Saturday, February 27, 2010

Indian Budget 2010-11 highlights

1. The budget proposals at a glance. Total Budget is for Rs 11.09 lakh Cr, of which Rs 7.36 lakh Cr has been allocated for non-Plan expenditures and Rs 3.73 lakh Cr towards Plan expenditures.







2. The fiscal deficit is forecast for 5.5% of the GDP (Rs 3,81,408 crore) for 2010-11, down from the revised estimate of 6.7% of GDP (Rs 4,14,041 crore) for 2009-10. This includes all obligations to oil and fertilizer companies, thereby phasing out the off-balance sheet obligations. The actual net borrowing of the government in 2010-11 would be Rs 3,45,010 crore. The revenue deficit is also expected to decline to 4% of GDP from 5.3%. The government has also explicitly declared its commitment to reduce the public debt to GDP ratio to 68% over the next five years, from over 80% now.





The budget proposals hope to lower the deficit through disinvestment proceeds, sale of telecome 3G spectrum, and an overall reform in the expenditure management of the government including subsidies. It has targeted a revenue of Rs 40,000 crore from divestment of PSU shares (against the estimates of Rs 25,000 crore for 2009-10, only Rs 12,660 crore has been raised by dilution of stakes in NHPC, NTPC, and REC) and Rs 35,000 crore from the auction of 3G spectrum (the same was budgeted in 2009-10 also). The 3G auction process is slated to start on April 9 and the spectrum is expected to be available commercially to all the successful bidders from September 1.

3. The total expenditure on food, fuel and fertilizer subsidies in 2010-11 (at Rs 108,666.91 crore) is estimated at over 12% lower than the revised estimates of 2009-10 (at Rs 123,936.26 crore).

Petroleum subsidy (given to state-run oil marketing firms for selling cooking gas to households and kerosene to public distribution system at below cost) is forecast to come down to Rs 3,108 crore from Rs 14,954 crore (original budget estimate for 2009-10 pegged petroleum subsidy at Rs 3,109 crore, although it was finally Rs 14,954 crore). The food subsidy (for running PDS) is estimated to decline marginally to Rs 55,578.18 crore next fiscal from Rs 56,002 crore in 2009-10. Fertiliser subsidy (the actual fertilizer subsidy in 2008-09 was 2.5 times larger than the budgeted Rs 30,986 Cr) is pegged lower at Rs 49,980.73 crore in next fiscal from Rs 52,980.25 crore in 2009-10. Under this subsidy, the government would provide Rs 15,980.73 crore for indigenous (urea) fertilisers, Rs 5,500 crore for imported (urea) fertilisers and Rs 28,500 crore for sale of decontrolled fertilisers (DAP, MOP and complexes) with concession to farmers.

4. Over 46% (Rs 173,552 crore or $37 bn) of the total plan outlay of Rs 373,000 crore for 2010-11 was allocated to the infrastructure sectors, including road, power, railway, ports and airports. This is up from around 30% last year. It includes doubling of allocation for R-APDRP for cutting electricity distribution losses; increased plan outlay for renewables by 61%; increased allocations for roads (Rs 19894 Cr, up 13%) and railways (Rs 16752 Cr) to Rs 36,600 crore, up by Rs 3,300 crore; estimates disbursements by the India Infrastructure Finance Company to touch Rs 9,000 crore by March 2010 and reach around Rs 20,000 crore by March 2011. The take-out financing scheme, where banks sell their loan book from infrastructure companies to IIFCL, announced in the last Budget, was expected to provide funding of Rs 25,000 crore over the next three years.

The boost to infrastructure comes even as the PM's Committee on Infrastructure has estimated the infrastructure investments at $1.5 trillion for the 12th Plan (against $500 bn for 11th Plan). The Planning Commission has reported that though infrastructure investments rose from 4.5% of GDP in 2003-04 to 6% of GDP in 2007-08, it still remains well short of the 11% of GDP of China.

5. The spending on social sector has been hiked to Rs 1,37,674 crore, around 37% of the total Plan outlay in 2010-11, and another 25% of the Plan allocation is proposed to the development of rural infrastructure.

In the three years from 2007-08 to 2010-11, the Plan outlays on the Bharat Nirman scheme would have doubled from Rs 24,600 to Rs 48,000 crore and that on the NREGA would have shot up over threefold from Rs 12,000 to Rs 40,100 crore. Money in the hands of farmers would also be bolstered by the whopping sum of Rs 3,75,000 crore earmarked for agricultural credit this year, up by 66% in just three years.

6. Indirect tax collections, which actually fell Rs 34,368 crore between 2007-08 and 2009-10, are budgeted to increase by nearly 29 per cent in 2010-11 over the Revised Estimates (RE) for this fiscal.



In contrast, direct tax revenues, which did not suffer even in the peak slowdown phase (the RE for 2009-10 has overshot the budgeted number by Rs 10,608 crore), are slated to rise by only 11% in the coming fiscal. Therefore, the share of direct taxes in the Centre's gross tax receipts is estimated to fall to 56.6% from the 60.1%in the RE for 2009-10. The Centre's gross tax-GDP ratio, which hit a peak of 12% in 2007-08 and had declined to 10.3% in the RE for 2009-10, is being projected to recover to 10.8% in 2010-11.

Further, by widening the service tax net, the revenue collections from service tax for 2010-11 have been pegged at Rs 68,000 crore with no increase in rates, up from Rs 58,000 crore in 2009-10.

7. Coinciding with the first year of the implementation of Thirteenth Finance Commission (TFC), transfers to the States (states are entitled to 32% of the Centre's tax income under the TFC award, against 30.5% earlier) from the Central tax pool are expected to increase by about Rs 44,000 crore, from the revised estimate of Rs 1,64,832 crore in 2009-10 to Rs 2,08,997 crore in 2010-11.

8. The Union government lost Rs 5,02,299 crore of potential revenue during 2009-10 on account of various exemptions, rebates and concessions given to individual and corporate tax-payers (subsidies to preferred tax payers). This is nearly 80% of all tax collections in the year and has gone up by nearly 18% over the previous year. Including the export-related subsidies and exemptions worth Rs 37,970 crore, revenue foregone would reach a whopping Rs 5,40,269 crore, or about 86% of actual tax collections.



The corporate sector got concessions in corporate tax worth Rs 79,554 crore, an increase of nearly 20% over the previous year. Taking advantage of various exemptions and rebates, they paid taxes at the rate of 22.78%, substantially lower than the statutory tax rate of 33.66%. Interestingly, public sector companies paid tax at the rate of about 27% while private sector paid at the rate of about 22%. Individual tax-payers could save on I-T to the tune of Rs 36,186 crore, an increase of 8% over last year.

Thanks to the tax benefits to the Software Technology Parks of India (STPI), which are now set to go away in March 2011, the effective tax rates on software firms as a percentage of profits before tax could go up from the average 15-17% now to 26%.

Update 1 (10/3/2010)
Businessline has this graphic about the budgetary shortfalls.

Update 2 (15/3/2010)
And this snapshot of budget subsidies over the years


Update 3 (16/3/2010)
Excellent snapshot (from Business Standard) of infrastructure allocations this budget. On a total Union Budget of Rs 11.09 lakh crore, infrastructure plan outlay forms 16%. Of the Plan expenditure, it forms 46%. This allocation forms 38% of the annual requirement of $100 bn or Rs 4.5 lakh Cr (Planning Commission estimates $500 bn required over the 11th Five Year Plan). 30% is estimated to come from the private sector and PPPs, while state/local governments and off-budget resources are set tocontribute the remaining 32%.



Update 4 (19/3/2010)
The changing shares and absolute values of Plan and non-Plan expenditures over the past five years is shown below


Friday, February 26, 2010

Ease of getting an electricity connection for business activity

"An entrepreneur would like to connect his newly built warehouse for cold meat storage to electricity. The internal wiring up to the metering point has already been completed by the electrician employed by the construction firm, and the entrepreneur would now like to obtain the final electricity connection from the local distribution utility. The electrician working for the entrepreneur estimates that the warehouse will need a 140 kVA (kiloVoltAmpere) connection. How many procedures and days will it take to release the service?"


