Tuesday, March 31, 2009

Policies for urban metro rail systems

China has embarked on a massive construction drive of underground metro rail systems in many of its largest cities. At least 15 cities are building subway lines and a dozen more are planning them, as Beijing is pushing local and provincial governments to step up their infrastructure spending to offset lost revenue from slumping exports. Much the same is being contemplated in India, as metros have become the latest fad in urban mass transit. Therefore China's experience carries important lessons for India.

The dramatic urbanization and ballooning population of vehicles has placed severe strains on Chinese cities, necessitating the development of an effective network of high volume public transit system. The relative ease and cheap cost of land acquisition in urban areas (both expensive and legally difficult in cities in other countries) for stations and ventilation shafts, low labor costs, and economies of scale from large construction distances makes metro development in China easier when compared to others.

While subways have major environmental externalities and social benefits, their ultimate success depends on having in place an attendant set of policies, more so given their high construction and O&M costs. But China, and many other developing countries, including India, may be falling short on this, thereby failing to optimize on the usage and benefits of such modern mass transit systems. For example, even as it is constructing a large metro rail network, China is also constructing large integrated townships and encouraging the development of sprawling new suburbs, which in turn spreads the population out further and increases commute distances, thereby reducing the benefits from any new mass transit system.

Subways can be effective, especially given the price-sensitive nature of commuter base in developing countries, only if both its ticket prices are affordable and also if the cost of using other alternative modes of transport are higher. The former demands that (and experience of cities bears it out), atleast in the initial years, subsidizing a major share of the sunk capital costs will be inevitable. However, alternate revenues streams from the development of associated real estate, especially in stations, can cover up a considerable part of the capital costs.

The latter requires having in place policies that discourage the use of private cars - stricter and costlier licensing, high parking fees, toll bridges, private car free areas, congestion pricing, stronger regulation of private carriers like taxis and auto-rickshaws, etc - besides higher usage cost for other mass transit systems. It also requires seamless cross-modal integration with other transit facilties and provision of other logisitics like adequate parking facilities at metro stations. In the absence of these requirements (and most of them are absent in China and India), metro systems can remain as expensive and under-utilized white elephants bleeding tax payer money.

Update 1
Superb series of posts by Edward Glaeser which finds that the benefits - economic, social and environmental - are not even remotely as large as was thought of. He also examines the economic and environmental case for high speed rail, and finds that it may not match up. See also this classic study on the full cost of high speed rail.

Mobilizing resources in hard times!

Even as the economy hurtles downward, enterprising individuals are finding innovative ways to raise resources locally,

"Earlier this month, after residents of Pocatello rejected a school levy intended to help address a depleted budget and rising costs, Mr. Harrison (Economics teacher) decided to find a way to help. He approached Dan McIsaac, the pizzeria owner, and brokered a deal. If Mr. McIsaac paid about $315 for 10,000 sheets of paper for Mr. Harrison’s classes, more than a year’s supply, the pizzeria could run an advertisement across the bottom of every sheet handed out in class."

The growth story of Facebook

NYT has an excellent chronicle of social networking leader Facebook, which since its launch in February 2004, is now set to register its 200 millionth user, doubling in size in the last eight months. Though Facebook is privately held and doesn’t publicly disclose its earnings, various press and analysts’ estimates of its 2008 revenues span from $250 million to $400 million, though not enough to cover the company’s escalating expenses. This excellent graphic captures the growth of Facebook.

Update 1
Twitter is emerging as an increasingly useful business tool and information sourcing site.

Monday, March 30, 2009

Crony capitalism - American style?

The sub-prime mortgage bubble induced financial meltdown and economic recession has inflicted devastating damages, including as Paul Krugman writes, tarnishing Anglo-American capitalism and the American government and governance systems, and irreparably damaging America's credibility in a role of global economic leadership.

In a brilliant and revealing article in the Atlantic, Simon Johnson (also here) is brutally precise about the crisis and the way out. He writes that "the finance industry has effectively captured our government — a state of affairs that more typically describes emerging markets, and is at the center of many emerging-market crises. If the IMF’s staff could speak freely about the US, it would tell us what it tells all countries in this situation: recovery will fail unless we break the financial oligarchy that is blocking essential reform. And if we are to prevent a true depression, we’re running out of time."

In good times, the powerful elites within emerging economies over-reach and take too many risks, all on the firm and well-founded belief that their partners in government will bail out the joint enterprise if things turn sour. The close nexus between the private sector and the political establishment means that businesses and their lenders (most often foreign banks and institutional investors) can take risks with the belief that they will have the upside to themselves and the downside to be pushed off to the tax payers. Further, growing political support meant swifter clearances, better access to lucrative contracts, tax breaks, easier credit from government banks, and subsidies.

As the economy booms, these businesses are subject to the same set of excesses in investments and borrowings as in any bubble. Then the bubble bursts and the downward spiral starts - credit first becomes scarce and then freezes, defaults mount, lay-offs begin, business investment comes to a halt, consumption gets deferred and the economy slips ever deeper into a hole.

