective of winning over his electorate. This remains true even today and is the fundamental choice facing any politician. To this, we may also add that the politician also faces ample incentives to make money.

I will outline two broad strategies that can be applied to winning elections. There may be variants between Strategy I and Strategy II, but a typical electoral strategy falls somewhere in between the two. Strategy I is the regular stereotype of how a candidate fights elections.

Strategy I : The politician offers inducements or allurements like liquor or cash to win over the voter. Though the typical candidate spends a fortune in such transactions, these inducements are transitory. Even after spending this money, he is not sure of bagging the vote, since his oppponent can pay a little more and outbid him. There is a very real danger of the candidate losing his money and the election too.

Strategy II : In contrast, if the politician fulfills an important felt-need of the village, say a school building or drinking water bore or distribution line, the villagers feel gratified and owe him a debt. This translates into a more enduring and stronger relationship between the politician and the voters in the village. There is a greater probability of them voting for him than if he had resorted to the first strategy. Apart from striking a more durable contract with his voters, the politician benefits in two ways from this strategy.
1. He saves the huge amount he would otherwise have had to spend in buying off his voters.
2. He also pockets his share of commission from the contract awarded to execute the engineering work.

Quite often, this strategy runs into trouble as the executive machinery and administration are not able to deliver on the promise. At other times, the work executed is of very poor quality, and the school building develops leaks after six months. In both cases, the politician gets disrepute and loses his electoral appeal. He is then left with no choice but to return to his original strategy of buying off his electors. Therefore it needs to be kept in mind that the officials and the administration plays a critical role in helping or failing the political representative.

As can be seen, Strategy II is easily more beneficial to the incumbent. He can have the best of both worlds - minimize his expenditure, and increase his chances of victory. But implementing Strategy II requires the support of the bureaucratic and administrative machinery, who are responsible for delivering on the promises made by the politician. This is in turn gives them an incentive for posting capable officials (who are more likely to be reasonably honest) in important positions, thereby reducing cronyism and its attendent corruption.

What are the objections? The major argument against Strategy II is that it always favors the incumbent. Further, since the opposing candidates cannot use this approach, they fall back on Strategy I. Behavioural economists have documented that people tend to forget older gains and be more attracted to the latest gains (since cash and liquor inducements are made just before the voting process). Further, they also acknowledge personal gains more than social or civic gains. This makes the incumbent wary of the inducements offered by his opponents. There is therefore an unstable equilibrium about this arrangement. If the incumbent finds that his opponent gaining ground by resporting to unscrupulous vote buying strategies, he may be forced to defect.

The response to this objection is two-fold. One, if the incumbent is able to fulfill the felt needs of his electorate, then he surely deserves to be re-elected. After all, the whole process of democratic elections is to find out the candidate who can deliver on his promises. If we have a candidate who is able to deliver on his promises, which are in turn reflection of the electoral demands, then where is the need for a replacement? For any opposing candidate to succeed, he has to possess attributes and faith of his electorate that are superior to that possessed by the incumbent.

Two, the opponents should also adopt the same strategy as the incumbent and become rational agents. They should identify the most important felt-need of the village or locality, and make its fullfillment one of their major poll planks. They now benefit from the same advantages as the incumbent - saving the money spent buying voters and rents from contractors. Further, the opponent even gains an advantage over the incumbent, in that he is now promising something which the incumbent failed to deliver. All this will also incentivize candidates, especially in local body elections, to focus on important local issues and needs, thereby making elections more meaningul and issue oriented. And there are no shortage of important felt-needs in every area or village, for all candidates to espouse.

The benefits of such competitive populism on the society and polity are enormous. The challenge now is to make the politician a rational economic agent and get them to abandon Strategy I and adopt Strategy II! Or in other words, get all candidates to play the same game and not defect! More of this in a later post.

Tuesday, March 25, 2008

Town Planning in our cities

The Town Planning wing in any Municipal Corporation is like the perennial whipping dog, most often rightly so and many times for the not so right reasons. Nearly half the complaints received by the VMC through its 103 complaint redressal system relates to Town Planning. The commonest complaints include illegal and unregulated constructions, road and public space encroachments, hawkers menace, inadequate enforcement of zoning and usage regulations, irregular and unauthorised parking, and even property disputes between private individuals. The one common factor with all these violations is that they are so commonplace, and herein lies the problem.

Vijayawada has an area of 60 sqkm, population of 12-15 lakhs (depending on where you draw the stats from), and 1.75 lakh houses. There are exactly 8 Building Inspectors, or 1 per 7.5 sq km or 1 per 22,000 structures, supervising all the town planning activites on the field. The entire VMC Town Planning Division, including the City Planner and office staff, is only 23. The situation is no different elsewhere. And, this regulatory work is only a small proportion of their regular Town Planning work.

Now, given all these numbers, it does not require any great insight to conclude that it is impossible to enforce the kind of aforementioned complaints with such thin field presence. The major portion of such complaints are commonplace, routine and regular in nature and large in number, and can be controlled (if ever they can be) only by focussed personal inspections and vigilance. The problem is compounded by the exasperatingly tortuous bureaucratic and legal process/hurdles involved in rectifying such deviations or violations.

I will list out a few of the most commonly cited violations of town planning regulations.
1. Every (sic) construction in our cities have deviations. It has almost become the norm to extend cantilever and balconies beyond the permissible setbacks and illegally expand the floor area. Many owners deviate from the plans during construction and add more rooms. A smaller proportion of houses indulge in major deviations like converting a part of the authorised parking area into housing units, or adding an extra floor.

I am convinced that this happens because the house owners try to maximize their floor area by occupying beyond the permissible setbacks. The fantastically huge land values and building lease rents, means that individuals find the financial incentives for deviating too attractive to be given up. This is likley to remain so irrespective of the penalties imposed.

2. Many road side houses encroach into the road margins by either constructing walls or structures. This is a common practice, resorted to by more well off, and can be again traced back to the huge land values. In other areas, where the roads are at a lower level, the house owners construct ramps into the road, thereby encroaching on road space.

3. Most of the shops have no parking and their customers use the road margins for parking. Our policies do nothing to incentivize the shops, but transfers the parking costs to the customers. The same is true with smaller houses, where there is no strict requirement for parking space. The presence of small and fragmented plots, and the presence of multiple tenants in these houses, means that internal street roads get converted as parking lots.

4. With apartment fees being much higher than that for individual houses, many builders find it highly remunerative to take plans for G+2 or G+3 individual house and then illegally convert them into multi-unit house.

5. Most our internal roads have adequate width and support the Master Plan requirements. The problem arises from the presence of encroachments - hawkers, parking, and construction - that reduces the carriage way available for traffic.

6. Lip service is paid regarding enforcement of land use regulations. Commercial activities and shops spring up overnight in every location, without any required permissions, in total disregard for the areas' land use specifications. In fact, houses are constructed with the specific objective of converting some portion into a shop.

Surprisingly, there is a very high degree of tolerance for such activities among citizens. In many cases, it goes beyond tolerance and involves a tacit local accommodation among all the stakeholders. In fact, the overwhelmingly major proportion of town planning complaints come because of personal disputes between parties and rarely out of civic concerns. That very few complaints come due to genuine civic concerns is surprising since none of these activities can be done without the knowledge of the neighbours. This is not to underplay the regulatory duties and responsibilities of Town Planning wing and exonerate their lapses and corruption.

On the demand side, the incentives favoring deviations are substantial. This becomes especially so, in light of the rocketing land and rental values, which place a premium on utilizing every available vacant land and every possible floor space. A typical appartment can increase the floor space in each unit by a quarter, simply by extending the balcony projections to 4-6 ft beyond the pillars. The builder saves a significant amount by evading the building fees for this excess floor space, and pases on some share of this benefit to the buyer. The Town Planning Building Inspector, too gains his regular share of rent, for turning a blind eye to this deviation. Every individual stakeholder benefits in this arrangement, though the society collectively suffers the consequence.

All the aforementioned activities, that take place in violation of town planning regulations are classic examples of negative externalities. I have already written about them in previous posts. The incentives for such activities are very high because of the massive stakes and benefits gained by indulging in them. Such unauthorised activities take place because the individuals benefit substantially at a very small cost of being detected and punished, and share only a very small portion of the social costs inflicted by their actions.

These things cannot, repeat cannot, be physically policed without the presence of large field supervision. And I am not sure such supervision is the most desirable option, because it has other more debilitating dimensions and is not sustainable. For example, it is likely to increase the avenues for corruption. As long as demand side inclinations to deviate remains very strong, no amount of regulatory interventions can help.