The World Bank's Doing Business Report 2010 finds that it would take 7 procedures, 67 days and cost 504.9% of the country's GDP per capita to get the service released in India, the duration being amongst the lowest in the world. The OECD average is 4.6 procedures, 87.6 days, and 58.3% of per capita income. The methodology for calculating the procedures and costs are outlined here.

Let me list out the processes involved for release of the service in a typical electricity utility in India

1. Application at the Citizen Charter Center (single stop and immediate process)
2. Preparation of estimates by the utility and its sanction (a week)
3. Payment of the connection charges (security deposit, development charges, and service line laying charges) by the consumer on intimation.
4. Execution of the work (done either by the department or on turnkey, under utility supervision, by the customer, depending on his choice)
5. Procurement of the satisfaction certificate from the Electricity Inspector before release of the service
6. Physical release of the service by the utility staff (immediately on receipt of the certificate from Inspector)

The Citizen Charter of a typical utility specifies that the service will be released at 11 KV potential within 60 days of the receipt of the full connection charges. The sanctions are generally issued within a week of receipt of the application, thereby making the 67 days for release of such services.

The actual time taken may be much less in urban centers and in industrial areas, especially if the service lines are laid by the applicant himself. If we take the example of urban areas, as assumed by the Doing Business Survey, the typical Indian utility releases the service within 20-30 days if there is no line extension and only a transformer erection and 25-35 days if there is a small line extension work in addition to the transformer erection. Such service release conditions are mostly found in densely populated urban areas.

However, in rural areas and outskirts of cities, in the absence of network in the surroundings, a new line would have to be laid to deliver power to the consumer. Further, such network extensions can be carried out quickly in city surroundings as opposed to rural areas. It is therefore natural that the service gets released much quickly and at a cheaper cost in the urban areas. This is another example of the inherent locational advantages enjoyed by businesses in urban centers in comparison with their similarly placed counterparts in rural areas.

Wednesday, February 24, 2010

Central banks and banking regulation

The sub-prime crisis and the the Great Recession have prompted calls for a radical restructuring of the extant financial market regulation architecture. One of the most important issues being debated involves the role of Central Banks in banking supervision.

On the one side are those who see monetary policy and financial market regulation as distinct and independent activities and therefore favor a separate regulator, different from the central bank, to supervise the banking sector. However, there are others like Mark Thoma and Paul De Grauwe who point to the difficulty of separation of these two activities into distinct and independent functions, and feel that the central bank should be the primary regulator of the financial system.

Central Bank governors including Ben Bernanke and D Subba Rao argue that monetary policy and the structure and condition of the banking and financial system are irretrievably intertwined and therefore advocate an important role for the Fed in regulation and supervision of banking sector.

I am inclinced towards an opinion that while the central banks should have an adequate level of control over systemic risk through macro-prudential regulation, a separate regulator for individual firm specific risks may not be a bad idea.

In a Vox article, Hans Gersbach proposes "a new policy framework whereby the central bank chooses short-term interest rates and the aggregate equity ratio while banking regulation and supervision, including the determination of bank-specific capital requirements, would be left to separate bank-regulatory authorities". This approach seeks to reconcile the need to expand the role of the central bank by giving it greater control over the banking sector while at the same time giving individual bank regulation to a separate regulator.

The aggregate equity ratio of the banking sector, defined as the ratio of total end-borrower lending (credit for non-financial firms, households, and governments) plus other non-bank assets to total equity in the banking sector, is a measure of the capital cushion of the banking sector. Gersbach advocates an aggregate equity ratio rule, which "relates the required equity ratio of the banking system in the next period to the current aggregate equity ratio and to the state of money and credit". He concedes that "while it is impossible to find a fixed aggregate equity ratio rule, it will be essential that such a rule is as systematic, transparent and accountable as traditional monetary policy regimes". He writes,

"The state of money and credit indicates how strongly consolidated and unconsolidated balance sheets of banks or financial intermediaries expand or contract in comparison with average growth. It is often useful to concentrate on sub-aggregates such as total credit to non-banks or total short-term debt liabilities of banks to non-banks and among banks themselves. The latter measures include both traditional monetary aggregates such as household deposits and other liabilities such as commercial papers and repurchase agreements which provide signals about the price of risk and other financial-market conditions.

All remaining activities for the regulation and supervision of banks are executed by separate and less independent bank-regulatory authorities. These authorities act under the aggregate equity ratio constraint set by the central bank. They determine bank-specific capital requirements that may require upward and downward adjustments of capital requirements, depending on whether a particular bank holds a high-risk or low-risk asset portfolio... Those separate authorities also regulate shadow-banking, operate the deposit insurance scheme and may intervene to restructure or close banks."


He feels that the setting the interest rate and the aggregate equity ratios enables central banks "to conduct flexible inflation targeting and to moderate booms and busts as a system regulator". This rule can be deployed as an effective counter-cyclical adjustment mechanism - lower the ratio to enable banks to write down equity as asset prices decline or credit losses mount so as to moderate the bust, and "lean against the wind" and raise the ratio when the balance sheet assets and liabilities (and thereby leverage) start exploding during a boom.

Update 1 (18/4/2010)
Thomas Hoenig of the Kansas Fed makes the point that Fed should supervise all banks (and not just the large banks, which pose systemic risk, as in the current Bill before Senate) and that all insolvent large banks should be placed into receivership and resolved in an orderly fashion just as smaller banks (currently the decision to close a large financial firm that is failing would depend on the Treasury Department’s petitioning a panel of three United States Bankruptcy Court judges for approval to place the firm in receivership with the Federal Deposit Insurance Corporation. The panel would have 24 hours to make a decision, and if it turned down the petition, the Treasury could re-file and subsequent appeals could be considered. So a decision to put the firm in receivership might not be timely enough under the circumstances).

Monday, February 22, 2010

China's high-speed rail march

In its breakneck paced surge towards economic superpower status, China has been making massive investments in modernizing and expanding its infrastructure. One of the more remarkable successes is the development of high-speed railway lines (which average speeds of up to 215 miles an hour), on which China has surpassed the US and is fast catching up with leaders Europe and Japan.

There are 42 high-speed lines which have been recently opened or set to open by 2012 (the US hopes to build its first high-speed rail line by 2014!). The recently opened 664 mile Wuhan-Guangzhou high-speed line which has so many tunnels through mountains that at times it feels like a subway and which cost $17 billion to build cuts travel time from 11 hours to just three hours.



As the Times reports, the web of superfast trains have the potential to make China even more economically competitive, connecting the vast country as never before, much as the building of the Interstate highway system increased productivity and reduced costs in America a half-century ago.

Like in case of the power sector, the massive economies of large-scale production created by these investments have had the result of many Chinese companies emerging to take advantage of the rapidly expanding new market. It is only a matter of time before they assume global leadership position in the development of these equipments and technologies.

Like all else in the country's infrastructure, this dramatic expansion too has been largely top-driven. The government plans to shift much of passenger traffic into these high-speed lines and free up the existing lines for freight traffic. The global recession and a $100 bn infusion of the $586 bn Chinese stimulus spending has advanced the original plan for achieving the aforementioned objective from 2020 to 2012. The 42 projects include 5,000 miles of track for passenger trains at 215 miles an hour and 3,000 miles of track for passenger and fast freight trains traveling 155 miles an hour.

However, like with all the other massive infrastructure investments in China, this too has its share of criticisms - heavily subsidized investments, possible over-investment and redundancies in network, need to subsidize operating expenses (the ticket prices are kept well below the rate of recovery) and so on.

