Saturday, September 21, 2019

Three China Books

The three best China economic development books I have come across. I have read two.

For those in India who hanker after China, these three are chastening reads. 

1. Yuen Yuen Ang - How China Escaped the Poverty Trap (see this review) 

2. Yasheng Huang - Capitalism with Chinese Characteristics (hear this podcast and my summary here)

3. Ning Wang and Ronald Coase - How China Became Capitalist (see this presentation summary)

All three have a common strand - for a highly centralised policy, the tolerance for local experimentation and improvisation is astonishing. This has involved adaptation among all actors - the communist party, the government, the civil society, and the private sector. The dynamics associated with it is fascinating. It could not have been planned. The best that was done was perhaps certain principles of engagement that were appropriate for the cultural and political context of China. Those were then allowed to play itself out under some benign oversight of the Party.

China has great lessons for India. Ironically, it is not the outcome of what it has done - the spectacular growth rates and the global economic and political superpower status - that should attract India. Instead, it should be the HOW of what it has done that should be of relevance to Indians. And figuring out those principles relevant to the Indian context and getting started with them.

Interestingly all three books were written by natives and not western academics. It is perhaps understandable. A complex project like this, and that too about a complex country like China, requires a person whose understanding of the country cannot be learnt. It has to be a deeply internalised output. 

All three are inter-disciplinary scholars. Not mere economists. They are works of true intellectuals and scholarship, weaving multiple strands of inter-disciplinary insights.

When will we have a similar modern India book, with both a historical sweep as well as political, social, and economic depth of analysis? Unfortunately, when I look around, I don't see intellectuals or scholars around in the academia, based here or abroad, who can pull something like this off. 

Wednesday, September 18, 2019

Financialisation link fest

Rajeev Mantri's excellent collection of article references on financialisation.

1. Fractionalising home equity - Patch Homes defines itself,
Patch Homes is a modern finance company. We provide home equity financing with no monthly payments or interest, in exchange for a share in the future appreciation or depreciation of your home’s value.
Sample this admiring article,
The bigger idea behind Patch and some other startups out there is the ability to break up your home equity into pieces and sell some of it while holding onto most of it. I call this fractionalizing home equity. In the existing home finance world, the only thing you can do with your home equity is borrow against it. And many homeowners do this. It is a big market and helps a lot of homeowners out. But once you borrow against your home equity you have larger monthly mortgage payments to make and many can’t afford to do that. And you need a certain credit score to be able to access the home equity loan market.
What Patch offers instead is to take a piece of your home equity (currently limited to $250k maximum) and sell the upside on it to a investment fund. Note that I said upside. This is effectively a call option on the equity not a full transfer of that equity... There are some great use cases for a partial sale of home equity. One example I like a lot is a family whose children are heading to college and soon will be out of the home. They plan to sell the home when all the kids are gone but don’t want to do that until then. They could sell some of their home equity, help pay for college, and then sell the house after all of the kids have graduated.  
2. If you thought that the falling and negative rates had its limits and would spook investors, then you did not account for the fact that it is not just humans who trade today,
Some money managers trading these bonds have nevertheless chalked up big gains for the year. One of the most obvious strategies has involved simply riding the big rally. Yields fall as prices rise; managers who clung on to their holdings as yields tumbled below zero have reaped juicy profits. Among the biggest winners are computer-driven hedge funds that try to latch on to market trends. While many human traders may question the wisdom of buying or keeping a bond that apparently offers a guaranteed loss, robot traders that monitor price moves have no such qualms... Some human investors “focused on fundamentals have struggled to hold on to bonds” as yields have turned negative.
It is not just holding securities and waiting for yields to decline, there are other opportunities,

For starters, fund managers based outside the eurozone can profit from buying Europe’s negative-yielding government debt thanks to an uplift from hedging the currency. That is because such hedges are based on the relative levels of short-term interest rates. These are much higher in the US than in the euro zone, meaning dollar-based investors are effectively paid to hedge their euro exposure back into dollars. For instance, a two-year German Bund currently yields around minus 0.88 per cent. However, after hedging the currency, this becomes a positive yield of around 1.9 per cent for dollar-based investors. For a US-based investor, this is better than buying a two-year Treasury.


Managers can also earn money from the steepness of yield curves. While German government bonds up to 30 years in maturity are now offering negative yields, the curve is fairly steep. That means a likely rise in price for an investor who buys a 10-year future, then waits until it becomes a nine-year, and then sells it and buys a 10-year again, pocketing a small gain... For euro-based fund managers sizing up how to bet on negative-yielding debt, the cold reality is that they are penalised for doing nothing. That is because of the negative rate of interest paid on cash held by custodians — the companies like State Street and BNY Mellon that look after a fund’s assets. That could amount to a drag of about minus 1 per cent a year, meaning that buying a bond with a smaller negative yield is more attractive than leaving cash in its account.
3. The financialisation story marches on with Apple, sitting on over $200 bn worth surplus cash reserves, raising $7 bn in debt. It plans to use the money for general corporate purposes, a euphemism for share buybacks and dividends.