We have a problem where practically everyone (and this is true) violates building rules, and many of these rules no longer have the sanctity. This is the surest indicator that there is something amiss with the rules. There is therefore a strong case in favor of simplifying and liberalizing these rules, so as to focus only on the important objectives of building regulation. Preventing negative externalities would be a good touchstone for filtering building rules - parking, inconveniencing neighbours, easier land use conversions etc. The more long term and sustainable way of addressing such deviations is to create a climate of civic intolerance for such violations and deviations. More on these in a later post.

But like the low voter turnouts in elections, such problems suffer from the "tragedy of commons". Every citizen thinks his neighbour will take the initiative and make the complaint and he can enjoy the free ride!

Monday, March 24, 2008

Higher Education trends

Harvard University has finally taken the plunge, and it was only to be expected. In an industry/activity, where the quality of students is the primary determinant of success, it was not surprising that the University announced significant expansion of its aid coverage for undergraduate students. It is a belated acknowledgement of the fact that any University, even Harvard, is only as good as its students. And fortunately, economic background do not determine the quality of students! But the consequences of this shift are likely to be more profound.

Harvard's decision has led to a number of other richer Universities following suit in increasing aid and substituting grant for loans. The Universities claim that these efforts are aimed at making higher education more affordable and also clear the damaging perception that the elite Universities are going out of reach for all but the richest. But the real motivation may be the growing realization that high tution fees and other college costs are driving away many middle and even upper-middle class students from the elite Universities, in turn depleting the quality of these schools.

Harvard currently provides a free undergraduate education to students from families earning up to $60,000 a year. Under its new plan, families earning between $120,000 and $180,000 a year would pay only 10 percent of their incomes for tuition and fees on an education that is currently priced at more than $45,000 a year. More than 90 percent of American families would be eligible for this aid. More than half of all Harvard undergraduates will now have some form of scholarship. It would cut costs by a third to 50 percent for many students and make the real costs of attending Harvard comparable to those at major state universities. In fact, a Harvard degree will now be cheaper than degrees from many leading public universities.

The cost for the University with a $35 bn and rapidly growing endowment, thanks to the generous tax exemptions on their investments, is a miniscule $120 million, up from $ 98 million earlier. The Harvard management Company (HMC), which manages the University's endowment, made nearly $ 7 billion from its investment income in 2006-07, a 23% rate of return. (Former PIMCO ED, Mohamed A. El-Erian, heads the AMC)

In this context, it is important to highlight the most important development in US higher education since the early 1990s - spectacularly growing university endowments. Since then, universities have hired sophisticated money managers and moved their portfolios into hedge funds, private equities and other high-performing investments, resulting in skyrocketing endowments. This development has coincided with the decline in subsidies to public universities. The result has been the emergence of a sharp division among university endowments - fewer than 400 of the roughly 4,500 colleges and universities in the United States had even $100 million in endowments in 2007.

The market for higher education has certain unique characteristics, which set it apart from the regular forces of supply and demand. The quality of a school is dependent on the quality of its students and to a lesser extent on its instructors. It is therefore important for any University to widen its recruitment base, so as to be able to reach out to all the best and the brightest students. This in turn demands that entry barriers for such students are eliminated or atleast lowered. One of the more commonest ways of doing this is to incentivize them by offering fantastic aid packages, which competitors cannot match. Only Universities with deep pockets can play this game and succeed.

What are the likely consequences? In the short run, it is likely to make it more affordable for even the middle class students to access the elite Universities. But the more long run distortions possible are
1. Those high achieving students from less well-off backgrounds and therefore unable to afford the expensive elite universities, would have gone to the other colleges. But the generous aid packages attract them to the elite schools, thereby depleting the quality pool for the not so rich colleges. The already wide gap between the elite and the rest widens.

2. The tuition discounting to the middle and upper middle class in smaller universities could end up shifting financial aid from low-income students to wealthier, thereby making pricing seem even more arbitrary and creating pressures to raise full tuition to pay for all the assistance.

3. This will open up pressures on the universities to expand aid coverage to include even the wealthy high achieving students, thereby reducing the amount of aid available for the poorer. Aid will become an instrument for buying off the merit students, a practice openly flaunted by the numerous IIT and other professional courses training institutes in India.

4. Reduce the economic diversity of the student intake, thereby reducing the quality of the school. Donald E. Heller, director of the Center for the Study of Higher Education at Pennsylvania State University, says that "if Harvard’s new aid program encouraged more middle- and upper-middle-income students to apply, then the number of slots for low-income applicants in an entering class will probably decline."

5. In all likelihood, this trend will hasten the process of attracting the superstar instructors. Do not be surprised if the remuneration for the other critical determinant - superstar professors - too rockets up at a much larger rate in the coming years. Superstar professors are being courted by Universities by offering better pay and benefits and tenurial positions.

6. A distribution similar to private and public schools is likely to emerge in college education, with the best schools attracting the best students and the others left with the remaining. A self-reinforcing spiral of widening quality gap between the elites and the rest is set in motion. The increasing quality of students improves the quality of the elite universities, while the depleting quality of students lowers the quality of the rest.

7. A distinctly two-tier higher education system will emerge, with a set of elite universities having massive endowments, thriving and attracting the best, leaving but the crumbs for the rest.

The same trend is observed in India among training institutes for entrance examinations to the various professional courses like Engineering, IIT, Medicine, IAS, MBA etc. This trend can be gauged by the same names dominating the field every year. The well established reputation and the deep pockets of the major training institutes ensures that most of the good students join them, thereby imposing forbiddingly high entry barriers on new entrants. These institutions compete to woo the best students, even offering them financial incentives over and beyond full fee expemptions, thereby effectively buying them over. Simulataneously, they raise the fees on the remaining students, and rake in more profits.

Sunday, March 23, 2008

Inflation and growth concerns in India

Two sets of recently released figures on the economy - the Index of Industrial Production (IIP) and inflation - have set off an interesting debate about the direction of our monetary policy. The RBI has become caught between the never ending debate about making a trade-off between inflation and growth.

Recently released CSO data on the IIP indicates that industrial growth decelerated in January 2008 to 5.3%, compared to 11.6% for January 2007. The biggest hit was taken by the two critical engines of industrial and consequently economic growth - consumer durables and capital goods. While the former fell 3.1% ( a rise of 5.3% in Jan 2007), the later rose a mere 2.1% (16.3% in Jan 2007) for the month of January 2008. However, Fast Moving Consumer Goods (FMCG, consumer non durables), exhibited a 10.1% growth in January, compared to 9.1% last year. Food products, beverages, tobacco etc showed double digit growth. The growth rate of the core infrastructure industries group - crude petroleum, petroelum refinery products, coal, cement, electricity and steel - which has a 26.7% weightage in the overall IIP fell from 4.2%in January, compared to to 8.3% in January 2007.



Wholesale Price Index (WPI) had already begun to breach the self-imposed year-on-year 5% tolerance level in the third week of February and continues to rise. WPI based inflation rate breached the critical 5% mark to close at 5.11% for the week eneded March 1, 2008, the highest in over nine months. It further rose to 5.92% when the latest figures were relased for the week ended March 8, 2008, to reach teh highest figuresince May 7, 2007. The prices for cereals increased 6.28%, for milk 9.71%, vegetables 9.79%, dairy products 9.31%, cement 5.13%, iron and steel 20.87%, and edible oils 17.52%.



There are many reasons to doubt that the drop in capital goods is not part of any long term trend. For a start, statistically 2006-07 was an year of extraordinary industrial growth, with the final quarter growth being 12.5%. Sustaining this was not realistic and maybe not even desirable, given the strains it would place on an already stretched out economy. Investments in the main consumers of capital goods like infrastructure have been growing and shows no signs of slackening. The order books of the main capital goods manufacturers remain buoyant and their sales numbers have shown robust growth. In fact, the key listed capital goods companies grew by about 33 per cent in the last quarter of 2007, in comparison to the same period last year.

The already committed investments in these sectors may be enough to sustain the present capital goods growth trends in the near future. The projected expenditures in these non tradeable services like ports, airports, highways, power, urban infrastructure, telecommunications etc is massive, are by themselves capable of sustaining very high growth rates. The Government's own flagship programs like the Golden Quadrilateral and other National Highway projects, PMGSY, JNNURM, and the programs to promote PPP in core infrastructure, should provide more than adequate demand side stimulus to sustain high rates of growth for sectors like capital goods. The demand for both residential and commercial real estate is both massive and ever growing, and has not shown any signs of slackening. The critical inputs to infrastructure sector like steel and cement, after a blip in January, exhibited robust growth in February.