The comparison of these mega investments with Indian Railways is stark. In fact, the budgetary support for Railways for 2009-10 was just $1 billion and total Plan outlay at less than $8 bn for the year.

Update 1 (16/3/2010)
Times reports that the 520-kilometer (325 miles) high-speed rail connection — called AVE for Alta Velocidad Española — between Barcelona and Madrid, opened in 2008, has cut journey time from the previous six hours by car to just 2 hours and 38 minutes. Two years ago, nearly 90% of the six million people traveling between Madrid and Barcelona went by air, while early this year the number of train travelers on the route surpassed fliers. This also contributes to Spain achieving its commitment to lower its carbon dioxide emissions by 20% over 10 years. Analysts say that such emissions per passenger on a high-speed train are about one-fourth of those generated by flying or driving.

But unlike the French, who sought to maintain a low-cost image as their trains gained speed, AVE tickets cost as much as plane tickets — from about €120 to €200 one way, or $160 to $300, though cheaper advance fares can be found. The train offers assigned reclining seats, computer outlets, movies, headsets, good food, even gloved attendants.

Other AVE lines connect Madrid with Seville and with Málaga. The number of flights between Madrid and Málaga has dropped by half in the two years since the AVE route between those cities opened in 2007. Requiring fewer employees and far less costly infrastructure than do planes, all AVE lines turn a profit and have easily survived price wars waged by airlines.

Among rail's competitive advantage are the fact that their lines are closer to residential areas; rail tickets remind passengers to be onboard a mere two minutes before departure; the only security procedure involves passing large suitcases though a scanner etc. Adding to rail’s competitive advantage, European environmental policies will probably force an increase in airline ticket prices over the next few years, since beginning in 2012, the biggest polluters among the airlines will be required to buy extra credits to 'pay' for their carbon dioxide emissions, and the cost will have to be passed on to travelers.

Update 1 (10/4/2010)
As part of its efforts to become a big exporter and licensor of bullet trains traveling 215 miles an hour, the Chinese government recently signed cooperation agreements with the State of California and General Electric to help build such lines.

Though state-owned Chinese equipment manufacturers had initially licensed many of their designs over the last decade from Japan, Germany and France, with domestic experience they have gone on to make many changes and innovations and emerge as manufacturers on their own right.

Update 2 (25/8/2010)

The China Railway Group, a construction company, is in talks with South Africa’s government for a $30 billion, 352 miles high-speed rail project between Johannesburg and the eastern port city of Durban, that is expected to cut travel times from 5-7 hours to 3 hours. South Africa is hoping Chinese state-owned banks can provide loans for the project.

Update 3 (18/2/2011)

The NYT reports that the recent sacking of Liu Zhijun, chief of the Chinese Railways Ministry, for "severe violations of discipline", hints at corruption and dilution of safety and quality standards in China's light rail surge. Mr. Liu had led China’s program to lace the nation with nearly 8,100 miles of high-speed rail lines and to build more than 11,000 miles of traditional railroad lines. The sheer size and cost of the endeavor — the investment has been estimated at $750 billion, some $395 billion for high-speed rail alone — has led experts to compare it to the transcontinental railroad that opened the American West.

China’s high-speed rail network has been built far more cheaply than similar projects in the West and in Japan. A mile of rail here costs roughly $15 million; in the United States, estimates peg the price at anywhere between $40 million to $80 million. Despite its heavy use (passenger rail traffic leapt to 1.68 billion trips last year, up 9.9 percent from 2009) and high ticket prices (several times those for a conventional train), the high-speed network is expected to remain a money-loser for the next 20 years.

Mr Liu's push to speed up things has pushed the Railway Ministry's debt burden beyond an unsustainably high $170 bn. A 2010 analysis by China Minsheng Bank found that the ministry’s debts equaled 56 percent of its assets and could reach $455 billion, or 70 percent of its assets, by 2020. Mr. Liu recently began an aggressive program to deal with the debt by selling stakes in the railway to investors like large state-controlled banks.

Update 4 (14/6/2011)

Concerned at safety, authorities have decided to lower the travel speeds of the new light rail lines. As part of its fiscal stimulus spending, the Chinese government has developed or is developing nearly 8,100 miles of high-speed rail lines and some 11,000 miles of traditional railroad lines, at a cost of $750 billion.

A new line between Shanghai and Beijing will halve the 10-hour rail trip between the country’s great metropolises, but even the lowest ticket price of about $63 nearly equals the net monthly income for rural residents.

Electricity sector reforms - the way ahead

The British government's Office of Gas and Electricity Markets (Ofgem) has released the conclusions of its year-long study of whether the current arrangements in the country are adequate for delivering secure and sustainable electricity and gas supplies over the next 10-15 years.

This discussion paper comes even as Britain faces the twin problems of meeting an estimated $317 billion price tag for energy investment to both replace old infrastructure and meet growing needs, and doing so while respecting the European Union’s target of sourcing 20% of energy from renewable sources by 2020.

It draws attention to the difficult financial conditions in the medium term, fuel sourcing risks in the medium and long-term, distorted short-term price signals at times of system stress that do not fully reflect the value that customers place on supply security, and the uncertainty in future carbon prices that is likely to delay or deter investment in low carbon technology and lead to greater decarbonisation costs in the future. It proposes five possible policy ‘packages’, starting with those involving the least reform and intervention in the market on the left and moving to the most dramatic move away from competitive markets on the right.



About the five proposed packages, it writes

"A minimum carbon price, which would provide long term certainty for investors and should bring forward low carbon investment, features in three of the packages. Improved price signals coupled with measures to promote demand side response, should improve security of supply by increasing the incentives to make peak energy supplies available and invest in peaking capacity including storage. In two of the packages, we include enhanced obligations on industry players to deliver a specific level of supply security. In some packages, we include the concept of a centralised renewables market designed to help manage the variability of some forms of renewable energy sources for both the generator and the system operator. Long term capacity tenders covering renewables, low carbon generation and/or gas storage feature in some packages to facilitate financing, and in one case these are coupled with short term capacity tenders for all generation and demand side response. The Central Energy Buyer package envisages a single entity responsible for coordinating the procurement of new energy supplies, or at least certain forms of energy supplies or infrastructure such as strategic gas storage."


And its assessments of the five packages

"Those that target specific volumes and types of investment, such as the Central Energy Buyer and Capacity Tenders, would in theory be expected to increase the probability of delivering security of supply and environmental objectives. However, there are risks associated with leaving a central entity to make all the key decisions, which could turn out to be wrong. There is also a risk that large scale, centralised supply side solutions will dominate at the expense of small scale, local solutions and demand side response. These packages are also likely to be more difficult and time consuming to implement, and importantly there may be significant legal issues, particularly with the Central Energy Buyer where the existing European legal framework would limit what is possible.

The less interventionist Targeted Reforms or Enhanced Obligations package are conceptually easier to design but continue to leave key decisions about supply security to individual market participants, which may provide less confidence of achieving specified levels of supply security and carbon reduction... there are legal issues and complexities around the design and implementation of a minimum carbon price that could impact the timing and effectiveness of these packages...

More mandated outcomes could reduce the cost of finance (by reducing investor risk), reduce the risk of high prices resulting from under-investment, and remove some of the inefficiencies in current mechanisms such as the Renewables Obligation (RO). However, such approaches may expose customers to risks of overinvestment, and deprive them of some of the benefits of innovation and cost reductions driven by more effective competitive markets."




China's spectacular success with capacity addition, especially with super-critical technologies for thermal plants and solar and wind power plants, is a testament to the effectiveness of a virtual centralized market model. The enabling policy framework of equipment standardization, bulk manufacturing orders, clear and ambitious renewables targets, attractive subsidies for renewables undeprin their model. However, the Chinese experience also shows that this model has the potential to lead to over-investment and massively inefficient and incentive distorting subsidy handouts.