As Simon Johnson writes, "Yesterday’s 'public-private partnerships' are re-labeled 'crony capitalism'... The government is forced to draw down its foreign-currency reserves to pay for imports, service debt, and cover private losses. But these reserves will eventually run out. If the country cannot right itself before that happens, it will default on its sovereign debt and become an economic pariah. Needing to squeeze someone, most emerging-market governments look first to ordinary working folk — at least until the riots grow too large. The government, in its race to stop the bleeding, will typically need to wipe out some of the national champions — now hemorrhaging cash — and usually restructure a banking system that’s gone badly out of balance. It will, in other words, need to squeeze at least some of its oligarchs."

Pointing to the striking parallels between "crony capitalism" in emerging economies and the descent of the US to a "banana republic", he writes,

"In its depth and suddenness, the US economic and financial crisis is shockingly reminiscent of moments we have recently seen in emerging markets (and only in emerging markets): South Korea (1997), Malaysia (1998), Russia and Argentina (time and again). In each of those cases, global investors, afraid that the country or its financial sector wouldn’t be able to pay off mountainous debt, suddenly stopped lending. And in each case, that fear became self-fulfilling, as banks that couldn’t roll over their debt did, in fact, become unable to pay. This is precisely what drove Lehman Brothers into bankruptcy on September 15, causing all sources of funding to the U.S. financial sector to dry up overnight. Just as in emerging-market crises, the weakness in the banking system has quickly rippled out into the rest of the economy, causing a severe economic contraction and hardship for millions of people.

But there’s a deeper and more disturbing similarity: elite business interests—financiers, in the case of the U.S.—played a central role in creating the crisis, making ever-larger gambles, with the implicit backing of the government, until the inevitable collapse. More alarming, they are now using their influence to prevent precisely the sorts of reforms that are needed, and fast, to pull the economy out of its nosedive. The government seems helpless, or unwilling, to act against them."

Sunday, March 29, 2009

More on financial market regulation

Mathias Dewatripont, Xavier Freixas, and Richard Portes of the CEPR have compiled an excellent e-book that analyzes a range of policy proposals for how the G20 process and the London Summit might bring about concrete, implementable results that can restore confidence and lead the way to recovery.

It concludes that while the ongoing banking crisis is no different from other systemic crises, its uniqueness "comes from the specifics of the macroeconomic fragility and the channels of contagion which are to some extent unprecedented". The global nature of the crisis, involving developed, emerging and poor countries, means that any solution should involve "reciprocal commitments and actions".

It attributes the sudden transformation from markets that were (thought to be) perfectly transparent and efficient to complete opacity (similar to an Akerlof adverse selection market in lemons with its no-trade equilibrium) and rigidity to "the complexity of instruments, the increased risk of the collateral on which the securities were based, the failure of credit rating institutions to perform properly, and the lack of adequate countercyclical prudential regulation".

It finds that "three key factors combined to trigger the regime switch - liquidity shortages that occurred, despite generous liquidity injections by central banks all over the world; the buildup of huge portfolios of credit default swaps (CDS) in a small number of institutions that suddenly became vulnerable with the onset of the crisis; and the collapse of credit ratings awarded to structured securities as a basis for valuing and trading these securities". The other factors included, "the procyclical bias of Basel II regulation; the lack of a proper system for dealing quickly with insolvent banks; and the tendency of bank compensation systems to encourage excessive risk taking by employees, coupled with poor corporate governance and the failure of shareholders to act to protect their investments".

The report argues that "neither monetary nor fiscal policies will work unless and until the blockages in the supply of credit are resolved. Financial intermediation and the structure supporting it must be restored to near-normal conditions to stop the accelerating decline". It makes the following recommendations for achieving this

1. Address global imbalances and capital flows
a) Create credible insurance mechanisms for countries that forego further reserve accumulation and stimulate domestic expansion, along three possible lines - more central bank swap lines; ’reserve pooling’; and an expansion of IMF resources - together with IMF emphasis on a large, flexible, fast-disbursing facility that would come with little or no conditionality to countries that are adversely affected by global shocks. Large loans to the IMF by major reserve holders offer one way of funding this insurance until Fund quotas are raised, as they must be.
b) Accelerate the development of emerging market country financial systems, with particular emphasis on local currency bond markets and on foreign currency hedging instruments. Promote regional cooperation in the design of common institutional standards for financial market development and work to lift barriers to cross-border asset trade within regions.