The construction sector, which encompasses all these infrastructure investments, exhibited one of the lowest sectoral ICORs in the Tenth Plan period at a very low 1.2. It has also been shown that construction sector generates one of the highest employment rates for every rupee investment. All this will ensure that the economic multiplier will be significant from these committed and projected investments. So any talk of a major slowdown may be not based on any logical foundations.

The recent budget cut CENVAT on all goods from 16% to 14%, excise duties on automobiles from 16% to 12%, excise duties on drugs and diagnostic equipments, and some packaged food items from 16% to 8%. These rates were cut with the objective of lowering prices and thereby spurring consumption and boosting industrial and business activity. The consumer durables sector, especially two-wheelers and automobiles, is expected to be one of the largest beneficiaries of this. The Sixth Pay Commission is expected to put nearly Rs 350 bn in the hands of consumers, thereby providing a major filip to manufacturing demand. These are all strong stimulus measures that are expected to keep aggregate demand high, and thereby keep the corporate investment climate healthy.

The Government have responded to the rising food and commodity prices by piecemeal and stop-gap measures like price controls, freeing imports, banning exports (on edible oils), lowering customs duties (on rice and edible oils), imposing export duties (on steel), and prohibiting futures trading (on food grains). These efforts are based on the wishful but futile assumption that it is possible to insulate the Indian economy from the global trend of rising food and commodity prices. This attempt at importing deflation by freeing up the external sector has severe limitations, given the small quantities involved in such trade and the high prices prevalent in the global markets.

The rising global commodity prices, both food and non-food, has pushed up import prices. Addressing this inflation with monetary policy levers may not only not yield results, but may backfire badly, especially at a time when growth itself is slowing down. That the inflation is not driven by demand side pressures is also clear from the fact that growth in money with the public has declined form a very permissible 17% to an even less 14% in Febraury, 2008. The RBI figures show that money supply which has been growing at 22.2% annually, is slowing down to an estimated 21.2%. It is clear that while the demand side is robust, the supply side appears constrained. The rise in inflation is therefore more due to cost push factors than demand pull ones.

The primary objective in a cost push inflation scenario is to ease supply side bottlenecks. The major domestic supply side bottle necks that have been driving prices up include stagnating agricultural production, declining private capital investments in manufacturing, and over-stretched infrastructure, especially power and transport logistics.

The domestic supply side factors that are driving inflation need to addressed through some immediate policy interventions. Infrastructure bottlenecks are an immediate priority that will continue to strangle any economic growth. It is impossible for India to grow at double digit growth rates, by maintaining low inflation, without massive investments in its creaking infrastructure. Agriculture investments, both physical and those aimed at improving productivity, have been declining and this is manifested in the stagnating production, thereby forcing imports. This needs to be addressed immediately on the highest priority, especially given the large share of population dependent on agriculture.

The external sector has also been a significant determinant on price increases. Since 2004, import prices of oil have soared from $34 to $110, palm oil from $471 to $1177, and Thailand rice from $225 per tonne to $510 per tonne. Our import basket has taken an enormous hit, and naturally inflationary pressures have been building up. Commodity prices worldwide - food grains, cash crops, energy and metals - have been growing at an alarming rate. Over the six years to February 2008, the Goldman Sachs broad commodity index jumped by 288 per cent, the energy price index by 358 per cent, the non-energy index by 178 per cent, the industrial metals index by 263 per cent and the agricultural index by 220 per cent.

The external factors are beyond our or anybody's control, and cannot be helped beyond a certain extent. The stronger rupee will help in ensuring cheaper imports and controlling inflationary pressures. The major hope will be that the US recession and resultant drop in consumption will set in motion a chain of events that will bring down global aggregate demand. The reduced US demand will immediately translate into a lower demand for manufacture imports from East Asia and China, and hence demand for many primary commodities and metals.

All this will also reduce the demand for oil and other energy supplies. Economic growth in the merging economies too will drop, though not sharply, thereby further reducing domestic demand in these markets. All this is likely to result in lower commodity prices, which will benefit large domestic market and commodity import dependent economies like India and China.

There have been calls from many quarters to tighten monetary policy in the light of the rising inflation. This may be a wrong prescription for many reasons. Any monetary tightening now will only generate expectations that would force both inflation up and push medium term growth down. Interest rates are critical for Indian industry, especially the massive small scale and unorganised sector, who depend solely on bank debt to finance a major share of even their working capital requirements.

What should the Government do at such times? Such times are a strong reminder of the continuing need to maintain a robust and effective Public Distribution System (PDS), which would help insulate atleast the poorest of the poor from global economic volatility. It is also a reiteration of the importance of food security, and the need to make investments in agriculture with the objective of increasing productivity and thereby expanding production. There is very little Governments can do to control the rising commodity and energy prices, apart from cosmetic exercises that play to the galleries, but will achieve precious little. Aggressive promotion of investments in infrastructure will be important for easing the constraints faced in a sector vital for promotion of overall economic growth.

These times also highlight the immense complexity involved in aggressively intenventionist market controlling approaches like price controls and duty hikes. Therefore, in such circumstances, if the Government decides to assist a category of consumers with some subsidy, it is more appropriate that such subsidies be transferred as direct cash transfers than by meddling with the price mechanism. Such measures are better able to co-ordinate with the market and deliver the full bang for the buck. Besides, it will also prevent market distortions that have consequences that often go much beyond the duration of the crisis itself.

What should the RBI do to ward off inflationary pressures? It appears that the RBI's dilemma can be resolved if not by easing the monetary policy, but atleast by holding on to it, so as to address growth concerns. Any tightening of monetary policy would have serious implications at a time when the investment climate is not at the pink of health. Further, in a cost push inflation scenario, any monetary tightening will be ineffective.

It also a timely reminder about the need to keep a low interest rate cushion when the economy is doing well, so that it gives the Government a sufficient enough interest rate buffer that it can exercise and increase rates when inflation rears its head. In fact, we should have lowered the interest rates late last December itself, in anticipation of such a reality, given the storm clouds that were then gathering around the US economy.

For the foreseeable future ahead, Indian economy will have inflationary pressures stoked up due to factors that are cost-push than demand-pull. Inflation is more likely to arise out of the economy's inability to provide the critical inputs necessary to sustain the fast pace of growth. In such circumstances, monetary policy will be more critical in lowering the cost of capital and encouraging growth, and will have only a minimal role in controlling inflation.

In the final analysis, a 7-7.5% GDP growth rate is by any yardstick a very good deal, especially at a time of such tumult in the global economy. Given the fact that the robust 9% plus growth of the past few years, was taking its toll on an over-stretched economy and supply side constraints were becoming increasingly evident, a relative cooling off should even be welcomed.

Given all our supply side constraints and infrastructure bottlenecks, sustaining a 9% growth without stoking off inflation was an impossibility. A slowdown in growth to 7-7.5% should suit us, in so far as it would help prevent over-heating and consequent build up of inflationary pressures, all of which have the potential of squeezing medium-term growth itself.

Economics of ethanol as a biofuel

By enacting the Energy Independence and Security Act of 2007, the US Government legislated into force a whole new economy in biofuels, whose consequences are bound to be felt for decades to come.

As David Rotman writes in the Technology Review, "the energy bill prescribes a minimum amount of biofuel that gasoline suppliers must use in their products each year through 2022. The new mandates, which significantly expand the Renewable Fuels Standard of 2005, would more than double the 2007 market for corn-derived ethanol, to 15 billion gallons, by 2015. At the same time, the bill ensures the creation of a new market for cellulosic biofuels made from such sources as prairie grass, wood chips, and agricultural waste. The standards call for the production of 500 million gallons of cellulosic biofuel by 2012, one billion gallons by 2013, and 16 billion gallons by 2022."

Economists are worried about the distortions such mandates will create in the agriculture and energy markets. Producing 15 billion gallons of conventional ethanol will require farmers to grow far more corn than they now do. And even with the increased harvest, biofuel production will consume around 45 percent of the U.S. corn crop, compared with 22 percent in 2007. Because corn is the primary feed for livestock in this country, that means higher prices for everything from beef to milk and eggs. High corn prices could also make it harder to switch to cellulosic biofuels, because farmers will be reluctant to grow alternative crops. Since it became apparent that the biofuel standards would become law, the price of corn has risen 20 percent, to around $5.00 a bushel.