In contrast, the Indian model of targetted reforms with loosely binding renewables obligations, leaves decisions to the individual market participants and leaves many questions about supply security unanswered besides distorting price signals. The effectiveness of this model is questionable, especially when private sector may not have the resources and capability required to meet the massive target.

The biggest challenge for power sector in the days ahead will be that of arranging fuel supplies, one which the government is ideally suited to more effectively address or atleast facilitate. This becomes all the more important in view of the inevitability of sourcing fuels, both coal and gas, from external sources. This also means that it is imperative that the government strengthen the energy security dimension to its foreign policy. Further, the huge capacity addition requirements, manifested in the persistently high and under-estimated peak power deficit, means that there is very little possibility of inefficiency by way of idle capacity accumulating as a result of a centralized push.

Regarding renewables, the policy stance is less clear given the large tariff differentials. It becomes very difficult to incentivize private participants to invest in renewable sources without massive, and possibly unsustainable, tariff incentives, atleast for the foreseeable future.

In the coming days, I will be posting more on the requirements for a desirable market structure for India.

Monetary exit updates

The US Federal Reserve's decision to raise its discount rate (rate at which the Fed lends to banks) by 25 basis points from 0.50% to 0.75% is surely the clearest signal to the markets that the central banks has started the decent from its extraordinary monetary loosening of the past two years.



It is also the surest indication of the policy makers belief that the worst of the sub-prime crisis and recession is behind and that normalcy is returning back to the credit markets and a sustainable recovery is underway. However, with consumer price inflation for January at just 0.2%, and full recovery some way down the road, interest rates appear set to remain long for the foreseeable future. In fact, the Fed did also announce that it was not yet ready to begin a broad tightening of credit that would affect businesses and consumers as they struggle to recover from the economic crisis and that the short-term federal funds rate will remain "exceptionally low" for an "extended period".

As part of its liquidity tightening, the Fed also announced that the typical maximum maturity for primary credit loans, in which banks borrow from the discount window, would be shortened to overnight, from 28 days, starting March 18; and raised the minimum bid rate for its term auction facility — a temporary program started in December 2007 to ease short-term lending — to 0.50 percent from 0.25 percent.

The Fed’s balance sheet stands at $2.2 trillion in assets, which includes $1.03 trillion in mortgage-backed securities and $165.6 billion in debts guaranteed by housing entities. Short-term Treasury bills, historically a mainstay of the balance sheet, now make up just a tiny fraction of the picture. On the liabilities side, banks hold $1.2 trillion in reserves at the Fed.

The ultra-low rates had presented banks with easy profit opportunities in two ways - access to cheap money and the opportunity to arbitrage on the record spread (2.9% between two and ten year Treasuries) between short and long-term interest rates. The increased discount rates will have the effect of bridging the spread and increasing the cost of capital.

But as a Times article points out, the Fed's exit is a few months behind that in the emerging economies of Asia, indicating the two-track recovery process between the developed and emerging economies. Australia was the first to start the exit, from October 2008, and has already raised its rates three times to 3.75%. Both India and China have raised the reserve ratios (banks have been asked to set aside a larger portion of their reserves) in an effort to limit the amount they can lend to consumers and businesses. Vietnam too raised its rates by a percentage point in November last year.

Update 1 (5/3/2010)
The ECB, which sets monetary policy for the 16 countries using the euro, left its benchmark interest rate at 1%, where it has been since May 2009. The ECB also continues its liquidity support operations to banks. In Britain, the Bank of England left its benchmark rate unchanged for a 12th month, at 0.5%.

Update 2 (21/3/2010)
The RBI in India made a sudden decision, in advance of its April 20 annual credit policy review, to raise its key policy rates – repo and reverse repo – by 25 basis points each with immediate effect to 5% and 3.50% respectively. This is the first rate hike since July 2008.



With headline inflation on a year-on-year basis at 9.9% in February 2010 exceeding its baseline projection of 8.5% for end-March and even manufacturing inflation showing signs of rising, RBI reasoned that "given the lags in monetary policy, it is better to respond in a timely manner, even if it is outside the scheduled policy reviews, than take stronger measures at a later stage when inflationary expectations have accentuated". Signs that recovery is firmly on, with industrial production gaining 16.7% in January following a 17.6% increase in December, also prompted the monetary contraction.

Australia and Malaysia both increased rates this month, as Norway and Israel did at the end of last year.

Sunday, February 21, 2010

Corruption in public service delivery - the demand-side explanation and solutions

A summary of the demand-side dynamics of corruption that has been explored in some of the previous posts. Very long post!

Government corruption, defined as "sale by government officials of government property for personal gain", imposes debilitating economic costs on the society and its stakeholders. Its economic cost includes increasing the cost of doing business - bribes, transaction costs, delays, uncertainty risks associated with contract and law enforcement; raising the opportunity cost for citizens by way of lost time and money; lowering the quality of works and services delivered and thereby its net or life-cycle benefits; imposing entry barriers to competitors; shifting activities out from the country/state/area; and mis-allocating resources away from productive capital investments and to rent-seeking and speculative activities.

To this extent, it is the largest tax paid by both consumers (by way of higher prices and poor quality) and producers (lower profits) and drives a wedge between the actual and privately appropriated marginal product of capital. And being illegal, it creates more incentive distortions than the usual taxes apart from not adding to the revenues of the government.

Conventional explanations of corruption have relied on supply side arguements which claim that government officials "demand" bribes and therefore leaves citizens with no option but to pay up or else face harassment and delays in accessing public services. Bribery, fraud, embezzlement, kickbacks, cronyism, and extortion by the nexus of politicians, bureaucrats and criminals nicely fit into the popular stereotype of government corruption.

The conventional approaches to controlling such corruption are typically top-down and include fool-proof regulations, strict enforcement of severe punishment for violators, limiting discretion for officials, transparency, accountability, decentralization of administration and supervision, and awareness creation among citizens. There is a limited role for the citizens in these solutions.

However, I am inclined to argue that the aforementioned explanation is only half the story and ignores the demand-side forces that often triggers and certainly amplifies the supply-side pressures. However much recent financial market turmoils have discredited the "rational economic man" hypothesis, it cannot be denied that human beings respond to incentive, and incentives matter even more when the stakes are high or pay-offs substantial and the costs of deviation minimal and its deterrent low.

The socio-economic and administrative environments in countries like India provide ample opportunities for corruption and pilferage - an entrenched culture of tolerance for such corrupt practices, people willing to pay much higher prices for accessing services, badly paralyzed and ineffectual enforcement mechanisms, governments with monopoly of delivering public services and so on.

People "pay" bribes to illegally (ineligible, out-of-turn etc) access government services at a lesser cost and without any inconvenience. Incentive distortions that encourage people into acting so arise due to benevolent rules, incomplete monitoring of rules etc. Consider the following sets of incentives.

Why access services with great difficulty, when it can be had conveniently by outsourcing the activity for a price (and the agency finds ways to keep costs down by gaming the system and developing a greased-palm network)? Why abide by (building or factory licensing) regulations when you can avoid or get around it by paying for it? Why pay more taxes when you can evade taxes at a much lesser cost (by bribing the official)? Why leave out the easy money in government contracts when you can bribe the official and compromise on service or work quality? Why stand in ques when one can access the need/service out of turn by using connections or by bribing the official? Why not grab public resources and encroach government land or buildings when it can be had at far lesser price than its market value?

Corruption in the myriad welfare programs have been the focus of much attention and debate. A multi-layered bureaucratic architecture, supported by an elaborate system of guidelines and procedures exist to both select beneficiaries and administer the delivery of benefits. However, the complexity of this bureaucracy creates ample opportunities for collecting bribes for moving files and expediting decisions, bribes for sanctioning works and selecting beneficiaries, and disbursing benefits.

Addressing corruption therefore requires going beyond the usual regulatory approaches to appropriately aligning incentives within the system so as to get officials and citizens to act in accordance with rules. Change incentives to change behaviour.