4. Many parts of financialisation involve practices that border on fraud, like this by making money from the weaker oversight on municipal bond issuances by financial intermediaries systematically underpricing them. Sample one story,
When the West Contra Costa Unified School District in California needed money to repair and upgrade deteriorating classrooms, it hired Piper Jaffray Cos. to sell $191 million of municipal bonds... However, within a day of the initial sale, the original buyers sold, or “flipped,” $35 million of the district’s bonds for a profit of $306,000... Within 10 trading days, the post-offering trading had generated $1.24 million of market-adjusted profits. Piper Jaffray participated in some of that trading, buying back bonds and reselling them... The post-offering buying and selling suggests West Contra Costa’s bonds—sold in what is called a negotiated offering—were initially underpriced. That means the district will pay more in interest over the life of the bonds than it would if the bonds had been priced closer to what subsequent investors paid.
And it is systematic,
A Journal analysis of municipal-bond data found such post-offering trading to be routine. About $60 billion, or roughly 5%, of newly issued bonds in negotiated offerings between 2013 and 2017 were sold to customers who turned around and sold them to dealers within a single day of the initial offering, usually for a profit, the Journal found. Prices on those flipped bonds were then marked up further as they were sold to longer-term investors, bringing the total market-adjusted profits to more than $900 million. The Journal’s investigation found that those profiting from the flipping often include the banks hired to price and sell the bonds... Underwriters are obligated to purchase any bonds they can’t place with customers, which ties up cash and exposes them to risk. So they have an incentive to price the bonds to move—and, if necessary, to sell them to customers who have no intention of holding them for long. When those customers want to sell, the underwriter often will step in to buy. Under federal rules, underwriters have a duty to set prices that are “fair and reasonable” taking into consideration all relevant factors, including their “best judgment” of the fair market value... During the period of the Journal’s analysis, insurers bought and quickly sold $3.7 billion of newly issued municipal bonds, the filings show. Of that total, $2.6 billion, or 70%, was sold back to the underwriter that had just priced and sold the bonds. The underwriter paid the insurer more than the initial price 88% of the time... The trading profits suggest the bonds were underpriced, meaning taxpayers will wind up spending additional money for interest payments...
When cities and school districts decide to sell municipal bonds, they engage securities firms to underwrite them. Generally, the public entities have two options. They can put the bonds up for competitive bids and award them to the securities firms that price them with the lowest interest cost. Or they can choose an underwriter in what is known as a negotiated offering. Negotiated offerings account for about 75% of the money raised in bond offerings... The underwriter, after consulting with the issuer, slices the total amount to be raised into a series of bonds with different interest rates and maturity dates, then buys the bonds at a discount to their offering prices—typically less than half a percentage point. The difference between the discounted price and what the underwriter sells them for is the underwriter’s pay. The underwriting process sets up an obvious conflict. The municipal issuer wants to pay the lowest possible interest rate. The underwriter wants to ensure the bonds will be attractive enough to easily resell to investors and bond dealers. The Municipal Securities Rulemaking Board, or MSRB, which writes rules for underwriters, requires them to disclose that they have “financial and other interests that differ from those of the issuer.”
And when talking of such trades, can Goldman Sachs be far away,
In 2017, the Washington Economic Development Finance Authority sold $134 million of tax-exempt bonds on behalf of a private company building a facility that would convert farm waste to paper pulp. The company, Columbia Pulp I LLC, paid Goldman Sachs & Co. $3.8 million, or about 2.9% of the money raised, to underwrite the bonds. The unit of Goldman Sachs Group Inc. set prices so the bonds would generate annual interest of 7.75% for buyers—a high yield indicative of the speculative nature of the company’s new technology. Goldman sold the bonds in 25 trades, all at 11 a.m. on July 25, 2017. A little more than an hour later, some of the original buyers sold $10.75 million of the bonds to dealers at 5.3% more than they had just paid, generating profits of $571,000. Later that day, according to NAIC filings, Goldman bought back $6.6 million of bonds it had sold to insurers for $376,000 more than the buyers had paid. Trading records show Goldman then resold those bonds for a $42,000 profit. Within 10 trading days of the initial sale, $32 million of the bonds were flipped by initial buyers, the Journal analysis showed. Goldman and the dealers and customers who bought and resold them made market-adjusted profits totaling $2.2 million. 
5. Stock ownership has been rising unabated,
More Americans than ever are invested in the stock market. Just 30 years ago only about 30% of Americans owned any form of stock—now more than 50% do... The rising popularity of index and mutual funds makes stock market investing easier and safer, since risk is spread across many securities. But the bigger reason is the increased popularity of 401(k)-type retirement plans in the 1990s gave many Americans easy access to the stock market. Often they are automatically invested in stock... In 1989, only 22% of Americans under 35 owned stock, while in 2016 41% did.
6. Softbank has plans to take retail investing further down the road,
SoftBank Corp.’s brokerage unit plans to do something that may be a first in capital markets. It will allow individuals in Japan to participate in initial public offerings with as little as a 1,000-yen note (worth a bit less than a 10-dollar bill). One Tap BUY Co., controlled by the wireless unit of investment giant SoftBank Group Corp., is preparing to start offering such sales as early as March 2020 after obtaining the necessary regulatory approvals. This will mark the first time that investors will be able to subscribe to an IPO by investment amount rather than specified number of shares.
7. But this coverage expansion comes with its risks. A study finds,
An increase in local stock wealth driven by aggregate stock prices increases local employment and payroll in nontradable industries and in total, while having no effect on employment in tradable industries. In a model with consumption wealth effects and geographic heterogeneity, these responses imply a marginal propensity to consume out of a dollar of stock wealth of 2.8 cents per year. We also use the model to quantify the aggregate effects of a stock market wealth shock when monetary policy is passive. A 20% increase in stock valuations, unless countered by monetary policy, increases the aggregate labor bill by at least 0.85% and aggregate hours by at least 0.28% two years after the shock.
And this,
It also suggests that in the same way a recession can be self-fulfilling, sustained growth can be, too. If people feel richer because of the stock market and spend more, the companies will be more profitable and stocks will climb further. At least for a while. Without a meaningful rise in productivity, even a self-fulfilling boom can crash if there’s some external shock or anything that undermines confidence.
8. Fuelling financialisation have been the failure of the gatekeepers, both market-based ones like rating agencies and auditors as well as the public regulators. Much has been written about them. WSJ has more on rating agencies,
Inflated bond ratings were one cause of the financial crisis. A decade later, there is evidence they persist. In the hottest parts of the booming bond market, S&P and its competitors are giving increasingly optimistic ratings as they fight for market share... The problem is particularly acute in the fast-growing market for “structured” debt—securities using pools of loans such as commercial and residential mortgages, student loans and other borrowings. The deals are carved into different slices, or “tranches,” each with varying risks and returns, which means rating firms are crucial to their creation. The Journal analyzed about 30,000 ratings within a $3 trillion database of structured securities issued between 2008 and 2019. The data, compiled by deal-tracker Finsight.com, allowed a direct comparison of grades issued by six firms: majors S&P, Moody’s Corp and Fitch Ratings, and three smaller firms that have challenged them since the financial crisis, DBRS Inc., Kroll Bond Rating Agency Inc. and Morningstar Inc. The Journal’s analysis suggests a key regulatory remedy to improve rating quality—promoting competition—has backfired. The challengers tended to rate bonds higher than the major firms. Across most structured-finance segments, DBRS, Kroll and Morningstar were more likely to give higher grades than Moody’s, S&P and Fitch on the same bonds. Sometimes one firm called a security junk and another gave a triple-A rating deeming it supersafe.
The fundamental problem is well acknowledged,
Behind the ratings inflation is a long-acknowledged flaw Washington didn’t fix: Entities that issue bonds—state and local governments, hotel and mall financiers, companies—also pay for their ratings. Issuers have incentive to hire the most lenient rating firm, because interest payments are lower on higher-rated bonds. Increased competition lets issuers more easily shop around for the best outcome.
In the aftermath of the financial crisis, though there was pressure on SEC to impose restrictions one ratings shopping by issuers, vested interests prevailed and little changed. But the importance of rating agencies has only increased,
Investor reliance on credit ratings has gone from “high to higher,” says Swedish economist Bo Becker, who co-wrote a study finding that in the $4.4 trillion U.S. bond-mutual-fund industry, 94% of rules governing investments made direct or indirect references to ratings in 2017, versus 90% in 2010.
And the rating agencies business is booming,
Strong bond issuance and a rebound in the lucrative structured-securities market have brought good times back to the rating industry. SEC disclosures show fees for rating structured deals can top $1 million. Industry revenue rose 20% to $7.1 billion in 2017 from 2016, the most recent SEC data show. S&P’s and Moody’s shares are up more than eightfold in the past decade, and their stocks hit all-time highs last week.
And the risks too are becoming more apparent,
Two fast-growing structured-bond sectors are commercial mortgage-backed securities, or CMBS, and collateralized loan obligations, or CLOs. CMBS fund deals for hotels, shopping malls and the like. CLOs are backed by corporate loans to risky borrowers, typically to fund buyouts. In a May speech, Federal Reserve Chairman Jerome Powell compared CLOs to precrisis mortgage-backed debt: “Once again, we see a category of debt that is growing faster than the income of the borrowers even as lenders loosen underwriting standards.”
9. Finally financialisation in pharmaceuticals industry,
From 2006 to 2015, 18 major pharma companies spent $261bn on buying back shares, 57 per cent of what they spent on R&D, according to William Lazonick, a professor of economics at the University of Massachusetts Lowell.