Professor Wallace Tyner of Purdue University studued the economics of corn, ethano and oil, and finds that biofuels struggle to compete with oil on cost, in part because of extreme sensitivity to the commodity price of corn. In the absence of government subsidies or mandates, according to his model, no ethanol is produced until oil reaches $60 a barrel. But with oil at that price, ethanol is profitable only as long as corn stays around $2.00 a bushel, which limits production of the biofuel to around a half-billion gallons a year. As oil prices increase, so does ethanol production. But production levels continue to be limited by the price of corn, which rises along with both the demand for ethanol and the price of oil (farmers use a lot of gasoline). Even when oil reaches $100 a barrel, ethanol production will reach only about 10 billion gallons a year if there are no subsidies; and even then, ethanol is profitable only if corn prices stay below $4.15 a bushel. If oil hits $120 a barrel, ethanol production will, left to market forces, reach 12.7 billion gallons--still more than two billion short of the federal mandate.

Tyner claims that setting the ethanol market at 15 billion gallons will mean an "implicit tax" on gasoline consumers, who will have to pay to sustain the high level of biofuel production. When oil costs $100 a barrel, the consumer will pay a relatively innocuous "tax" of 42 cents per gallon of ethanol used (the additional price at the pump will usually be only a few pennies for blends that are 10 percent ethanol). But at lower oil prices, the additional cost of ethanol will be far more noticeable. If oil falls to $40 a barrel, the implicit tax for ethanol will be $1.05 a gallon--or $15.77 billion for all the nation's gasoline users.

Update 1
Here is an article about how the ethanol craze may be driving up food prices.

Saturday, March 22, 2008

Another bubble in the making

The sub-prime mortgage crisis and the resultant loosening of monetary policy, so as to ease the credit squeeze, may actually end up blowing a new bubble. Commodities trading is the new boom sector. In an ironic twist to the tale, the leaner, lighter, and knowledge and internet-based economy is being now propped up by the clunky and mundane commodities economy of copper, wheat, and oil. The recent small drop in commodity prices, is seen as only a temporary blip, since the factors repsonsible for the higher prices continue to be active.






A NYT article describes the commodities market thus,"The heart of commodities markets is the so-called cash market, a “professionals only” setting where producers sell boatloads of iron ore, tanker ships full of oil and silos full of wheat for immediate use. Wrapped around that core are the commodities futures markets. Here, hedgers and speculators trade various versions of a derivative called a futures contract, which calls for the delivery of a specific quantity of a commodity at a fixed price on a particular date."

"Futures contracts trade both on regulated exchanges and in the immensely larger but less regulated over-the-counter market, where banks and brokers privately negotiate futures contracts with hedgers and speculators around the world. The prices at which all these contracts trade indicate the potential strength of demand and supply for commodities still in the ground or in the fields. That makes them important to everyone who produces, buys and uses those goods — wheat farmers, baking companies, grocery shoppers, oil companies, electric utilities and homeowners. Prices here can also influence the values of the increasingly popular exchange-traded funds, or E.T.F.’s, that focus on commodity investments."



Investors perceive that commodities like oil and gold offer a safe hedge against inflation. They are seen as one of the few remaining sources of double-digit gains that have fast been disappearing from the markets for stocks, bonds and real estate. Small investors are plunging in, too, using dozens of new retail commodity funds to participate in markets that by one measure have jumped almost 20 percent in the last six months and doubled in six years.

As NYT reports, "the biggest speculators and lenders in the commodities markets are some of the same giant hedge funds, commercial banks and brokerage houses that are caught in the stormy weather of the equity, housing and credit markets. As in those markets, an evaporation of credit could force some large investors — especially hedge funds speculating with lots of borrowed money — to sell off their holdings, creating price swings that could affect a host of marketplace prices and wipe out small investors in just a few moments of trading."

Margin calls and volatility can be managed as long as the prices of commodities continue to rise, as they are now. Credit will continue to flow uninterrupted, further raising the prices of commodities based financial instruments. But commodity prices can record daily percentage changes that dwarf typical movements in stocks, thereby adding considerable volatility to the market. And when the time of reckoning comes, as it should, the same sub-prime mortgage backed securities story will get enacted.

Wall Street and the global financial markets need to face up to the reality that there is a deep solvency problem. There are whole classes of asset backed securities, traded and re-traded many times over, insured and reinsured, which are now valued at a fraction of the original value of the asset. In some cases, the original asset itself has been liquidated or has spiralled into oblivion. The repayment of these liabilities can be postponed for some days or months. They can even be transferred or shifted to some others. All this financial engineering will only be at great cost to the long term health of the financial system, as it will release moral hazard and information asymmetry problems aplenty into the system.

The bottomline is that somebody has to bear these liabilities. The sooner we realise it the better. The breathing time that the Fed is giving by its rates cuts, liquidity injections and the extraordinary relaxations in credit standards has to be utilized effectively to wring out these losses in a slow and phased out manner.

Instead it would appear that the financial and mathematics wizards and Nobel laureates occupying the backrooms of the Wall Street firms and hedge funds, are using this breather to spin out new asset categories that would seek to shift or transfer away (or even conceal) their liabilites and risks to other unsuspecting investors and lenders (of which there appears to be plentiful in supply, even after the very recent, bitter lessons of the sub-prime mess). The game will go on and the agony will be postponed for a few more days or months.

The technology stocks led equity market boom (remember Dow 36,000!) of the nineties and the real estate market bubble of this decade generated huge Ponzi schemes, with deferred judgement days, that spread wealth around a wide base of consumers and investors. A whole generation of investors have grown up used to double digit returns, that has been the distinctive mark of the last two decades of financial market innovations and booms. It is no surprise that this era is now coming to an end. It had to end, for those boom era returns were built on fickle foundations and thereby not sustainable.

One of the most eternal and profound lessons from the financial market is simple - that which goes up has to come down, and that which goes up furthest has to go down the deepest! Investors will be all the more wiser to pay heed to this basic lesson.

Friday, March 21, 2008

Why are commodity prices high?

The popular explanation for the spectacular rise in the prices of energy, minerals, farm products, and other industrial inputs has been rapid growth in the world economy. China booming, India getting into the high growth bus, American consumers spending away like there is no tomorrow, even the Europeans consuming aggressively - these are some of the commonly mentioned reasons.

Professor Jeffrey Frankel of the Harvard Kennedy School argues that this may not tell the whole story, since commodity prices have soared more than 25% since August 2007, despite all the major economies slowing down and expectations of a US recession mounting. His more profound macroeconomic explanation is: "real interest rates are an important determinant of real commodity prices".

He writes that "high interest rates reduce the demand for storable commodities, or increase the supply, through a variety of channels: by increasing the incentive for extraction today rather than tomorrow (think of the rates at which oil is pumped, gold mined, forests logged, or livestock herds culled); by decreasing firms' desire to carry inventories (think of oil inventories held in tanks); by encouraging speculators to shift out of spot commodity contracts, and into treasury bills".

"All three mechanisms work to reduce the market price of commodities, as happened when real interest rates where high in the early 1980s. A decrease in real interest rates has the opposite effect, lowering the cost of carrying inventories, and raising commodity prices, as happened in the 1970s, and again during 2001-2004. It's the original "carry trade.""

He summarizes the theoretical model,"A monetary expansion temporarily lowers the real interest rate (whether via a fall in the nominal interest rate, a rise in expected inflation, or both -- as now). Real commodity prices rise. How far? Until commodities are widely considered "overvalued" so overvalued that there is an expectation of future depreciation (together with the other costs of carrying inventories: storage costs plus any risk premium) that is sufficient to offset the lower interest rate (and other advantages of holding inventories, namely the "convenience yield"). Only then do firms feel they have high enough inventories despite the low carrying cost. In the long run, the general price level adjusts to the change in the money supply. As a result, the real money supply, real interest rate, and real commodity price eventually return to where they were. The theory is the same as Rudiger Dornbusch's famous theory of exchange rate overshooting, with the price of commodities substituted for the price of foreign exchange".

As economic growth slowed sharply since August 2007, both in the United States and globally, the Fed reduced interest rates, both nominal and real. Firms and investors responded by shifting into commodities, not out. This, Prof Frankel claims, is why commodity prices have resumed their upward march over the last six months, rather than reversing it.

Paul Krugman picks holes in this arguement, claiming that contrary to what should have been happening if this were true, commodity inventories have actually been falling.