Regulations have to be kept to a minimum and as simple as possible. It is important to avoid falling into the trap of excessive reliance on procedural rigour and bureaucratic oversight that ironically enough ends up increasing rather than decreasing the opportunities for corruption. Some official discretion, with attendant risk of rent seeking, is a more efficient trade-off, especially in an appropriately tailored regulatory environment. It is surely better to have a program that achieves at least some of its objectives (while enriching a few), than have one that only enriches the many without achieving any of the objectives!

A more institutional approach to containing corruption in the delivery of welfare programs is to expedite the implementation of two recent initiatives of the government - Total Financial Inclusion (TFI) and Unique Identification (UID) number. A UID number helps in targeting beneficiaries of welfare programs, so as to avoid duplication and fraudulent claimants. An individual bank account provided under the TFI program enables the direct transfer of welfare assistance, and thereby avoid the problems of leakages and pilferage that characterize the delivery of welfare benefits. Taken together, both UID and TFI can go a long way towards eliminating corruption in welfare programs.

We can also go beyond the traditional norms of transparency by rating various government agencies on the levels of corruption in them. Such ratings, to be done by an independent non-government agency, can use surveys to measure actual and perceptions of corruption. Grading can be done across departments and sections within the same department. These grades can then be publicized so as to create public stigma and instill a sense of shame among officials of the department, and thereby generate some momentum towards reform. The same rating disclosure can be extended to cover officials in various departments.

It is commonly observed that people’s willingness to pay for specific services/goods are higher than the price formally charged. In view of the general perception of difficulties associated with accessing government services, people access the service by resorting to paying the differential (or a part) as rent directly to the official concerned or outsourcing to a broker for a price. These brokers in turn end up striking a mutually beneficial partnership with the officials and a rent-seeking chain gets entrenched.

The problem arising from the higher willingness to pay for civic services can be overcome by introducing differential pricing for them. In other words, citizens who pay brokers and agents to access services without inconveniencing themselves can be encouraged to make those payments directly to the government by offering an additional category of service provision that takes care of the concerns of these people and deliver services swiftly and without any hassles. The tatkal service for railway tickets, priority banking services are examples of such service delivery.

Since government monopoly of public service delivery is a major contributor towards breeding corruption, it is only appropriate that there be alternative channels for delivering the same service - either within government or private ones. The competition arising from this can be an effective check on keeping some control on corrupt practices. For example, the delivery of civic services like assessment of property tax or birth registration can be either through the regular municipality office or an outsourced customer service center. Within the same department itself, the presence of multiple officials at different locations and levels to access for accessing specific services can generate competition among them and keep corruption under check.

A more subtle way to address the corruption challenge is to "nudge" people into acting or taking decisions in a manner that they would otherwise not have done. This can be done by structuring or designing the environment in which they act or make decisions. Computerization by way of work-flow automation environment of entire chain of activities, using default choices and pre-defined options and an integrated database can help design the environment so as to make people to act as desired.

Other examples of nudges include removing drawers from the tables of government offices so as to eliminate the preferred location for stashing away bribes; removing the pockets from the pants of officials working on regulatory beats (like the Nepalese government did with airport staff at Kathmandu international airport); un-manned honesty cafes (as being experimented in Indonesia) where people can help themselves of beverages and snacks and make payments voluntarily into drop boxes.

Saturday, February 20, 2010

The proposal for European Monetary Fund

I had blogged earlier about the crisis facing the Euroland and the fundamental structural problems associated with monetary integration which is not accompanied by political union. The PIIGS governments, constrained by the rigid conditions of the Stability Pact, also do not have access to the conventional policy instruments - interest rate policy, currency devaluation, running up fiscal deficits etc - to fight the depth of recession and unemployment facing them. And in the absence of a political union, labor mobility and fiscal transfers from the center to the affected periphery members becomes difficult.

Desmond Lachman draws attention to Willem Buiter's characterization of Greece being five minutes to midnight to put the crisis in perspective. Since adopting, the Euro, Greece has lost more than 25 percent in competitiveness, which has contributed to a widening in Greece's external current account deficit to more than 10 percent of GDP. At the same time, Greece's budget deficit has ballooned to 12 percent of GDP, while its public debt to GDP ratio is approaching 120 percent, or double the Maastricht criteria.

A Roundtable in the Economist draws attention to the twin-failure of EMU to encourage member governments to maintain control of their finances and to allow for an orderly sovereign default, and advocates setting up a European Monetary Fund (EMF) to address this challenge. It proposes that The EMF could be run along similar governance lines to the IMF, by having a professional staff remote from direct political influence and a board with representatives from euro-area countries. Though it would conduct regular and broad economic surveillance of member countries, its main role would be to design, monitor and fund assistance programmes for euro-area countries in difficulties, just as the IMF does on a global scale.

Daniel Gros and Thomas Mayer suggest that the EMF raise its initial funding by borrowing from the market with the full and joint backing of all its member countries. Subsequently, in order to limit moral hazard associated with bailouts, "only those countries in breach of set limits on governments’ debt stocks and annual deficits would have to contribute, giving them an incentive to keep their finances in order".

They estimate that an annual contribution of 1% of the "excess debt" (over and above the Maastricht limit of 60% of GDP) and "excess deficits" (over the limit of 3% of GDP) would have accumulated about €120 billion ($163 billion) over the past decade, enough to cover the likely costs of rescuing Greece. About the mechanism to enable members to access funds to address their fiscal balance, they write,

"Any member country could call on the funds of the EMF up to the amount it has deposited in the past (including interest), provided its fiscal-adjustment programme has been approved by the Eurogroup of euro-area finance ministers. Any call on EMF funds above this amount would be possible only if the country agreed to a tailor-made adjustment programme supervised jointly by the European Commission and the Eurogroup, and on condition that the EMF ranked ahead of all other creditors."


About the EMF's role in managing a sovereign default in the aftermath of a sudden withdrawal of market funding from a euro-zone government, without creating much moral hazard among profligate governments and reckless investors, they write,

"If a euro-area country loses access to market financing, the EMF could step in and offer all holders of debt issued by the defaulting country an exchange against new bonds issued by the EMF. The fund would require creditors to take a uniform 'haircut', or loss, on their existing debt in order to protect taxpayers. The EMF could, for example, tie its guarantees to the 60%-of-GDP Maastricht limit on debt, so that creditors of a country with a debt stock of 120% of GDP would face a 50% haircut. The losses to financial institutions would be limited and certain, reducing the risk of contagion...

Having acquired bondholders’ claims against the defaulting country, the EMF would allow the country to receive additional funds only for specific purposes that the EMF approved. The new institution would provide a framework for sovereign bankruptcy comparable to the Chapter 11 procedure for bankrupt companies in America."


This presumes that in case of an insolvency, the EMF will both be able to mobilize sufficient resources quickly enough for the failing member and also push through the required structural and fiscal adjustment measures, to both prevent other countries being dragged into crises through market contagion. Desmond Lachman and Edwin Truman doubts this and therefore describes the Gros-Meyer plan as a non-starter. In particular, Truman feels that the financing by fines based on deviation from the Maastricht conditions, presence of the IMF to fall back if the EMF imposes unpalatable conditions, the difficulty of structuring haircuts on sovereign debts etc makes it politically difficult to implement. Lachman also feels that since sovereign borrowing is now done preponderantly in the securitization market rather than in the form of bank loans, any debt restructuring, a la Brady Bonds, is very difficult.

Mark Thoma makes the important point that without monetary policy autonomy, individual members are denied one of the most critical macroeconomic policy levers in attentuating the economic cycle. He therefore advocates a strong fiscal policy to make up for the absence of monetary policy in economic stabilization, and feels that there should be fiscal federalism to effectively manage resource transfers from a centralised authority in an attempt to stabilise economic activity (like that exists between states and the federal government in all countries). He therefore argues for a European Fiscal Fund with a centralised authority can more effectively coordinate policy across countries and avoid the free-riding incentives that exist for individual countries.