Tuesday, September 17, 2019

Price-fixing in competitive markets

The Economist points to the differences in trans-Atlantic prices in sandwiches and other lunch takeaways. 
In Britain lobster rolls cost £5.99 ($7.31); in America $9.99. In both countries they are filled with lobster from Maine, along with cucumber, mayonnaise and more. Rent and labour cost about the same in London as in downtown New York or Boston. Neither sticker price includes sales tax. Yet a Pret A Manger lobster roll in America is a third pricier than in Britain, even though the lobster comes from nearer by. This Pret price gap is not limited to lobster rolls. According to data gathered by The Economist on the dozen Pret sandwiches that are most similar in the two countries, the American ones cost on average 74% more... The lunch market is local. New Yorkers do not care about prices in London. And they—alongside Bostonians and Washingtonians—are used to their local high prices, for reasons that include bigger portions (though not at Pret) and tipping habits. Londoners are keener on sandwich lunches, which means stiffer competition in that part of the market.
 
There are two points for consideration.

1. Even in the age of globalisation, the law of one price is hardly a universal feature. Market characteristics are important determinants of pricing. It is important that we bear this in mind before suggesting trade and liberalisation as universal cures for all price 

2. More importantly, Econ 101 teaches that competitive markets lead to efficient price discovery, one which minimises rents. Alternatively, competitive markets are more or less free from rent-seeking. In other words, competition is the antidote to price manipulation. 

The presence of multiple providers deters price fixing (intensive margin). Then there is also the possibility of competition from new entrants if entry barriers are not prohibitive (extensive margin). 

But though the New York or Boston or Washington lunch markets are competitive (on both intensive and extensive margins), they seem to be immune from the dynamics of competition. Even with multiplicity of lunch providers, there seems to be implicit price fixing. Competitors are not creating competition! So what gives?

I am inclined to believe that information and differentiation are important contributors. In the canonical models of competitive markets, there are several providers. These providers operated under conditions of information asymmetry about competitors as well as the market itself. As the market consolidated into a few large chains, the information asymmetry naturally bridged. The plethora of market analyses too minimise information asymmetry. Competitors knew enough about each other and about their buyers and the market itself. The conditions for implicit collusion were created.

The differentiation of the market based the product offering was a further dampener on competitive forces. The number of providers in the market for each differentiated product was even smaller, whereas the buyers were self-selected captive customers. This further lowered information asymmetry. In fact, differentiation may have the dynamic of lowering competition in general. 

This about pricing decisions is fascinating,
Menu pricing starts with a simple rule, says John Buchanan of the consulting arm of Lettuce Entertain You Enterprises, a restaurant group: take the cost of ingredients and multiply by three. Then ask yourself how much customers would expect to pay for a dish of this type, and how much they would expect to pay for it from you. A Pret lobster roll and one from a fancy seafood restaurant are quite different propositions. Lastly, check what the competition charges. “Only a small part of this decision is what I would call scientific,” says Mr Buchanan. “A lot has to do with a subjective judgment of what the market will bear.

Friday, September 13, 2019

Financial engineering to tackle poverty?

The development community have tried out several strategies and approaches to address persistent and critical development challenges. But most of them have not yielded satisfactory enough results. The natural inclination is therefore to try out something different. Do something innovative.

Nothing wrong in thinking this way. 

The only issue, most often, is that such thinking betrays a lack of perspective about the problem. How difficult is the challenge that we are trying to address? What is the context in which these problems exist and their potential solutions are to be grounded? What is the solution choice set available and its assessment? What has been the history of attempts to address the problem? And so on. 

When this perspective is deficient, these innovations become compelling magic-pill solutions. They are easy to explain and comprehend and resonates with our strongly held priors of how technocratic innovations can address persistent development challenges. Most importantly, they leave us comforted that the problem can be solved within a finite time and with the available public resources. In some ways, we are searching for the proverbial free lunches or the low hanging fruits. 

The two main sources for such innovation are technology and financial engineering. This post focuses on the latter. 

Development cosmopolitans argue that we need to deploy finance in service of development goals. The assumption is that finance has a disciplining and risk mitigation role which can be useful, for example, to trigger payouts on insurance against pandemics, natural and man-made disasters etc.

It is part of the dominant narrative that the financial sector has done innovative things with structured instruments. Never mind the fact that the vast majority of them have been value extractors and have engendered serious incentive distortions within the financial markets. Never mind all the increasingly recurrent bouts of financial markets induced economic crises and pervasive distortions arising from financialisation. But the narrative endures. Its hegemony has not spared development opinion makers. 

Poor people get ruined by episodes of catastrophic health conditions. So let’s give them micro-health insurance. Poor people grapple with uncertain weather and pest attacks that imperil their crops. So let’s help them mitigate the risks with index insurance. Poor people struggle to save enough for old age. So let them subscribe to micro-pensions. 

Such financial instruments are not confined to helping individuals. Development experts feel that countries and markets too could do with innovative finance. Not only are the underlying theoretical frameworks behind these ideas flaky - see this and this - but also there is little evidence about its efficacy in overcoming persistent development challenges and improving the lives of the world's poor. 

Not satisfied with inflicting themselves directly on the poor people, cosmopolitans pursue grander macro-economic ambitions. Countries face recurrent natural disasters and struggle to cope with the resultant damage. So help them with weather insurance. Aid comes in very late, is insufficient, and does not allow countries to plan effectively for post-disaster relief and rehabilitation. So some cosmopolitans have even suggested getting countries to subscribe to “pooled funding attached to contracts that pay out when disasters hit”, and if pooled finance is not available “transfer risk to the insurance sector by using concessional insurance to create certainty”. They have proposed "combining novel insurance contracts that provide fast payouts based on ‘parametric’ triggers with clear incentives to manage risks and invest in reducing losses". They claim that "an insurance paradigm for disaster aid will save many more lives for much less money". 

Millions of poor people struggle from certain infectious diseases which do not have effective enough vaccines at an affordable price. So guarantee them a commercially viable market so that pharmaceutical companies can be encouraged to invest in the development of such vaccines. Poor people and their national governments cannot afford expensive drugs for diseases like AIDS, Hepatitis, and Cervical Cancer. So provide them volume guarantees so that pharmaceutical companies can leverage economies of scale to lower prices enough to make it affordable. 

Governments do a bad job of delivering desired development outcomes. So let’s use the disciplining force of finance to help realise desired outcomes, or do outcomes-based financing. Learning outcomes are deficient in public schools or recidivism among released prisoners is very high. So let’s structure a complicated instrument called Development Impact Bond (DIB), with a transaction intermediary, implementation agency, independent outcomes evaluation agency, legal advisor, investors, and outcomes payers. 

Never mind there is scant or no evidence whatsoever of anything like these having worked at anything remotely close to scale. Never mind that the weak state capacity and limited markets in these contexts are in no position to take on such financial engineering. Never mind that these instruments open up opportunities for corruption and cronyism that often end up sinking countries into macroeconomic mess. Never mind that neither the corporate track record of financial institutions and big-pharma or big-tech nor their corporate governance standards and development commitment signals nor anything about their industry/corporate incentives suggests that these wonderful things are possible. But the logical attraction of these innovations, like those of the alphabet soup of financial market instruments, is irresistible. 

How do these innovations fare when subjected to rigorous scrutiny? 