The weak dollar may also have contributed to the rise in commodity prices. With most global commodities being priced in dollars, a weak dollar makes commodities cheap for non-US buyers. The aggressive rate cuts of the Fed, which will further weaken the dollar, will in turn drive up the prices of commodities contracts.

Thursday, March 20, 2008

Ed Glaeser on how cities are unfairly taxed

Edward Glaeser argues that city residents are unfairly taxed to care for the poor and sustain the lifestyles of the sub-urbanites.

Cities have attracted a disproportionately larger share of urban residents - the 2000 Census showing that 19.9 percent of city residents were poor against only 7.5 percent of suburban residents. He writes, "Poor people come to cities because urban areas offer economic opportunity, better social services, and the chance to get by without an automobile. Yet the sheer numbers of urban poor make it more costly to provide basic city services, like education and safety, and those costs are borne by the city's more prosperous residents."

Sub-urban residents do not pay the full environmental costs of low-density, car-based, and energy-intensive lifestyles. Prof Glaeser quotes from the National Household Travel Survey to argue that "suburban households in Greater Boston buy 85 percent more gas at the pump than households living within 5 miles of downtown. That amounts to about 6 tons of carbon dioxide emissions each year. Suburban households in Greater Boston also consume about 20 percent more electricity than city dwellers. This is responsible for an extra 2 tons of carbon dioxide emissions per household per year." Besides the standard transportation policies "fail to charge people for the full social costs of driving long distances on crowded highways". The localized school system encourages prosperous parents to flee urban poverty and leave public schools emaciated and deprived of quality.

Glaeser calls for encouraging urban growth by densification of residential clusters close to the downtown, instead of the traditional approach of imposing land use restrictions to drive development away from the dense areas of the city center. Densification also lowers the costs of delivering civic infrastructure and maintaining law and order. Apart from reducing the social and environmental costs, such densification also forges human capital connections that powers the urban innovation engine. As Glaeser says, "you become smart by being around other smart people"!

This analysis needs to be reworked for developing country contexts, with its larger cities and massive populations. It is commonplace in many cities to increasingly find the more affluent moving to the suburbs, where land is cheaper, so that they can buy larger lands and settle. These people typically commute to their workplaces in the city by private transport, thereby imposing huge social and economic costs, which are typically borne by the poor and the middle class. The problems faced by the recently inagurated Delhi Gurgaon expressway is an expression of this cost, as people residing in Gurgaon commute in large numbers to their workplaces in Delhi using their private transport. It not only imposes costs on the private commuters themselves, but also on the middle class and poor who rely on public transport to commute the same route.

The amount of space available in the downtown, especially in the major cities, is often inadequate for meeting even the present commercial and institutional requirements, leave alone prospective demand. The residential requirements, both present and more importantly the future, are too massive to be accomodated in the downtowns. Further, the spiralling land costs in the downtown means that the economic utility associated with using it for residential purposes is much lower than using it for commercial or institutional uses.

Therefore, given the massive numbers and huge requirements of valuable land, it may be more appropriate to develop residential clusters on the suburbs, that get connected to the city center through public tranpsort facilities. For this model to succeed, private transport travel from the suburbs should be adequately disincentivized through toll collections or congestion charges, and public tranpsort facilities improved.

Private transport imposes unacceptably high negative externalities - pollution, traffic congestion, high energy use (whose resultant costs are mainly borne by the poor) etc. There may even be an economic case for arguing that those most likely to use private transport be encouraged to stay closer to the city center, as it would minimize the collective private travel times and costs. This is in keeping with both economic fairness and efficiency, as these people are more likely to have the resources to bear the high land costs in the downtowns and also derive greater marginal utility by being closer to the city center. Further, for the convenience of residing in the city center with all its attendant benefits like lower commute times, the more well off should forego the pleasure of living in a larger land areas.

Wednesday, March 19, 2008

Inflation is back: Propsects for the world economy

The monster of inflation is rearing its head across the world. Except for deflation laden Japan and the EU, inflation is rising everywhere. In the extreme case, it was recorded at 66000% in Zimbawe for 2007. Central Banks across the world are facing the choice between inflation and growth, exports and imports, soft and hard landings.

One school argues that today's rising global inflation is just a temporary aberration, driven by soaring prices for food, fuel, and other commodities. Others argue that for the past two decades, the world economy benefitted from an unusually benign low inflation conditions - spurt in the globalization of production chain and the immediate resultant benefits, cheap East Asian (especially Chinese) imports, massive consumption binge by American consumers, low commodity prices, rising forex reserves and resultant global savings glut, etc. Therefore, they argue, the cyclical inflation has now returned.

Unlike other macroeconomic variables, which are rooted in tangible economic data - production, consumption, savings, investment etc - inflation is considerably dependent on the intangible "expectations" held by producers, investors and consumers, about the future economic climate. The highly volatile global financial markets have added more mystery to the already uncertain economic prospects, especially now with a recession looming large in the world's largest economy. Therefore the fight against inflation cannot be confined to addressing macroeconomic variations or distortions, but involves influencing the minds of the major economic stakeholders. One way to control this is to demonstrate visible Central Bank and Government commitment to keep inflation under control. However, such a monetary policy should not mean the effective enslavement of interest rates to the single point agenda of targetting a fixed inflation rate.

So far, the US Federal Reserve has been aggressively cutting interest rates in the face of a fast deepening credit crisis and recession, brought about by the bursting of the sub-prime mortgage bubble. It does not appear to recognise that the credit squeeze has its roots not in any ordinary liquidity crisis, but in a very deep solvency crisis that is threatening to engulf all the major Wall Street institutions. Easy money and loose monetary policies cannot mandate away such a solvency crisis. Somebody has to pay for the past sins that ran up this crisis.

Economists like Kenneth Rogoff feels that "the price of this “insurance policy” will almost certainly be higher inflation down the road, and perhaps for several years". He also argues that since many countries, peg their currencies to the dollar, formally or informally, any US rate cut has immediate implications for them. These Asian, East European and Latin American countries are forced to follow suit, lest their currencies appreciate as investors seek higher yields and their exports become uncompetitive. The loose US monetary policy, it is argued, may therefore have set the tempo for "inflation in a significant chunk – perhaps as much as 60% – of the global economy".

About the possibilities facing the world economy, Ken Rogoff writes, "If the US tips from mild recession into deep recession, the global deflationary implications will cancel out some of the inflationary pressures the world is facing. Global commodity prices will collapse, and prices for many goods and services will stop rising so quickly as unemployment and excess capacity grow." On the other hand, "a US recession will also bring further Fed interest-rate cuts, which will exacerbate problems later. But inflation pressures will be even worse if the US recession remains mild and global growth remains solid. In that case, inflation could easily rise to 1980’s (if not quite 1970’s) levels throughout much of the world."

Though Prof Rogoff may be partially correct, there are important differences across the US and rest of the world. The problems and hence choice facing the developing countries, including the dollar bloc of developing economies, are different from that facing US. The inflation in the US, despite showing signs of a slow rise, is at a relatively low 4% and may not be an immediate danger. But the credit crisis which threatens to drag down the real economy means that a loose monetary policy is imperative. In contrast, the emerging economies are in strong shape but are facing sharply climbing inflation in the face of rapidly rising energy and commodity prices.

The European Central Bank (ECB) has hitherto adopted a wait and watch policy, concerned at the rising Euro which is eroding their export competitiveness, but also happy that the cheaper imports have kept a lid on domestic inflation. Any medium term hike in rates is virtually ruled out, except in extraordinary circumstances, as it would drive the Euro up even higher. Interest rates are at a low 0.5% in Japan, and inflation at 0.8% is even too low for comfort.

Ken Rogoff assessment may also have over emphasized the importance of the US economy and under estimated the increasing share of the emerging economies in global economic growth. It is estimated that the US contributed less than 20% to the global economic growth in 2007, whereas India and China combined contributed more than 40%. The robust domestic demand in many of these countries, especially in non-tradeable services like infrastructure, may be enough to offset any fall in demand arising from a US slowdown. Despite all the recent US recession talks and falling consumption demand there, oil prices have continued to rise.

Robert Reich argues that for far too long now the US consumers had kept the party going on everywhere. But unlike old times, when a US recession dragged the world economy with it, the massive stock of petro dollars that record oil prices have built up in the Middle East and sino dollars that the Chinese economic boom has accumulated, is most likely to now ensure that a large part of the world economy stays afloat. Add to this the robust domestic demand in many emerging economies like India and buoyant commodity export incomes in Latin America and East Asia, and we have the recipe for a decoupling. As Robert Reich says, the middle classes in these countries have joined the consumption party, which has just started and is set to go on for some time.