In view of the pro-cyclical rather than counter-cyclical nature of ECB policies towards Europe’s periphery (ECB drove up the Euro just as the periphery started to collpase and now ECB want the PIIGS to cut wages and deficits when they are gasping for breath), Peter Boone feels that an EMF is bound to fail and titl the balance even mroe towards the core countries. Under the proposed EMF, the core European countries, which control monetary policy in a manner that serves them best, would also effectively control procedures for bailing out or ejecting the periphery.

Tyler Cowen suggests that instead of an ambitious and politically difficult to implement EMF, the ECB should be reformed to expand its mandate beyond price stability and include more co-ordination in fiscal policies with individual governments, as was the case with the Fed-Treasury co-ordination in the US. He is right on target in claiming that the "essence of the European dilemma is the divergence between monetary union and fiscal separation, layered on top of some low-trust, dysfunctional cross-national governance. Multiplying intermediate institutions won't make those problems go away."

Roberto Perotti feels that the fiscal transfers possible under the EMF (by drawing on forced savings and fines) would be too small to address the problems like that facing Greece today. He also feels that the conditionalities under any fiscal restructuring program to prevent sovereign default are too political to be so easily implemented.

Update 1 (23/3/2010)
Daniel Gros sums up the EMF proposal here.

Friday, February 19, 2010

Deficits, inflation and macroeconomic policy making

Here is my Vox post on how the obsession with low deficts and inflation contributed towards the current recession and constrained governments from adequately responding to it.

Deficits, inflation and macroeconomics

The last two decades of global macroeconomic orthodoxy had the twin objectives of keeping inflation low and government deficits down. Accordingly, central banks made inflation targeting their primary, if not their only, objective, and low fiscal deficits assumed sacrosanct character in national macroeconomic policy making. Fundamentally, these two attributes have come to be hard-wired into the fabric of the economy and its actors as the twin-pillars of the dominant macroeconomic consensus.

However, in the aftermath of the events of the past eighteen months, both these holy cows are now under attack and are being increasingly blamed for the current recession and the failure of governments to adequately respond to it. It is now clear that the success of central banks and governments with achievement of these two objectives may ironically enough have exacerbated the crisis. Let us examine the respective roles of both these parameters of macroeconomic policy making.

The entrenched, almost pathological, opposition to assuming debts and running deficits have had three consequences

1. Debt averse governments dragged their feet in coming to the rescue of ailing economies, thereby possibly deepening the downturn. In keeping with the prevailing ideological beliefs, governments relied on monetary policy interventions to provide the expansionary stimulus.

2. Even when they did finally come over, the response was, except possibly China, inadequate and mis-directed. Once governments finally came round to initiating stimulus spending, the politics of formulating fiscal stimulus measures took over. Acrimonious debates erupted about the relative superiority of direct spending measures against tax cuts, and the respective multipliers of each approach. In keeping with the prevailing orthodoxy, tax cuts found more favor among the political establishments.

3. And now, at the slightest indication of deficits rising and public debt increasing, and when economies are showing nascent signs of recovery, pressure is mounting on governments to exit the stimulus and re-balance budgets.

In other words, it may be a case of too little, too late and too short! The virtues of counter-cyclical macroeconomic policy have never been more missed and knee-jerk and reactive policy making appears to have taken over.

The current recession draws attention to the necessity of a counter-cyclical fiscal policy with its thrust on running up surpluses during the upturns. Further, in view of the inevitable controversy and long-drawn out debate that accompanies any fiscal stimulus, it is important to have an appropriate level of self-acting fiscal stabilizers to cushion the economy from any steep declines in aggregate demand as policy makers debate on enacting stimulus measures. Finally, given the difficulty associated with timing an exit from expansionary policies, it is always better to err on the side of caution and exit only after there are credible enough signs that recovery has firmly taken root.

The second leg of the global macroeconomic consensus was the obsessive pursuit of low inflation. This became embodied in the almost messianical zeal with which central banks focused on inflation targeting and communicating very low inflation targets. Interestingly, this inflation focus was confined only to goods and services in the real economy and completely overlooked the asset bubbles that were building up in the financial markets. In any case, that is another matter.

However, the credit crisis that unfolded after the sub-prime mortgage bubble burst has clearly exposed the limitations of an inflation-straitjacketed monetary policy. It left central banks with limited maneuverability to expand credit flows once the credit markets froze and market confidence plunged. The related ultra-low interest rates only compounded the problem by driving economies into zero-bound interest rate induced liquidity traps and unleashed deflationary expectations. The low inflation and nominal interest rates meant that real interest rates were already too low for governments to lower it by much. In simple terms, monetary policy had lost traction.

Paul Krugman points to Olivier Blanchard's telling comment that captures the paradox of low inflation rate,

"Higher average inflation, and thus higher nominal interest rates to start with, would have made it possible to cut interest rates more, thereby probably reducing the drop in output and the deterioration of fiscal positions... Maybe policymakers should therefore aim for a higher target inflation rate in normal times, in order to increase the room for monetary policy to react to such shocks."


Krugman also points to the work of George Akerlof, WIlliam Dickens and George Perry who claim that unlike the conventional natural rate of unemployment models (where unemployment is invariant to the rate of inflation),

"When inflation is low it is not especially salient, and wage and price setting will respond less than proportionally to expected inflation. At sufficiently high rates of inflation, by contrast, anticipating inflation becomes important and wage and price setting responds fully to expected inflation."


This effectively means that at very low inflation, getting relative wages right (by lowering them and thereby reducing unemployment) would require that a significant number of workers take wage cuts, whereas at higher inflation rates when it is very salient, it is much easier to achieve the required adjustments in relative wages.

The trouble with an approach that seeks to target a higher inflation rate is that it runs the risk of unleashing the hitherto capped inflationary expectations and thereby eroding the tenuous credibility of central banks painstakingly built up over many decades. However, as the Great Recession and Japan’s deflationary lost decade of nineties shows, the cost associated with pursuing ultra-low inflationary policies can be far higher than the risk inherent in a higher inflation target. In any case, central banks today have enough credibility and monetary and credit policy instruments at their disposal to both anchor inflationary pressures and rein in inflation if it threatens to go out of control.

When faced with a deep recession - especially one where businesses have postponed their investment and individuals their consumption decisions, and banks have shut their credit taps off – exacerbated by a zero-bound interest rate and low inflation, the only credible enough source of stimulating aggregate demand is the Government. Everything else, including deficits must take a back seat or else the economy faces the strong possibility of getting trapped in a deep trough with high unemployment, from which recovery can be long and tortuous.

Going forward, it is not going to easy for governments to suddenly reverse their macroeconomic policy stances without a complementary accommodation by the markets. In other words, it is can only be hoped that the markets will not start panicking when the "green shoots" of inflation appears, as it will with recovery taking hold, and force governments into premature tightening as is happening now with increasing deficits.

Thursday, February 18, 2010

Industrial policy in telecoms?

India is at the threshold of becoming the second largest telephone market in the world and its telecom operators are now scouting the world for expanding operations. The dramatic development of the sector has been projected as an example of how the power of private sector and markets should be unshackled to promote economic development. But as Sanjay Nayak writes in a recent Mint op-ed, all is not well

"Most leading countries in the world have nurtured their telecom products industry that have not only met internal strategic needs, but also created successful businesses that export several billion dollars worth of equipment around the world. Unfortunately, our domestic growth in telecom has not resulted in creating even a single global telecom product company. Compared with India, China with a proactive policy and government support has been able to create a $50 billion telecom product and ancillary industry that has gained global success.

The focus of our telecom policies over the last 15 years has mainly been on delivery of cost-effective telecom services. There has been no support or encouragement in creating a strong domestic product industry, resulting in large-scale import of equipment, rather than manufacturing them locally. Unless we take immediate steps to encourage product development, we will be importing at least Rs5 trillion of telecom equipment in the next five years. More importantly, we will miss a unique opportunity to create another knowledge-based industry and several jobs, which could replicate the success of our information technology services industry."