In 2017 the Bank sold Pandemic Bonds to private investors who would have to payout upto $150 m if any of six deadly pandemics hit. It was to get triggered and cause payouts if certain pre-defined pandemics break-out. The investors who would have kept getting payouts as long as the pandemics don't happen. 

Last year Ebola struck the Democratic Republic of Congo. It has already killed nearly 2,000 people. But the scheme has not paid out. The 386-page bond prospectus contains a clause making payout conditional on the disease spreading to a second country, with at least 20 people dying there. Ebola has indeed spread, to neighbouring Uganda. But it has killed just three people there, with no new cases since June. Investors, including pension funds and asset managers, had bought $320m of the bonds in a deal that was heavily oversubscribed. The notes covering Ebola give them an annual coupon of 11.5 percentage points above LIBOR, a benchmark interest rate. The World Bank, with contributions from Japan and Germany, has already spent $87m on coupon payments, swap premiums and fees. Unless the outbreak worsens, investors will get their money back when the bonds mature next year... In all insurance contracts the cost of cover exceeds the expected payout (otherwise insurers would go bust). For pandemic bonds and related swaps this risk premium is about $17m a year. That money would be better spent on public-health systems and surveillance to try to catch outbreaks earlier.
Take crop insurance. Consider the challenges faced by a weather index insurance agency. It has to cover for an episode which has a high frequency but is completely uncertain, ensure the data is credible and minimises basis risks (affected farmer not eligible for claim because the index trigger was not hit), and pay out an amount which is commensurate to the damage suffered. It also has to keep the premiums affordable for the poor farmers, ensure that pay outs are done within a reasonable time, and genuine victims are not excluded. And it has to do all this with poor quality of index data and very patchy actuarial data, not to mention very unreliable crop damage models built on the index data. 

A viable insurance model assumes reasonable premiums, diversified risk pool, and low frequency of insured episode incidence. But in case of crop insurance for the poor, the actuarial model has to support ultra-low premiums even with the constraints of high (and increasing) frequency of index triggers being hit, highly correlated insured pool (weather is the same over reasonably large areas or regions), and significant enough reimbursements required to make this meaningful enough for the farmers.

An insurance product benefits from risk pooling on time (long-term premium payments), space (different uncorrelated geographies or types of people), and portfolio (different sets of policies) to keep claims ratio below 1. The multitude of small micro-insurers trawling the low income countries enjoy none of the basic requirements. In the context of micro-insurance based financial products, pls read thisthis, and this

If we try doing the math, we will soon realise in no time that self-financed micro-insurance for the poor is an impossible proposition. In fact, it is no surprise that even the most efficient and largest crop-insurance schemes in the developing world, including China, enjoy over 80% premium subsidy support. India’s new massive nation-wide crop insurance program, Pradhan Mantri Fasal Bima Yojana (PMFBY), has premium subsidy of a whopping 98%As the slide 6 here shows, subsidies, even in the US with crop-insurance are substantial. Even by squeezing out all the efficiency gains from financial engineering and technology, the commercial viability frontier will still remain very distant. In any case, whatever the insurer will pay out has to come from what is remaining after covering their costs – a claim ratio above 100% is not sustainable.

In simple terms, index insurance tries to do both financial engineering and weather modelling to address a complex development challenge. This is a double challenge. One, the actuarial models have to support affordable premiums. Two, the index data model that underpins the premium calculation has to be robust enough to minimise basis risks and also ensure that the development objectives are met. The first suffers historical data deficiencies and the second is an emerging area of research fraught with deep uncertainties. 

In contrast, a direct payment to identified victims does not involve any of the risk mitigation and transaction costs associated with managing an insurance. However, it does involve the challenge of assessing damages and their validation, whereas an index insurance only requires more easily verifiable (though less directly linked to the desired outcome) index triggers. But it eliminates the significant basis risk faced by farmers and ensures that the desired development objectives are realised. Besides, it also captures the true cost of crop damage mitigation in a clean, direct, and efficient manner. 

In light of the above, it stands to reason that the most efficient crop risk mitigation strategy would be direct income payments and not heavily subsidised insurance.

If we are engaging on a truly evidence-based policy making mode, the focus of innovation should be on helping governments make accurate assessments of crop damages in quick time. The one area where significant efficiency gains can be realised is from optimising the process of data collection and its validation. And this could be outsourced to a competent agency. But is anyone even talking about this?

Much the same analysis and conclusion applies to the other aforementioned examples of financial engineering-based innovations. All of them gloss over fundamental constraints.

Micro-insurance and pensions assume that poor people can save enough to pay for insurance, a deeply questionable assumption even in developed economies. It is a massive leap of faith to assume that debilitating state capacity weaknesses can be overcome by the disciplining force of finance (through outcomes-based financing) to realise complex development outcomes like learning outcomes. Financial models, however compelling, can do little to overcome powerful political economy forces that motivate aid spending. In pharmaceuticals industry, more so than most other industries, the market failure is less about incentive compatibility problems that can be fixed with financial incentives as about fixing the prevailing intellectual property rights regime and the flawed shareholder value maximising approach to capitalism. It is about increasing and targeting public investments into research and development about diseases that affect those less than well-off. 

In all these cases, as we peel enough layers into the problem it becomes evident that these so-called innovations are mere band-aids on gangrene. At best they are temporary palliatives. At worst, they represent an inadequate understanding about complex development challenges. In any case, they deflect the attention of governments, entrepreneurs, donors, and opinion makers away from the important task of engaging more deeply with the problem and figuring out more meaningful and serious solutions to those problems. 

None of this is to deny the value of these innovations, even with all their shortcomings. For sure, they have relevance in certain contexts, at certain times, and for certain problems. But as general solutions to addressing the fundamental underlying problems, their relevance is marginal. But by projecting them as a panacea, as mentioned earlier, proponents risk detracting from more meaningful engagement with the problems. Kinky development, as Lant Pritchett calls it. 

One of the basic principles of Econ 101 is that there are no free lunches. This is one of the few which have survived the test of time. It is indeed true. Always!

Tuesday, September 10, 2019

Making in India for the World - Industrial Policy for India's car manufacturing industry

Faced with contracting sales, Indian car manufacturers are lobbying for measures to bailout the industry, including lowering of GST.

BVR Subbu (HT: Ananth), former President of Hyundai and one of the most respected industry veterans, has rubbished their claim,
Has anyone totted up the gross profits of India's top three car makers and the top three 2-wheeler manufacturers over the last ten years? If I recall right just the top three 2-wheeler manufacturers made more Rs 12,500 crore in gross profits last year. One would imagine that an industry that has had such an unprecedented and extended run of profitability for almost a decade, would have enough cash reserves to tide over a dip in fortunes of the sort that we are presently witnessing. Not a meltdown by any standards, what we are seeing is merely a reduction in profitability that is sought to be painted as an apocalypse scenario.
Never mind the several possible reasons, the doomsday scenario painted is clearly self-serving. 