He writes, "Consumer spending is rising almost three times as fast in developing nations as in rich nations. Real capital spending is rising by double digits there while it's rising only a bit over 1 percent a year in rich nations. And emerging economies' trade with each other is increasing faster than their trade with richer nations."

He also argues that the decoupling will have both good and bad news for US. The good news will be that the insatiable emerging market demand will boost US exports, generate handsome returns for US corporates, and provide enough capital to a credit straved Wall Street and US financial market. But the bad news is that unlike in the past when US recessions depressed global demand and kept prices low, the emerging market demand will keep commodity prices high. This will make the US recession even worse. Which of these two trends will predominate and for how long, will be difficult to predict.

What puts the US at a disadvantage relative to the others is the poor health of its financial sector and the virtually negative household savings. The last two decades of asset inflation based "income effect" has made a generation of Americans abandon savings, and thereby made household consumption dependent on the vagaries of the financial market. The US financial market is in a very bad mess, brought about by its own doing. In contrast, the fundamentals of the real economy remains strong, thanks to the efficiency improvements and massive cuts in workforce of the late nineties and early years of this decade.

The spectacular securitization led financial innovation of the last two decades, assisted by the historically low interest rate regime and asset bubbles in first stock and then housing markets, have driven down household savings and tightly knit up the fortunes of even households to that of the financial markets. Unlike the Europe and elsewhere, the private sector has long relied on financial markets to raise its funds. But now, with counter-party risk at its highest and banks unwilling to lend to even each other, the market for even plain vanilla debt instruments like commercial paper has dried up. This has forced the deferment of corporate investment plans. In many respects, the problems faced by Main Street are made in Wall Street - credit squeeze, widening interest rate spreads, flat demand for commercial paper, weak consumption demand as the wealth effect from the housing and stock market bubbles declines etc. So it is understandable that if Wall Street sneezes, credit dries up and Main Street catches cold.

The present crisis starkly highlights the rapidly emerging divide between the financial markets and the real economy. While Wall Street, and to an extent global financial markets, would prefer ever lower interest rates to combat the credit squeeze, the Main Streets across the world appear more concerned about inflation and its potential impact on economic growth. Wall Street would prefer a few years of high inflation rather than suffer a credit squeeze inspired short recession.

Nouriel Roubini captures the US recession balance sheet here. Then there are those like Paul Krugman, who feel that some inflation is actually desirable, in that it gives the Fed the freedom to keep real rates negative for some time. This is necessary in a weak environment like now, so as to give all the opportunity to stoke a recovery. He contrasts the present crisis in the US with the liquidity trap which Japan got into in the nineties due to the absence of this inflation buffer.

As Martin Wolf argues, the core inflation, stripped off volatile food and energy prices, has been on the upward trend in the US since 2003 and in EU since 2006. He claims that we are seeing a "global shift in relative prices, with commodities, particularly energy, becoming much more expensive, relative to manufactures". About the reasons for this trend, he writes, "The emerging economies and, overwhelmingly, of China, has accounted for the bulk of global incremental demand for industrial raw materials. Mandates to produce biofuels have also had an impact on demand for some agricultural commodities. Also important have been constraints on supply: bad harvests, inadequate investment and higher costs. The rising price of energy is itself a big reason why agricultural production has become far more expensive."

Martin Wolf feels that a big rise in relative prices of commodities will raise measured inflation and shrink the output of commodity-using sectors, aggregate real incomes and real demand. He advocates a three-fold action path for Central Banks
1. Remind the public that monetary policy cannot give them back the real incomes that higher commodity prices have taken away
2. Ignore what seem temporary fluctuations in relative prices, since a response would generate unnecessary economic instability
3. Respond to prolonged and continuing rises in relative prices. If they do not do so, upward shifts in inflation expectations and the inflation-risk premium in interest rates are likely.

In the US today, inflation expectations are on a knife edge. Since the January federal open market committee meeting, longer-term rates, including those on fixed mortgages, have risen rather than followed the federal fund rates downward. In such circumstances, a policy of aggressively cutting short term rates, may end up introducing significant long term distortions in the basic character of the financial markets and the economy itself. Apart from the domestic consequences, through its aggressive monetary loosening, the US is also maintaining the downward pressure on dollar and thereby end up exporting inflation to the emerging economies. The assumption that Fed can cut rates without fear of the consequences is plain wrong.

The final word should go to Martin Wolf, who argues that the right policy lies between the Fed’s one of doing everything possible to eliminate downside risks and the European Central Bank’s one of masterly inactivity. The Fed should be aiming at ensuring as soft a landing as possible, but a landing nevertheless. But for the developing countries, the choice may be to retain interest rates at the same level as far as possible, till inflationary expectations and trends makes tightening inevitable.

Sub-prime timelines

BBC has this detailed timeline, with the correpsonding report for each event, on the entire sub-prime crisis.

Update 1
NYT has this excellent description of how the massive risks got created in the financial markets.

Update 2
Here is an excellent description of the ABS led sub-prime mortgage crisis by John C. Dugan. (From Rodrik)

Tuesday, March 18, 2008

Minsky analysis of bubbles

The late Hyman P Minsky believed that Wall Street encourages businesses and individuals to take too much risk, generating ruinous boom-and-bust cycles. His "financial instability hypothesis", first developed in the sixties, was condemned as not worthy of serious consideration. John Cassidy has analysed the sub-prime mortgage crisis in terms of this hypothesis.

The Minsky’s model of the credit cycle has basically five stages - displacement, boom, euphoria, profit taking, and panic. A displacement occurs when investors get excited about something—an invention, such as the Internet, or a war, or an abrupt change of economic policy. Cassidy writes, "The current cycle began in 2003, with the Fed chief Alan Greenspan’s decision to reduce short-term interest rates to one per cent, and an unexpected influx of foreign money, particularly Chinese money, into U.S. Treasury bonds. With the cost of borrowing—mortgage rates, in particular—at historic lows, a speculative real-estate boom quickly developed that was much bigger, in terms of over-all valuation, than the previous bubble in technology stocks."

As a boom leads to euphoria, banks and other commercial lenders extend credit to ever more dubious borrowers, often creating new financial instruments to do the job. If it was junk bonds in the eighties, it was securitization of mortgages that got created now. At the peak of the market, in mid-2006, the smart traders and hedge fund managers cashed out and booked their profits. The panic bugle was first sounded in in July, 2007 as two Bear Stearns hedge funds that had invested heavily in mortgage securities collapsed.

Update 1
The Economist has this article on Minsky bubbles. It writes, "Government action is inevitable. In conventional industries, the demise of companies leads to “creative destruction” with capital being reallocated to more productive areas. But in banking and finance, a crisis leads to “deflationary destruction” as capital is eliminated. Businesses, investors and consumers lose confidence; borrowers are unable to repay their lenders, who suffer as well. But by stepping in to rescue markets when they wobble, central bankers create asymmetric risk."

Update 2
See also this excellent summary of Minsky's teachings by Rajiv Sethi.

Monday, March 17, 2008

The bailouts have begun

“Central banks and other regulators should resist the temptation to devise ad hoc rules for each new type of financial instrument or financial institution.”

That was Ben Bernanke, just 10 months ago, discussing his reluctance to regulate the booming market for arcane credit instruments. Fast forward to March 2008, and the afore-mentioned remark is coming back to haunt the Federal Reserve Governor. The world has changed so much, and so has Ben Bernanke. In the fickle world of global financial markets and its supposed regulators, "moral hazard" is no longer the concern, and bailout time has arrived. Edmund Andrews has this excellent chronology of the whole sub-prime crisis, leading up to the latest big blow - the collapse and bailout of Bear Stearns, the largest prime brokerage house.



The guarantee of a 28-day credit line to Bear Stearns, engineered through JPMorgan Chase by the Federal Reserve Bank of New York last week, is a defining moment in the crisis, with implications that go far beyond the immediate short term. It is the clearest yet indication to Wall Street that no sizeable firm with a book of mortgage securities or loans out to mortgage issuers will be allowed to fail right now. Bear Stearns will not be the first to fall wayside and cry for help, only to be rolled out the bailout carpet! It is only the new LTCM!