His policy prescriptions include Indian product companies being mandatorily given access to a certain percentage of the Indian domestic demand; matching R&D funding to entrepreneurs to create products and IPR; provide long-term working capital at competitive rates; promotion of telecom product exports as a thrust area for bilateral trade. I do not agree with some of them and there are other, less market distorting, ways to promote the sector.

If proponents of market-based approaches were correct, given the size of India's telecoms market and the potential for its growth, a large and competitive telecom products industry should have been up and running by now. However, despite the large technical and mangerial workforce, dominant domestic telecom service providers, a large and growing market, and domestic companies intent of expanding abroad, India does not have even a single global telecom product company.

The contrast with China could not have been starker. The development of massive capacity addition in conventional power generation, renewable energy, and high-speed rail have paralleled the emergence of downstream equipments and design sector. Local manufacturers have leveraged on the massive economies of scale presented by the capacity addition programs and developed world-class domestic design capabilities and manufacuring facilities. These manufacturers who emerged with active and well-planned government policy support, are today among the world leaders in their respective sectors and are capturing an increasing share of the rapidly expanding market (a large share of which is in India).

India should take a leaf out of the Chinese book and promote its own telecoms product sector - atleast the higher end R&D, intellectual property rights (IPR) creation, marketing, branding and support - and in the process help domestic makers capture atleast a share in the coming Rs 5 trillion domestic telecom equipment market and also the even larger global ambitions of Bharati and Co. If this requires an enabling policy framework called "indstrial policy", then so be it!

Update 1 (30/4/2010)
Citing security concerns, India has banned import of certain Chinese telecom equipments.

EMH or IMH?

I have blogged earlier about the two-fold implications of the EMH - that prices reflect all publicly available information (both events that have occurred and those that markets expect to happen) about the underlying intrinsic value of financial assets (strong form of efficiency) and prices of these assets are fundamentally unpredictable (weak form of efficiency).

The first implies that since price of an asset accurately reflects the (appropriately discounted) stream of earnings that it is expected to yield over the course of its existence), price signals can be relied upon to efficiently allocate resources among the various sectors within the financial markets. The second means that it is impossible to beat the market on a sustained basis by arbitraging on mispricings (and therefore passive index funds are more efficient investments than actively picking stocks).

Rajiv Sethi has an excellent post that draws the distinction between the allocative and informational efficiency dimensions of EMH, with the former corresponding to the strong and the latter to the weak forms of efficiency respectively, and argues that neither are states of efficiency. He writes,

"Prices may indeed contain "all relevant information" but this includes not just beliefs about earnings and discount rates, but also beliefs about "sentiment and emotion." These latter beliefs can change capriciously, and are notoriously difficult to track and predict. Prices therefore send messages that can be terribly garbled, and resource allocation decisions based on these prices can give rise to enormous (and avoidable) waste. Provided that major departures of prices from intrinsic values can be reliably identified, a case could be made for government intervention in affecting either the prices themselves, or at least the responses to the signals that they are sending. Under these conditions it makes little sense to say that markets are efficient, even if they are essentially unpredictable in the short run."


In view of the considerable range of non-fundamental information on market psychology that prices reflect, Rajiv Sethi prefers that EMH be renamed as the invincible markets hypothesis (IMH)!

Wednesday, February 17, 2010

IMF on macroeconomic policy lessons

Olivier Blanchard, Giovanni Dell’Ariccia, and Paolo Mauro have an interesting working paper that reviews the main elements of the pre-crisis consensus on macroeconomic policy making, identify what went wrong, what tenets of the pre-crisis framework still holds, and attempt to formulate the broad contours of a new macroeconomic policy framework.

On the way forward, they advocate combining monetary policy and regulatory instruments and using the broad set of cyclical tools that are institutionalized in the existing regulatory and prudential frameworks. They identify the main challenge as finding the "right trade-off between a sophisticated system, fine-tuned to each marginal change in systemic risk, and an approach based on simple-to-communicate triggers and easy-to-implement rules". Olivier Blanchard is spot on

"Keeping output close to potential and inflation low and stable should be the two targets of policy. And controlling inflation remains the primary responsibility of the central bank. But the crisis forces us to think about how these targets can be achieved. The crisis has made clear, however, that policymakers have to watch many other variables, including the composition of output, the behavior of asset prices, and the leverage of the different participants in the economy. It has also shown that they have potentially many more instruments at their disposal than they used before the crisis. The challenge is to learn how to use these instruments in the best way."



Their recommendations include

1. Interest rates should be used primarily in response to aggregate activity and inflation. A more broader range of instruments should be used to deal with specific output composition, financing, or asset price issues.

2. A combination of monetary and regulatory tools are necessary to deal with excess leverage, excessive risk taking, or apparent deviations of asset prices from fundamentals. For example, if leverage appears excessive, regulatory capital ratios can be increased; if liquidity appears too low, regulatory liquidity ratios can be increased; to dampen housing prices, loan-to-value ratios can be decreased; to limit stock price increases, margin requirements can be raised. These measures could be to some extent circumvented, but nevertheless are likely to have a more targeted impact than the policy rate on the variables they are trying to affect.

3. A complementary use of monetary policy and regulation necessitates an acceptable level of coordination between the respective authorities. Some have argued in favor of the central bank to be in charge of both. In any case, the neat separation between these two sets of instruments is a thing of the past.

4. Monetary policy will increasingly be seen as the joint use of the interest rate and sterilized intervention, to protect inflation targets while reducing the costs associated with excessive exchange rate volatility.

5. Very low inflation rates are not always desirable, as the current crisis has shown and there is a strong case for setting a higher inflation target in the future. Higher average inflation and thus higher average nominal interest rates before the crisis would have given more room for monetary policy to be eased during the crisis and would have resulted in less deterioration of fiscal positions. Maybe policymakers should therefore aim for a higher target inflation rate in normal times, in order to increase the room for monetary policy to react to such shocks.

At a 4% inflation rate, short-term interest rates in placid economies likely would be around 6% to 7%, giving central bankers far more room to cut rates before they get near zero, after which it is nearly impossible to cut short-term rates further.

The challenge here is balancing the central bank credibility associated with a rigid and well-communicated low inflation policy and the difficulty of anchoring inflationary expectations at a higher level of inflation. But the moot point is whether these costs are outweighed by the improved policy maneuverability that would be available in times of crisis from having slightly higher inflation.

6. The present crisis has clearly exposed the limitations of monetary policy, including the full range of credit and quantitative easing policies. Fiscal policy is decisively back to the centerstage, especially when the slowdowns are deep and there is enough time for stimulus spending to yield results despite its implementation lags.

7. It also highlights the importance of having automatic fiscal stabilizers that swing into action without waiting for the time consuming and politically controversial policies to be legislated into action. For example, temporary tax policies targeted at low-income households, investment credits, or temporary social transfers that would be triggered by a macroeconomic variable crossing some threshold (the unemployment rate, say, rising above 8 percent).

8. The crisis has underlined the need for countries to follow counter-cyclical policies that enables them to build up enough fiscal cushion to respond effectively during slowdowns with large enough stimulus measures. This also possibly means revisiting the conventional target debt to GDP ratios and aiming for much lower ratios than before the crisis.

See this discussion on the benefits and costs of the IMF's proposed 4% inflation target.

Update 1 (24/3/2010)
See these comments on Olivier Blanchard's proposal to raise the inflation target to 4% by David Altig, Mark Thoma, David Beckworth and Ryan Avent.

The Chinese string of pearls

The creeping infiltration of Chinese commercial (and by implication political) interests into India's neighbours has been cause for growing concern among the Indian foreign policy establishment. This worry is anecdotally captured in terms of the "string of pearls" - consisting of ports and other strategic installations and being built with massive Chinese assistance - to surround India and eventually undermine India’s pre-eminence in its Near Abroad.