Vivek Dehejia and Roopa Subramanya makes the right diagnosis,
Indian automobile makers are characterized by low productivity, as compared to other comparable car-producing countries. According to a 2016 research report by the World Bank, labour productivity in India in the automobile sector is only one-third of that in China, with correspondingly lower rates of productivity growth in India than in China over the years. Due to low productivity and an inefficiently low scale of production, in general, Indian automobiles are uncompetitive in the global market. It is a telling fact that a country which is the sixth largest automobile manufacturer in the world has barely 1% of global exports, and is largely absent from well-established global value chains (GVCs).
But their prescription to lower import duties and invite foreign competition, and thereby force the local firms to get competitive, is questionable. This is a regurgitation of the economic orthodoxy on how liberalisation can unleash competition and boost productivity among domestic firms. But where is the evidence of this having worked?

On the contrary, in his excellent chronicle of the so-called East Asian miracle, Joe Studwell (review here) has highlighted the contrasting fortunes of North and South East Asian economies with their car and other manufacturing industries. All the North East Asian economies protected the local manufacturing with very high tariffs, but had policies which incentivised local manufacturers to export and promoted export competition among them. In contrast, the South East Asian economies, in the absence of export competition policies, failed to develop automobile manufacturing competitiveness. Those who followed the textbook liberalisation and lowered import tariffs (Philippines) became export dumping grounds for multinational car makers which completely obliterated local manufacturing capacity. And those with high tariffs ended up fostering automobile sectors characterised by inefficiency and crony capitalism (Indonesia and Malaysia).

Sample Studwell,
The capacity to export told politicians in Japan, South Korea and Taiwan what worked and what didn’t and they responded accordingly. Since exports have to pass through customs, they were relatively easy to check up on. In Japan, the amount of depreciation firms were allowed to charge to their accounts – effectively, a tax break – was determined by their exports. In Korea, firms had to report export performance to the government on a monthly basis, and the numbers determined their access to bank credit. In Taiwan, everything from cash subsidies to preferential exchange rates was used... North-east Asian politicians then improved their industrial policy returns through a second intervention – culling those firms which did not measure up... Japan, Korea, Taiwan and China, the state did not so much pick winners as weed out losers... Such ruthless bureaucratic support of domestic manufacturing was aided in each state by the concentration of key industrial and foreign trade policy decisions in a single government agency: the Ministry of International Trade and Industry (MITI) in Japan; the Economic Planning Board (EPB) in Korea; the Industrial Development Bureau (IDB) in Taiwan; and the National Development and Reform Commission (NDRC) in China.
In other words, low import duties and resultant foreign competition is hardly a recipe for making in India. Tariffs, high or low, are a red herring. Instead, we need to have policies that promote making in India for the world

In fact, given the precedents in other sectors, including mobile phones or heavy equipment, if import duties are lowered, not only is it unlikely to boost exports, but also most likely even the existing manufacturing capacity would not have come up. 

It is perhaps an opportunity for the Government of India to re-examine its concessions and incentives to the automobile industry, and calibrate them towards export performance and fostering export competition among the different domestic manufacturers. How about an industrial policy that promotes Making in India for the World?

Perhaps the only problem with this approach would be that, with the global trade expansion plateauing, the export-based manufacturing growth ship may have to navigate strong headwinds. 

In any case, this is one more example of how Indian capitalists, who lose no opportunity to blame the government for the country's problems (and for sure, the government has enough to be blamed for), have themselves largely failed India.

Actually, if you read Studwell, one cannot but not come out with the feeling that if India had embraced the free market in the sixties or seventies, we would have followed more or less the South East Asian trajectory. While not holding a brief for the policies we adopted, it is only a cautionary note to those who simplistically today argue that India would have been much better off if we had embraced capitalism after independence.

Sunday, September 8, 2019

Weekend reading links

1. As Beijing commits to eschewing the use of real estate market to stimulate the economy, its effects on the local government finances will be felt immediately. Land sales account for as much as 38% of local government financing. And this comes at a time when local government finances are deep in deficit.
2. Working hard does not translate into being effective. Counter-intuitive in the world where the amount of time worked is seen as a measure of your productivity and commitment. 

Sample this
Charles Darwin ambled into his study around 8am and worked a good hour and a half before taking a break to read the mail. He did another 90 minutes before noon and then, after a walk and an afternoon nap, another briefish stint before dinner. As Mr Pang writes, if Darwin had been working in a company today, “he would have been fired within a week”. Yet he still managed to write 19 books, including On the Origin of Species, one of the most famous books in the history of science. Henri PoincarĂ©, the great French mathematician, wrote 30 books and 500 papers by following the less than blistering pace of a roughly four-hour day. The prolific Dickens wrote from 9am to 2pm, with a break for lunch.
This is a great essay that seeks to over-turn conventional wisdom on working long hours.

3. Nice tribute to Martin Weitzmann in The Economist. I am inclined to believe though having been passed over by the Nobel Committee in favour of William Nordhaus, he will have the last laugh in the most important environmental debate of our times,

In 1974, early in his career, he wrote a paper that became a foundation stone of every course on public economics. It posed the question: how should regulators rein in pollution? Should they issue (tradable) pollution permits to firms, thereby picking a quantity? Or should they tax polluters, thereby picking a price?... Mr Weitzman assumed that predicting the reaction of prices to a regulated quantity, and vice versa, is partly guesswork. Which you should regulate depends on the relative costs of mistakes. If getting the quantity of pollution slightly wrong would be costlier, then quantity should be pinned down, with prices allowed to work themselves out. If a slightly errant price can do more damage—say, because the need to buy expensive permits could put many firms out of business—then a tax, fixed at a safe level, is the way to go. Uncertainty was the theme that ran through Mr Weitzman’s career...


Perhaps the biggest debate in environmental economics in recent years has concerned discount rates. By how much should you mark down the environmental damage of pollution to take account of the fact that it comes mostly in the future? Mr Weitzman assumed that the correct discount rate is itself uncertain. He demonstrated mathematically that whatever rate is chosen, uncertainty means it should decline over time. The further you peer into the future, the lower your discount rate should be... William Nordhaus carefully prices the potential damage from global warming using an economic model, discounts it appropriately (he favours a relatively high rate) and compares the result to the costs of reducing emissions today. His models suggest that policymakers should implement a carbon tax starting at around $30-40 per tonne of carbon dioxide and tolerate warming this century of over 3°C, compared with temperatures in pre-industrial times. Mr Weitzman thought this approach problematic. Climate change, he argued, does not lend itself easily to cost-benefit analysis. Despite advances in climate science, the sensitivity of global surface temperature to atmospheric carbon dioxide remains uncertain. Even if the central case is that a given amount of pollution produces a manageable eventual rise in temperatures, a cataclysmic event, such as global warming of over 6°C, remains worryingly possible. Cost-benefit analysis, he showed, can break down in these conditions. His “dismal theorem” proved that with fat-tailed distributions, and under certain mathematical assumptions about people’s preferences, society should be willing to pay unlimited amounts today to avoid catastrophic risk.
4. The financialisation story marches on with Apple, sitting on over $200 bn worth surplus cash reserves, raising $7 bn in debt. It plans to use the money for general corporate purposes, a euphemism for share buybacks and dividends. 

5. Gillian Tett points to some interesting stats. On technology induced changes, 
Data from the Milken Institute, for example, suggests that while just 2 per cent of the US population lives on a farm today, that figure was 40 per cent in 1900 and 98 per cent in 1800.
And on labour mobility in the US,
While 6.1 per cent of Americans were moving between counties or states each year back in 1990 (and in previous decades, this was almost certainly far higher), in 2017, that figure dropped to 3.6 per cent. And when workers do leave depressed areas today, they typically relocate to places with a similar profile rather than to megacities or high-growth hubs.