The Bear Stearns bailout did not stop with the facilitation process for a private takeover by JP Morgan Chase. The Fed also announced a $30 bn line of credit to JP Morgan Chase to engineer the takeover of Bear Stearns. This was an extraordinary bargain for JPMorgan Chase - buying Bear Stearns at a tiny fraction of its market value just one week ago, and with the Fed shielding it from much of the risk.

This was followed by an unprecedented open-ended lending program for the biggest investment firms on Wall Street and lowering of the rate for borrowing from its so-called discount window by a quarter of a percentage point, to 3.25 percent.The move is aimed at preventing a chain reaction of defaults.

The credit squeeze which started with sub-prime mortgage holders facing difficulty in finding lenders, has spread to cover all short-term commercial debt, known as asset-backed commercial paper - used to finance mortgages, credit card debt, car loans and business loans. As Wall Street Banks strated taking multi-billion dollar write-downs, they have stopped lending and have been asking hedge funds and other borrowers to put up more money on the table to cover their borrowings. These margin calls are forcing sell-offs by hedge funds and other borrowers, making even relatively safe instruments like Municipal Bonds look risky.

The cassandras of doom among the financial analysts and the media covering Wall Street, have been spinning out stories one after the other about the potential losses. Bernanke himself initially estimated the sub-prime losses at just $100bn last July. On March 7, 2008, Goldman Sachs economists published an even higher estimate of mortgage-related losses, at $500bn, along with $656bn in other losses, for a total of $1,156bn, assuming a peak-to-trough house price fall of 25 per cent. Martin Wolf chipped in with losses amounting to $1,000bn. Prof Nouriel Roubini of New York University’s Stern School of Business broke new ground by prophesying the losses at a massive $3,000bn. The total volume of mortgage backed securities is about $6.1 trillion. The race to the discover the bottom goes on.

Financial media and commentators are calling for Government and Fed intervention, so as to "prevent the crisis spreading to other markets", a by now commonly touted reason for bailouts. That Wall Street and its media are experts at spreading fear is well chronicled - sample this by Ben Stein about Goldman Sachs. This frenzied race to the bottom has generated a fear psychosis that is threatening to sweep away the Bernanke and Co.

With every passing day, and more bad news spilling out, the Fed is forced to lower rates or step in with extraordinary measures like accepting even non-tradeable mortgage backed securities for its Term Auction Facility (TAF) loans. Wall Street expectations are for ever lower interest rates, so much so that the effect of any rate cut this week is likely to be minimal and and very short term. The fear is that the monetary policy is now a virtual fait accompli, dictated by media and Wall Street pressures, than by rational considerations and professional expertise of Bernanke and his colleagues in the Fed.

Update 1
As expected, the Fed caved in and lowered the Federal Funds rate, the short term rates charged on banks for overnight loans, rates by an unprecedented 75 basis points to 2.25%. This is the sixth cut in six months, and it now appears to be only a matter of few months before we reach ground zero, leaving the Fed with little room to even manouevre. Further, as the interest rate buffer gets reduced the inflationary and other recessionary expectations gets accelerated.

Update 2
Paul Krugman in his inimitable style describes the Fed policy as equivalent to putting out fire in a crowded theatre without a fire engine.

He writes, "Bank runs come in two kinds. In some cases, the bank run is a pure self-fulfilling prophecy: the bank is “fundamentally sound,” but a panic by depositors forces a too-hasty liquidation of its assets, and it goes bust. It’s as if someone calls “fire!” in a crowded theater, provoking a stampede that kills many people, even though there wasn’t actually a fire. In other cases, the bank is fundamentally unsound — but the bank run magnifies its losses. It’s as if someone calls “Fire!” in a crowded theater, and there really is a fire — but the stampede kills people who would have survived an orderly evacuation.

We’re in the second case. The Fed has spent the last 7 months trying to assure people that there isn’t any fire. But there is. Worse yet, thanks to decades of deregulation, the theater doesn’t have a sprinkler system - and the town the theater is in doesn’t have a fire department. And now we have to put together an emergency response."

Saturday, March 15, 2008

Lessons from Microfinance

Microfinance is increasingly accquiring a sacrosanct status in our anti-poverty programs. Whole poverty eradication programs are being tailored around the concept of micro-loans. It is seen as the biggest idea in poverty eradication for a long time, and is seen as the "Holy Grail" to wiping out poverty from the face of earth. Developing country governments believe that microloans will unleash billions of small entrepreneurs, whose small businesses will put an end to poverty. Spurred on by all this euphoria, the United Nations declared 2005 the “International Year of Microcredit” and in 2006 the Nobel Peace Prize was awarded to the doyen of micro-credit Mohammed Yunus.

Micro loans are generally smaller amounts and given at higher interest rates. Their repayment periods are also shorter. They are different from normal formal institutional credit, in so far as they are given without insisting on any collateral. In the context of India, most of the microfinance loans are given to Self Help Groups (SHGs), as the peer pressure of a group has been found to ensure regular repayment. These SHGs typically consist of 10-12 members, mostly women. Apart from ensuring access to credit, microcredit borrowers gain valuable experience in working within a formal institution, learning what to expect from lenders and fellow borrowers, and what is expected of themselves. This experience will be a help should they ever graduate to commercial credit or have other dealings with the formal financial world.

Surprisingly for such an important policy choice, and that too on a complex and multi-dimensional issue like poverty eradication, there has been limited empirical analysis of the impact of the micro finance movement. Google searches could not locate even a single rigorous and detailed study of the impact of micro finance activities on poverty eradication in pioneering states in India like Andhra Pradesh and Kerala.

The impact of micro finance loans need to be analyzed in the light of the experience of the past decade, and policies formulated based on this. What long term impact has microfinance had on SHGs who have been involved with thrift and microfinance activities for a long time? How have the incomes of SHGs increased after first, second, third, and further linkages with microfinance loans? What are the major uses to which microfinance loans have been put to? Have micro finance loans been instrumental in lifting families into a higher trajectory of livelihood or economic growth? Have these loans been instrumental in spawning small businesses in villages? What have been the economic multiplier of these micro loans? Is it the solution to poverty in the developing world, or something more modest— a way to empower the poor, particularly poor women, with some control over their lives and their assets? Finally, what role does micro credit have in our poverty eradication master plan?

James Suroweicki writes that micro finance loans are mostly used to “smooth consumption”—tiding a borrower over in times of crisis, or used for non-business expenses, such as a child’s education. It’s less common to find them used to fund major business expansions or to hire new employees. This is partially because such loans are usually very small and and generally come with very high interest rates, but also because the vast majority of microbusinesses have only one paid employee: the owner. He invokes the economist Jonathan Morduch who says that microfinance “rarely generates new jobs for others”, and argues that microfinance is therefore unsuitable to sustaining and creating entrepreneurship, which is vital to making a serious dent on poverty.

He claims that poor countries need not more microbusinesses, but "more small-to-medium-sized enterprises, the kind that are bigger than a fruit stand but smaller than a Fortune 1000 corporation." He writes about the problems facing these medium sized companies, "In high-income countries, these companies create more than sixty per cent of all jobs, but in the developing world they’re relatively rare, thanks to a lack of institutions able to provide them with the capital they need. It’s easy for really big companies in poor countries to tap the markets for funding, and now, because of microfinance, it’s possible for really small enterprises to get money, too. But the companies in between find it hard. It’s a phenomenon that has been dubbed the “missing middle.”"

The problem in the developing countries is a dearth not just of lenders but also of people willing to buy an ownership stake in companies, like the angel investors and venture capitalists that American entrepreneurs often rely on. Bank loans are not adequate and flexible enough for these middle companies to survive. As Suroweicki says, "Supplying the missing middle will require backers who want to invest in companies rather than just lend to them. "

But there have been encouraging developments as the microfinance movement continues to evolve. With microfinance loans increasingly taking the centre stage of poverty eradication efforts, banks and post offices have entered micro-finance lending in a big way. They lend micro loans to SHGs at slightly less than the regular bank rates. In fact, all the scheduled banks (the nationalized banks) in India have been given annual targets to provide micro loans to groups as part of their priority sector lending. States like Andhra Pradesh have gone one step further and give interest subsidy to SHGs that have been regular in repayment for a minimum period of six months. According to the present rules, SHGs can get upto Rs 1,50,000 for their first linkage with the bank, upto Rs 3,00,000 for their second linkage, and upto Rs 5,00,000 for their third linkage. (Rs 40 = $1)

Attracted by the large interest rates, many private Microfinance Institutions (MFIs) too have entered the sector. They lend at between 20-40% rates, which offers them significant profit opportunities. Unfortunately, the absence of proper regulation has left the door open for the emergence of a number of unhealthy lending and recovery practices, which have brought considerable bad name to the sector. The Government have in turn responded with regulatory proposals, some of which threatens to strangle private participation in the sector. These include capping micro-finance interest rates at lower rates, which would distort incentives and inhibit the market.