As this example of the massive integrated infrastructure development project in Southern Sri Lanka at the 2004 Tsunami devastated Hambantota (China’s Export-Import Bank is financing 85% of the cost of the $1 billion project) illustrates, unless India can match China's deep pockets, the "string of pearls" will only grow. The Times article quotes Sri Lankan President Mahinda Rajapaksa as saying that he had offered the Hambantota port project first to India, which turned it down.

These loans are an excellent example of strategic diplomacy with profound economic implications. All the infrastructure projects financed with Chinese grants and loans are invariably executed by Chinese contractors. Apart from the enormous goodwill generated among its recipients, these projects provide a platform for opening and expanding markets for Chinese goods and service exports.

The take away from all this is that in its strategic competition with China, Indian diplomacy should put its money where its mouth is!

Tuesday, February 16, 2010

Risk transmission and global financial integration

In a fascinating working paper, Joesph Stiglitz draws the analogy between integrated electricity grid networks and integrated global financial markets to argue that the former is not always optimal and when "faced with a choice between two polar regimes, full integration or autarky, autarky may be superior".

He argues that financial markets face the same trade-off as that faced by an electricity grid - a larger grid has greater capacity to limit the probability of blackout at any level (by drawing in on the larger numbers of alternative supply channels) but faces greater risks of a system-wide failure due to local failures (despite the presence of "circuit breakers" to isolate trouble spots). In the absence of integration, the failures would have been geographically constrained and the risk of "contagion" would be minimal. Prof Stiglitz therefore claims that diversification (through integration) and contagion are "different sides of the same coin - greater financial integration (especially if not done carefully) increases the risk of adverse contagion in the event of a large negative shock".

His model finds that it is not possible to always minimize the downside risk of integration (contagion) while preserving as much of the upside potential (diversification), especially with the likelihood of a bankruptcy cascade or systemic risk spreading in the existing credit market architecture. In the circumstances, it may be appropriate to introduce "circuit breakers" like capital controls when the markets face the risk of contagion and amplification of systemic risks.

He argues that the real estate bubble in the US was in accordance with the Greenwald-Stiglitz Fundamental Inefficiency Theorem which showed that even with rational expectations, so long as risk markets are incomplete, the market equilibrium will be inefficient. It also claimed that the effect of a shock can be amplified and lead to a process of trend reinforcement. In light of all this, imposing restrictions on certain sets of interactions (relationships) under certain circumstances may be welfare enhancing. He writes,

"Trade liberalization between two countries with negatively correlated outputs may reduce price volatility but increase income volatility, so much so that all groups in both countries are worse off. In an overlapping generations model, capital market liberalization impairs the extent to which a productivity shock at one time is 'shared' with future generations (as increased incomes raise savings and thus future wages) and thus can lower ex ante expected utility."


He rejects the assumption that the technologies/processes of global economic activity are convex and have concave utility functions (and therefore risk sharing or dispersal is always beneficial) as not correct. Information structures, learning processes, R&D, bankruptcy, and externalities, all give rise to a natural set of non-convexities. In the presence of these non-convexities, risk sharing can lower expected utility.

Therefore a firm experiencing a negative shock—forcing it closer to the brink of bankruptcy will have to pay higher interest rates, implying an increased likelihood of a further decline in net worth. Similarly, bankruptcy of one firm affects the likelihood of the bankruptcy of those to whom it owes money, its suppliers and those who might depend upon it for supplies; and so actions affecting its likelihood of bankruptcy have adverse effects on others - a bankruptcy cascade is set in motion. Externalities generated as a result of information costs and imperfections also contribute towards bankruptcy cascades.

His summary is very appropriate,

"In large non-linear systems with complex interactions, even small perturbations can have large consequences; even seemingly small changes in structure (introducing new 'connections' or contracts) can alter systemic stability. As our financial system became increasingly intertwined, through complex credit default swaps and other derivatives, too little thought was given to these matters, by the financial wizards that were creating the new products, by the bankers that were marketing them, by the economists that were touting their virtues, and by the regulators and policymakers who were responsible for ensuring the overall stability of the system."

Monday, February 15, 2010

Fed balance sheet and exit strategy update

The Fed's unconventional monetary policy actions involving buying up assets (mainly mortgage backed securities issued by Fannie Mae and Freddie Mac and assets of Bear Stearns and AIG) and extending loans to prop up ailing sectors has dramatically swelled the Fed's balance sheet to record proportions. At $2.2 trillion, it has nearly tripled since the summer of 2007 when the extraordinary measures were initiated culminating in lowering interest rates to nearly zero by December 2008.



I had blogged earlier here and here about the challenge now to manage the exit from this expansion. This assumes increasing importance as the economy starts recovering and normalcy is restored into the credit markets encouraging bankers to increase their credit disbursements, leaving open the danger of the excess reserves finding its way into the market, rapidly expanding the broad money supply, and stoking inflationary pressures.

The Fed's purchases of these assets and credit expansion was essentially financed by creating (printing) new money which then found its way into the balance sheets of individual banks. The banks in turn parked the extra liquidity as reserves with the Fed, beyond their statutory reserve requirements. The Fed therefore now holds $1.1 trillion in excess reserves that the banks can demand when they wish.

The Fed has been empowered since October 2008 to pay an interest rate on excess reserves, though this will have the effect of reducing the amount that the Fed turns over to the Treasury each year. This rate on excess reserves could act as a floor rate and the discount rate (rate at which the central bank lends short-term to banks, repo rate in India) would act as a ceiling, with the federal funds rate (interest rate banks charge each other for overnight loans, call money rate in India) floating between. Many central banks, including those of UK and Canada, are already empowered to pay interest on such reserve deposits.

The easiest exit strategy is to provide interest on the excess reserves created as the Fed gobbled up mortgage-backed securities and Treasury notes and bonds during the financial crisis. Given the low prevailing inter-bank lending rates, the Fed can encourage the banks to continue parking their reserves with the central bank by raising the interest paid on excess reserves (presently 0.25%).

The other instruments to drain off excess liquidity include reverse repurchase (reverse repo) agreements by which the Fed would sell securities from its portfolio with an agreement to buy them back at a slightly higher price at a later date; Treasury or Fed could offer term deposits, analogous to the certificates of deposit banks offer to customers; the Treasury could sell bills and deposit the proceeds at the Fed; the Fed could sell some of its long-term securities, including those backed by mortgages, taking more money out of the system.

In any case, many of the unconventional policy actions are due to be wound up. Two of the biggest — the Fed’s purchase of $1.25 trillion of mortgage-backed securities and of about $175 billion in debts guaranteed by Fannie Mae, Freddie Mac and Ginnie Mae — are to be completed by March 31.

In a recent speech Ben Bernanke outlined the Fed's exit strategy by claiming that the "FOMC anticipates that economic conditions, including low rates of resource utilization, subdued inflation trends, and stable inflation expectations, are likely to warrant exceptionally low levels of the federal funds rate for an extended period." He also reassured that the Fed had the tools to reverse, at the appropriate time, the very high degree of monetary stimulus.

David Altig has a nice discussion on the challenge of policy accommodation to follow the spiking of the punchbowl and the party.

Update 1



Update 2 (27/3/2010)
See Bernanke on the exit strategy here.

Update 3 (22/7/2010)
Interactive graphic on the Fed's balance sheet in RTE blog, at $2.3 trillion as on June 2010.

On the assets side, the increase in the balance sheet has been almost entirely due to the Fed's purchase of agency (Fannie and Freddie) debt in the form of mortgage-backed securities (MBS). In fact the Fed is holding about the same amount of treasuries as it did prior to the financial crisis. In other words, the Fed's actions to purchase securities has merely resulted in a change of ownership.

On the liabilities side of the balance sheet, the monetary base has expanded exponentially.



See this excellent explanation from David Andolfatto.