Friday, September 6, 2019

Fintech in perspective

Fintech is perhaps the most fashionable thing in the impact investment world today. There is a widespread belief that it can be transformative in addressing not just financial inclusion but poverty itself in a significant manner. 

Like with all fads, we need to be cautious about separating the hype from the reality. Evangelists cannot, by their very nature, entertain doubts and have to ride the bubble. And the converts are, again by their very nature, likely to be blind-spotted to the limitations of fintech.

As to evidence itself, the story is mixed and inconclusive. 

So here is an attempt to put the promise of fintech in its perspective. And I will not dwell on its undoubted benefits on the financial inclusion side which is already well-documented and part of the fintech folklore. I am therefore referring to those fintech companies offering lending and savings products, and not to digital and mobile money intermediaries.

A diagnostic of credit markets in developing countries reveals two important constraints. One, on the demand-side, the credit-worthiness assessment of borrowers is too expensive or unavailable, thereby either making credit too expensive or inaccessible to the vast majority of borrowers. Second, on the supply-side, the cost of capital (for lenders) is too high to facilitate affordable enough median loans and the volume of aggregate credit available (to such lenders) is too limited to meet the demand, thereby necessitating credit rationing that favours the more credit-worthy of borrowers. Regulatory restrictions and financial repression (arising out of fiscal dominance) amplify these challenges. 

Taken together, these two costs mean that the effective lending rate faced by the BoP market is at least 10-12 percentage points higher than the base lending rate in most low-income countries. 

Further, these are unlikely to disappear or even meaningfully lower in the foreseeable future, and even technology may have limits to significant lowering of these costs.

The presumption behind fintech is that it can lower the transaction costs (by enhancing credit-worthiness assessments, and reducing the general intermediation costs) and crowd-in capital (increase volumes). Let's examine each assumption.

For sure, fintech lowers the intermediation costs - after all digital transactions are cheaper than brick and mortar cash-in-cash-out transactions. While in theory digital trails make credit worthiness assessments easier, and that is indeed practically the case, the costs to bridge this information asymmetry are significant and the relative gains are less and trickier to realise. Also, as we are finding out now, in practice such digital trails with good enough quality are neither easy to accumulate nor disentangle. However, this, with time and technology could be significantly addressed. But it will take a good time, perhaps very long, before its impact is felt by those at the bottom of the pyramid. For those excited about big data, here is a cautionary note from no less a source that Ant Financial - big data ain't strong data!

The bigger challenge is with the assumption on the supply-side. For a start, given the local currency nature of the loans, in order to avoid asset-liability mismatches, it is only prudent that the refinancing credit come from domestic sources. 

Second, unlocking a large supply of domestic credit is very difficult. Domestic sources are of two kinds - deposits and capital markets. Deposit taking banks access credit through the former and capital markets, while a non-banking financial institution (NBFC) like a fintech credit provider accesses credit from either the banks or the capital markets or from the shadow financial sector. But each of these sources of finances are inherently limited in developing countries due to constraints that are not meaningfully impacted by the beneficial effects of fintech intermediation. Banks balk at lending to all but the most reputed NBFCs, whose clients are likely predominantly the non-poor. Capital markets are very narrow in every developing country, despite a very long and rich history of efforts to create both the supply and demand-sides of the market (Latin America is the best example). Shadow financial institutions, while thankfully small as on date, are unregulated and pose so many systemic risks that encouraging it is hazardous for countries where even the regular regulatory systems are so weak. One only needs to look at China where shadow financing has engendered so many excesses and distortions across the economy. 

Even thinking in terms of the value of fintech in boosting savings, thereby increasing the supply, runs into its set of challenges. At the aggregate level, the household savings rates in low-income countries are so low, and of this the financial (compared to property, jewellery, and other physical assets) savings rate is even less. And the adoption of fintech savings products by the low-income segments creates a set of very intractable behavioural challenges. 

In simple terms, there is a very rich body of research work that points to the multiple market failures that are responsible for the limited formal credit availability in these countries and none of them are likely to be addressed in any reasonable enough time and in any significant manner by fintech innovations. 

It is one thing for a fintech company to reach $50 m in assets, an altogether different thing to be doing $500 m, much less in the billions (or a market having 50 fintech lenders with $10 m in assets, compared to having just 3-4). No wonder that outside of China, fintech lending has remained still-born.

Other fintech innovations aimed at enhancing the efficiency of financial markets, too pose challenges. For example, some fintech providers have sought to position themselves as loan originators for banks. Now this, in turn poses a big challenge. An outsourced loan origination coupled with the ability of banks to securitise and sell their loan books poses a massive incentive distortion challenge for banks with systemic consequences - banks will have no incentive to ensure that the loans are of good quality. And we know what happened with just the latter in the US (from the housing market) during the financial crisis.

This is not to at all say that fintech innovation is a dead-end or not interesting, but merely to highlight the very formidable challenges, especially on factors outside the remit of fintech, that need to be overcome to realise significant sustainable gains from the entrepreneurship that abounds in the fintech sector. 

Tuesday, September 3, 2019

Remittance facts of the day

The FT has a very good exploration of the importance of remittances. It has now overtaken FDI as the largest channel of cross-border capital flows into emerging economies. The World Bank estimates $689 bn in remittance transfers by 270 million migrants this year.
Interesting graphic about India, the largest recipient of remittances - $69 bn in 2017, or 2.7% of GDP.
Remittances are considered a stable source of revenues, thereby making them an automatic stabiliser for the external account.

A less discussed feature is that perhaps remittances have among the highest multiplier of any inflows. Remittances are largely sent back by breadwinners who have migrated in search for better opportunities, and a significant share of their transfers are therefore most likely to be spent. In fact, this would be especially the case with remittances from Middle East, in case of India, given the profile of those working there. 

Notwithstanding its poverty alleviation effects, in the aggregate, there is little evidence of remittances being good for economic growth. On the contrary, there is evidence that remittances contribute to appreciation of exchange rate, and consequent Dutch disease, and is also correlated with making governments less responsive to citizen's needs. 
Large inflows allow governments to be less responsive to the needs of society. The reasoning is simple: families that receive remittances are better insulated from economic shocks and are less motivated to demand change from their governments; government in turn feels less obligated to be accountable to its citizens.
There are also examples of how remittance spawn unproductive investments in large houses etc.
Given all this, a high value global development imperative would be to lower the prevailing prohibitive costs of 7-10% associated with global cross-border money transfers. Even a 1 percentage points reduction puts $7 bn in the pockets of remitters!
The critical drivers of cost are cash handling at both sender and recipient sides, regulatory restrictions especially on the anti-money laundering (AML) side, and anti-competitive behaviour by entrenched firms. The tightening AML regulations in the developed countries have had the effect of closing down several correspondent banking relationships that western financial institutions have had with developing country partners. The number of active correspondent banking relationships fell 16% in the six years to 2018, even as remittance flows multiplied. The effect has been to increase the costs associated with cross-border transfers. 

Fintech has long been considered an important disruption opportunity in this market. But there are limits to how much fintech can be of help with addressing the three critical cost-drivers. More on it in a latter post.