Tyler Cowen and Karol Boudreaux, while acknowledging the undoubted benefits of micro-credit, puts its impact in perspective thus, "microcredit may help some people, perhaps earning $2 a day, to earn something like $2.50 a day. That may not sound dramatic, but when you are earning $2 a day it is a big step forward... The improvements may not show up as an explicit return on investment, but the benefits are very real. If a poor family is able to keep a child in school, send someone to a clinic, or build up more secure savings, its well- being improves, if only marginally."

It is undeniable that microfinance has had a deep impact on poverty alleviation, in terms of institutionalizing access to formal credit markets and helping people escape the clutches of exploitative money lenders. It has helped "smooth over" consumption and provided timely and adequate money for poor families to meet their important and immediate needs like health and education, besides providing a significant part of the working capital requirement for many self-employed families. Micro finance has therefore clearly helped in making incremental advances in the fight against poverty.

Apart from its immediate benefits, it has also brought millions of women into the orbit of the formal credit delivery mechanism. Its most lasting impact has arguably been in the massive force of social empowerment it has unleashed among the women members of the SHGs. As a poverty alleviation strategy, it has been a remarkable and undoubted success. But as a poverty eradication strategy - the jury is still out.

Drug distribution economics

The Economic Times has an editorial about a dilemma facing the pharamaceutical industry in India. Traditionally drugs have been retailed in India through a 5.5 million strong and well organized chain of chemists and druggists (commonly called "medical stores"). Now the organized retailers like Reliance Retail and Subhiksha have entered the drug retailing market, resulting in an immediate fall in drug prices, and many more are getting ready to take the plunge. This new development is facing strong resistance from the influential All India Organisation of Chemists and Druggists, who are demanding that drug companies refrain from selling to corporate retailers.

Traditional retail model, with its multi-layer inefficient distribution system, supports a large number of middlemen and intermediaries, which increases the transaction costs. A substantial portion of these transaction costs are invariably passed on to the patients, thereby keeping drug prices artificially high. Organized retailers can cut down on these transaction costs, can negotiate bargains with drug companies, and also lower costs through other scale economies. Further, organized retailing will certainly be able to curb spurious drugs, which form an estimated 30% of drugs sold.

Now let me rephrase this simple problem facing distribution chains in an industry.
Business Model A: The distribution network consists of wholesalers, and a large number of small retailers. The distribution chain gives employment to a large number of people, though its results in high transaction costs and higher prices for the consumers. It is clearly an inefficient economic model.
Business Model B: The distribution network is more vertically integrated, consisting of a few large corporate retailers, with a large number of retail outlets. This distribution chain while employing lesser number of people, will reduce transaction costs and also drug prices.

Rarely is the issue that of a simple transition from Model A to Model B, displacing large numbers of people. Most often there is a long drawn out transition between A and B, with elements of both subsisting and competing with each other. Thus both the small retailers and the corporate retailers will compete with themselves and the dynamics of their competition will play itself out.

The aforementioned example of small and big retailers is part of a much larger game, as the forces of a market driven economy and globalization are being unleashed on the world economy. The inefficiencies inherent in Business Model A presents a huge opening for retail entrepreneurs seeking out high margin opportunities. Process and strategy innovations will drive businesses to seek out such high margin opportunities. It is therefore inevitable that competition rises and efficiencies improve, and benefits gets allocated more efficiently among the different economic agents.

Thursday, March 13, 2008

Reforms in administration

In my first post, I had dwelt on the wisdom of Jim Collins' book 'Good to Great', where he argues that to create a good company you need to "get the right people on the bus, wrong people off the bus, right people on right places and then figure out where to drive the bus".

At the Vijayawada Municipal Corporation (VMC), over the past two years we have been trying out this approach in the public health (sanitation) and tax collection departments. The City is divided into sanitary divisions headed by a Sanitary Inspector (SI), with public health workers under him. The tax collection establishment is divided into revenue divisions, each headed by a Bill Collector (BC). Both the SI and BC are at the cutting edge of their respective work - the SI being responsible for supervising road and drain cleaning work done by the public health workers and the BC responsible for facilitating and monitoring tax collection.

A detailed analysis of both departments revealed both administrative excess and human resource deadwood, at the cutting edge. The numbers of sanitation and revenue divisions were found to be on the higher side. Given the difficulty in hiving off or retrenching staff in Government, we decided to have two buses - with all the right people in one bus and all the wrong people in the other bus.

Artificial administrative constructs that fail to take into account the reality of available resources and the changing nature of work practices and approaches are common place in Government. Most such administrative arrangements and work distribution have been put in place in response to demands other than the specific work requirements (like providing employment, promotion channels, need for a state wide standard etc). Further, these arrangements are made on low or below average productivity assumptions. Apart from not incentivizing anybody, it even disincentivizes the more active and efficient officials. This lack of flexibility results in highly inefficient allocation of work, thereby adversely affecting the desired outcomes. For example, highly capable and efficient Bill Collectors or Sanitary Inspectors, end up having the same work distribution as the inefficient and weak. The system gets trapped in an inefficiency spiral.

It was therefore decided to bite the bullet and completely re-organize the sanitation and taxation administrative machinery. The number of sanitation divisions was reduced from 45 to 34, and revenue divisions from 72 to 36, taking into account the field conditions and work convenience, and the availability of capable officials. The divisions were also allocated based on the efficiency and professionalism of the individual SIs and BCs, following a transparent process.

The remaining Bill Collectors were organized into enforcement teams and used for other miscellaneous non-core work. The remaining SIs were diverted to Malaria and other regularly allotted group work. They were given the incentive of getting posted back as a BC or SI, depending on their performance and conduct. The poor performing BCs and SIs in the first bus had the threat of demotion to the second bus, acting as a major incentive to maintain high work standards.

The first bus was populated by the core group of SIs and BCs, while the second bus contained the rest. The staff and the seating in the first bus was carefully chosen, keeping in mind the specific local requirements. The performance of the first bus determined the performance of the department, and was hence the focus of all the attention. In the absence of all the poor performers, the average performance standards of the second bus rose significantly and the internal incetive structures made the bus even more competitive. The second bus was no longer a drag on the performance of the department.

The results have been spectacular. Revenue collection efficiency has gone past 90% (used to be 75-80% previously), and the large private defaulters have all paid their dues. Tax revenues have increased by more than 60% since the experiment has been tried out. The revenue assessment, collection, and monitoring work has become more professional and standardized. The sanitation complaints reflected in a toll free complaints cell, 103, has declined sharply and this has been acknowledged by the City receiving the CRISIL award for sanitation in 2007. The trade licence issuance and fee collection has improved dramatically. While all of these improvements are surely not exclusively the result of the administrative revamp, it is undeniable that it has contributed a substantial share towards improving the performance.

This revamped sanitation and tax collection administrative arrangement immediately spurred productivity and efficiency improvements in many ways.
1. The larger administrative units ensured that the SIs and BCs had to innovate on process reforms and their work practices, so as to cover the increased areas.
2. The larger administrative areas and the peer acknowledgement at being chosen over their under-performing colleagues, provided a positive stimulus to them.
3. It lowered the administration costs in terms of supervising and monitoring, as the processes and scope became simpler and therefore more meaningful.
4. The under performing divisions fell sharply, as the poor and weak were phased out.
5. The average work standards were raised substantially in a single stroke. This also increased the performance related peer reference level for employees.
6. The SIs and BCs could now concentrate on their core work, while those on standby were utilized for the miscellanoeus work, which gets entrusted frequently by the Government.
7. The poor and weak SIs and BCs were no longer adversely influencing the performance of the department and on the better performing employees.
8. The smaller numbers also meant that peer effects were now much more positive and their infleunce on each member was substantial.

In many respects, we therefore have two buses. The primary bus populated by all the efficient employees and being driven to its destination through the collective efforts of all its occupants. The secondary bus follows the primary one, and serves as a standby to supply spare parts and other support when the primary bus experiences problems. While this two bus approach may not be suitable (due to inherent bureaucratic rigidities) in many government departments, they illustrate the influence of competitive pressures and motivation on employee performance.