Given the large remittance flows into India, and especially from Middle East, which include large volumes of smaller transfers, and also given the fintech enabling environment in the country, it is surprising that no such fintech disruptor has emerged from the country. One more example of how beyond copy-cat technnovation, the Indian start-up industry has struggled with creating genuine disruptors.

Monday, September 2, 2019

PPPs or not, building roads requires fiscal support

Newspapers point to a directive to the Roads Ministry to shift away from the current approach of building national highways. In particular the directive from the office of the Prime Minister apparently talks about three things - discontinue direct construction of roads, encourage private sector to take up construction, and monetise completed road projects.

The most worrisome thing for government apparently has been the rise in the volume of debt accumulated by the National Highways Authority of India (NHAI) over the last five years.
The NHAI has pursued a Hybrid Annuity Model (HAM) whereby the developers are paid out 40% in five instalments during the construction period and the rest as annuity over the concession period. It lowers the construction and traffic risks for the developer, and makes the government put upfront a significant share of the construction cost. 

Some observations

1. There is no point trying to assess the relative merits of Hybrid Annuity Model (HAM) and Viability Gap Funding (VGF) models. They are all variants of de-risking the model for commercial investors. We should be doing both (and BOT Toll), each depending on the commercial viability of the specific project. HAM is after all a form of annuitised hybrid VGF. 

2. Whatever the private participation model envisaged, global experience shows that any ambitious nationwide road building program required significant upfront fiscal support. In the absence of adequate fiscal support, the NHAI had to leverage up.  

In fact, the belief that BOT Toll approach (or any other market-based PPPs) will help crowd-in private capital is a stretch. It did not happen when it was tried out by the last government and it is unlikely to happen this time too. And whatever happened spawned renegotiations and bad loans for the banks. 

3. In fact, I imagine that all the road stretches which would have some reasonable commercial viability have already been developed or contracted, and we are now left with the vast majority of the stretches where commercial viability is questionable and large VGF/subsidy (of any kind) is inevitable.

4. The idea of "aggressive monetisation of existing assets" (using whatever approach, InvIT or other) is naive. The NHAI could not even get any bids for the second round of monetisation tender - nobody turned up for the second round. As I have written with V Ananthanageswaran in Can India Grow? (see pages 39-43), the pool of domestic and global non-banking money chasing infrastructure financing is very limited. The belief that there are vast pools of domestic and foreign capital willing to invest in roads in India is completely wrong - see this, this, this, and this

And it is most likely that Macquarie overbid for the first round where NHAI got nearly 50% above the off-set price. And we will reap its consequences in the form of skimping and asset-stripping in the years ahead. It has been the standard operating procedure for Macquarie from other parts of the world.

It again highlights the value of a development finance institution which focuses on long-term financing of infrastructure. Anyways, what is the NIIF doing? But it too pull this off without being sufficiently capitalised, and the projects themselves getting significant subsidy support. There are no free private sector lunches!

Tuesday, August 27, 2019

Palliatives will not address capitalism's problems

I had blogged earlier about Bridgewater's Ray Dalio's explanation of capitalism's problem as one of excesses that have built-up over the years,
Dalio's diagnosis is that capitalism's dynamics, especially since it has been taken to its extremes (say, in seeking profits, efficiency, productivity, market share etc) is now "producing self-reinforcing spirals up for the haves and dow for the not-haves, which are leading to harmful excesses at the top and harmful deprivations at the bottom". In effect, Dalio blames the dysfunctional nature of modern capitalism to an impersonal contributor, some inexorable dynamic of capitalism, say peak capitalism.
So there have been efforts from within in recent times to respond to these excesses. Innovations like the Universal Basic Income (UBI), impact investing, philanthro-capitalism, B-corporations, gender-lens investing, corporate social responsibility, responsible-sourcing, circular economy, carbon footprint tagging etc are examples. 

The use of environment, social, and governance (ESG) criteria in investing by financial institutions is another example
Businesspeople, being people, like to feel they are doing good. Until the financial crisis, though, for a generation or so most had been happy to think that they did good simply by doing well. They subscribed to the view that treating their shareholders’ need for profit as paramount represented their highest purpose... It is a view of the world... which has faced increasing pressure over the past decade. Environmental, social and governance (ESG) criteria have come to play a role in more and more decisions about how to allocate financial investment. The assets managed under such criteria in Europe, America, Canada, Japan, Australia and New Zealand rose from $22.9trn in 2016 to $30.7trn at the start of 2018, according to the Global Sustainable Investment Alliance... The discontent does not end with investors. Bright young workers of the sort businesses most desire expect to work in a place that reflects their values much more than their parents’ generation did...
On August 19th the great and good of ceo-land announced a change of heart about what public companies are for. They now believe that firms should indeed serve stakeholders as well as shareholders. They should offer good value to customers; support their workers with training; be inclusive in matters of gender and race; deal fairly and ethically with all their suppliers; support the communities in which they work; and protect the environment... Last year, employees at Google forced the firm to stop providing the Pentagon with ai technology for drone strikes and to drop out of the procurement process for JEDI, a cloud-computing facility for the armed forces. Google depends, perhaps more than any of its peers, on a smallish number of cutting-edge data scientists and software engineers; their views carry weight. Microsoft, despite similar misgivings from its employees, is still in the running for the JEDI contract. Amazon, for its part, is facing employee pressure over contracts with oil and gas companies.
For a start, it may be useful to scratch the surface and examine the ESG consideration details behind the trillions mentioned. Chances are that they would be so superfluous as to be meaningless.

This Harvard Business School case study and this discussion involving the professors concerned is a great example of how top-notch academic ideologues feel comforted by what are at best ultra-marginal tinkering on fund allocation processes of large investors. Such long-route to change can be interminably long. Most likely much ado about nothing!

In general, corporates have sought to deploy "virtue signalling" and initiated "feel-good" measures. These are not even token measures. In fact, they are perhaps downright disingenuous obfuscations. They are worse than band-aid on gangrene. Such song and dance at non-issues are on many occasions conscious efforts by the corporate elites and their ideological cheerleaders to distract attention from the core issue.

The Economist falls back on more of the capitalist medicine - accountability and competition. It proposes taking decision-making away from managers and vesting with shareholders even as shareholder base is broadened, on the grounds that this would bring in accountability and therefore demand for real change. And competition would help keep corporates honest in pursuing the interests of workers, consumers, and regulators. This is a great example of suggesting remedies, knowing fully well that they are both impractical and have little evidence of being effective.

Instead, a meaningful enough attempt will have to involve at least some corporate leaders showing the way with actions on issues like abjuring from tax avoidance, efficiency focused lay-offs and off-shoring, monopoly seeking or oligopolistic actions, providing decent wages and proportionate wage increases for workers, investing in and promoting the rights of lower level workers, ensuring adequate financing of pensions and other worker liabilities and so on. Now these would constitute real progress in addressing capitalism's excesses.

But then the argument would go that these are collective action or free-rider problems. No one corporate or group of corporates would want to pursue them since that would be shooting themselves in the feet. Never mind the reality of today's oligopolistic markets where just the 2-3 leaders could take the lead and show meaningful impact without compromising significantly on their commercial interests. 

Anyways, the collective action problem presents a convenient fig-leaf for liberal opinion makers blame the favourite whipping boy, government, for not putting in place appropriate policies. But if some government tries to engage with the problem, the same liberals accuse governments of meddling with markets or favouring one group over other. The lack of any broad-based ideological support and hair-splitting among opinion leaders (including The Economist) for the actions on European Union in the direction of anti-trust (whatever their real intentions) is a case in point. 

I think we need paradigm shifts. And these shifts are unlikely to emerge from within. The house has to burn down. 

Monday, August 26, 2019

Reforming the global monetary and financial system

It is gratifying when no less a person than the Governor of Bank of England Mark Carney breaks ranks from orthodoxy and summarises our book, The Rise of Finance. The core of the speech goes to the heart of what we have argued in our book. The global financial and monetary system is broken and the role of dollar is central to the problem.

In his speech at the annual Jackson Hole gathering of central bankers, Carney highlighted the problems associated with the world's reliance on the US dollar and spillovers especially on emerging economies from US monetary policy actions. He questioned the macroeconomy stabilisation orthodoxy on flexible inflation targeting and floating exchange rates. He advocated the creation of a new international monetary and financial system (IMFS) based on many more global currencies, where IMF could play a role to avoid having countries self-insure themselves against sudden-stops and capital flight by the inefficient and wasteful hoarding of US dollar assets, and greater global monetary policy co-ordination.

On the problems with the prevailing system,
Globalisation has steadily increased the impact of international developments on all our economies. This in turn has made any deviations from the core assumptions of the canonical view even more critical. In particular, growing dominant currency pricing (DCP) is reducing the shock absorbing properties of flexible exchange rates and altering the inflation-output volatility trade-off facing monetary policy makers. And most fundamentally, a destabilising asymmetry at the heart of the IMFS is growing. While the world economy is being reordered, the US dollar remains as important as when Bretton Woods collapsed. The combination of these factors means that US developments have significant spillovers onto both the trade performance and the financial conditions of countries even with relatively limited direct exposure to the US economy.
He argues that these developments have lowered the global equilibrium interest rates, which in turn influences domestic monetary policy actions, which in turn become a bigger problem when the US economic conditions warrant tightening by the UD Federal Reserve even as economic condition elsewhere are weakening. The result is a structural disinflationary bias in the world economy.

Greater cross-border trade, growth of global value chains, and globalisation in general have synchronised producer prices globally and also introduced a disinflationary bias on the world economy. This increase in global trade has been accompanied by the DCP or trade invoicing in dollars even when the trade does not involve the US, thereby weakening the automatic (external side) stabilisation effects of a floating exchange rate.
The resulting stickiness of import prices in dollar terms means exchange rate pass-through for changes in the dollar is high regardless of the country of export and import, while pass-through of non-dominant currencies is negligible. As a result, import prices do not adjust efficiently to reflect changes in relative demand between trading partners, in part because expenditure switching effects are curtailed, and global trade volumes are heavily influenced by the strength of the US dollar.
It has been shown that, controlling for the global business cycle, a 1% appreciation of the dollar against all other currencies leads to a 0.6% contraction in trade volumes in the rest of the world within one year.

In addition to trade invoicing, dollar is also the dominant currency in the financial markets, and all this creates a self-reinforcing spiral that predominates dollar ever more,
As well as being the dominant currency for the invoicing and settling of international trade, the US dollar is the currency of choice for securities issuance and holdings, and reserves of the official sector. Two-thirds of both global securities issuance and official foreign-exchange reserves are denominated in dollars. The same proportion of EME foreign currency external debt is denominated in dollars and the dollar serves as the monetary anchor in countries accounting for two thirds of global GDP. The US dollar’s widespread use in trade invoicing and its increasing prominence in global banking and finance are mutually reinforcing. With large volumes of trade being invoiced and paid for in dollars, it makes sense to hold dollar-denominated assets. Increased demand for dollar assets lowers their return, creating an incentive for firms to borrow in dollars. The liquidity and safety properties encourage this further. In turn, companies with dollar-denominated liabilities have an incentive to invoice in dollars, to reduce the currency mismatch between their revenues and liabilities. More dollar issuance by non-financial companies and more dollar funding for local banks makes it wise for central banks to accumulate some dollar reserves. 
And the net result is that actions of US government and the Federal Reserve have enormous spill-overs on the world economy, even in countries which have limited US exposure. Helene Rey has described the global financial cycle as a dollar cycle. Carney points to evidence on the harmful effects of spillovers,
For EMEs, this manifests in volatile capital flows that amplify domestic imbalances and leave them more vulnerable to foreign shocks. One fifth of all surges in capital flows to EMEs have ended in financial crises, and EMEs are at least three times more likely to experience a financial crisis after capital flow surges than in normal times. While the typical EME receiving higher capital inflows will grow 0.3 percentage points faster, all else equal, the typical EME with higher capital flow volatility will grow 0.7 percentage points slower... Bank research suggests that the spillover from tightening in US monetary policy to foreign GDP is now twice its 1990-2004 average, despite the US’s rapidly declining share of global GDP. Financial instability in advanced economies also causes capital to retrench from EMEs to ‘safe havens’, as it did during the 2008 financial crisis and the 2011 euro-area crisis. Connally’s dictum “our dollar, your problem” has broadened to “any of our problems is your problem”... Bank of England work finds that redemptions by EME bond funds (with large structural mismatches) in response to price falls are five times those for EME equity funds (with lower structural mismatch). In turn, EME equity funds are twice as responsive as advanced economy equity funds.
So what does he suggest? In the short-run he suggests transparent pursuit of flexible inflation targeting, with focus on trading off domestically generated inflation and output volatility, as well as co-ordination with fiscal and regulatory policies, at both national and international levels.
In the medium term, policymakers need to reshuffle the deck. That is, we need to improve the structure of the current IMFS. That requires ensuring that the institutions at the heart of market-based finance, particularly open-ended funds, are resilient throughout the global financial cycle. It requires better surveillance of cross border spillovers to guide macroprudential and, in extremis, capital flow management measures. And it underscores the premium on re-building an adequate global financial safety net... EMEs can increase sustainable capital flows by addressing “pull” factors including... expanding the scope and application of their macroprudential toolkits to guard against excessive credit growth during booms. Bank of England research finds that tightening prudential policy in EMEs dampens the spillover from US monetary policy by around a quarter... At the same time, it is in the interests of advanced economies to moderate push factors, including risks in their markets and institutions... Pooling resources at the IMF, and thereby distributing the costs across all 189 member countries, is much more efficient than individual countries self-insuring. To maintain reserve adequacy in the face of future larger and more risky external balance sheets, EMEs would need to double their current level of reserves over the next 10 years – an increase of $9 trillion. A better alternative would be to hold $3 trillion in pooled resources, achieving the same level of insurance for a much lower cost.


In the longer term, we need to change the game. There should be no illusions that the IMFS can be reformed overnight or that market forces are likely to force a rapid switch of reserve assets... Any unipolar system is unsuited to a multi-polar world. We would do well to think through every opportunity, including those presented by new technologies, to create a more balanced and effective system... Multiple reserve currencies would increase the supply of safe assets, alleviating the downward pressures on the global equilibrium interest rate that an asymmetric system can exert. And with many countries issuing global safe assets in competition with each other, the safety premium they receive should fall. A more diversified IMFS would also reduce spillovers from the core and by so doing lower the synchronisation of trade and financial cycles. That would in turn reduce the fragilities in the system, and increase the sustainability of capital flows, pushing up the equilibrium interest rate.