2. The challenges of macroeconomic policy in the crisis
a) Meet any threat of deflation promptly, before it takes hold, with a zero interest rate policy (ZIRP) and quantitative easing. Establishing an inflation target may help to avoid expectations of deflation.
b) A global ZIRP would raise a particular problem: not all countries can benefit from the stimulus of exchange-rate depreciation. A country with large trade surpluses with positive GDP growth should refrain from intervention to prevent appreciation, which would be a beggar-thy-neighbour policy.
c) International coordination of cooperatively designed fiscal stimuli is necessary to allow the internalisation of the effective demand externalities of a fiscal stimulus through the trade balance and the real exchange rate. Fiscal stimuli should follow the ’fiscal spare capacity’ of each country, i.e., its ability to generate larger future primary government surpluses.

3. Macro-prudential regulation
a) Mitigate procyclicality (of the Basel II regulations) by adjusting the Basel II capital requirements using a simple multiplier that depends on the deviation of the rate of growth of GDP with respect to its long-run average. Specifically, the requirements would be increased in expansions (or decreased in recessions) by some percentage points for a one standard deviation change in GDP growth, and thereby provide adequate buffers that will limit the procyclical effect of prudential regulation.

4. Market reforms
a) Require without further delay a centralized clearing counterparty for CDS trades. Consider going further to require that CDS be exchange traded and consider prohibiting CDS that do not insure a holder of the underlying asset (naked CDS).
b) Require that credit rating agencies (CRAs) be paid if possible by investors rather than by issuers, or at least that the link between CRAs and the issuer is severed, so that a CRA’s rating does not affect its future business with a given client. Also, for structured instruments, force greater disclosure of information about the underlying pool of securities. Prohibit indirect payments by issuers to CRAs in the form of the purchase of consulting or pre-rating services. Consider an open access, non-prescriptive approach by regulators, eliminating the NRSRO designation and the extensive ’hard wiring’ of the CRAs in the regulatory system.

5. Controlling financial institutions
a) Establish a harmonized special bankruptcy regime for banks. This would involve US style "prompt corrective action", giving the (independent and well-staffed) supervisory agency powers to limit the freedom of bank managers (possibly remove them) and shareholders (possibly expropriate them) before the bank is technically insolvent.
b) Consider the creation of an International Financial Stability Fund that takes equity positions in the financial institutions of participating countries and monitors their activities.

Financial sector regulation - Turner Review and Geithner Plan

The Obama administration has made its first step towards long term solution to preventing financial market crisis by putting in place "better, smarter tougher regulation". Much to the consternation of financial sector firms, the Treasury Secretary Tim Geithner has said it would require "not modest repairs at the margin, but new rules of the game". He outlined six measures to contain systemic risk and prevent financial market crisis

1. Establish a single entity with responsibility for systemic stability (a systemic risk regulator) over the major institutions and critical payment and settlement systems and activities.
2. Establish and enforce substantially more conservative capital requirements for institutions that pose potential risk to the stability of the financial system, that are designed to dampen rather than amplify financial cycles.
3. Requirement that leveraged private investment funds (hedge funds and private equity funds), with assets under management over a certain threshold, register with the SEC to provide greater capacity for protecting investors and market integrity.
4. Establish a comprehensive framework of oversight, protections and disclosure for the OTC derivatives market, moving the standardized parts of those markets to central clearinghouse, and encouraging further use of exchange-traded instruments (bringing instruments like CDS under regulatory oversight).
5. SEC should develop strong requirements for money market funds to reduce the risk of rapid withdrawals of funds that could pose greater risks to market functioning.
6. Establish a stronger resolution mechanism that gives the government tools to protect the financial system and the broader economy from the potential failure of large complex financial institutions. This would involve setting up a resolution regime that provides authority to avoid the disorderly liquidation of any non-bank financial firm whose disorderly liquidation would have serious adverse effects on the financial system or the US economy.

Announcing that the days of "light-touch regulation are over", Geithner also called for the government to more actively regulate executive compensation, not just at companies that are receiving federal bailout money, but at all companies that might be providing incentives for excessive risk-taking.

Meanwhile across the Atlantic, in the UK, the British Government commissioned Lord Adair Turner, Chairman of the Financial Services Authority (FSA), to do a review and submit proposals for more effective regulation of the financial markets. The Businessline has an excellent summary of its recommendations in the graphic below

The Turner Review (and its comprehensive discussion paper here) of financial regulation is the most comprehensive blueprint and starting point for any discussion on financial market regulation. In contrast to what people like Dani Rodrik have argued for, Turner says that purely national and piecemeal regulation is "by far second best", and calls for "internationally agreed" and systemic regulation. The Turner review identifies three proximate causes for the problems - global macroeconomic imbalances, inadequate bank capital and the need for better liquidity regulation, and financial innovation of little social value.

Questioning the "theory of rational and self-correcting markets", he points to the dichotomy in financial regulation between the US and the rest of the world, manifested in the debate between 'principles-based regulation’ and ‘rules-based regulation’. As Businessline writes, "The former held that all that is needed for an efficient financial sector is an enunciation by the empowered authority of the principles that are needed in the sector, and that if these were observed, heaven would be at hand... most of the rest of the world held that principles were all very well, but how would you ensure that they were observed if there were no rules?"

The Turner recommendations include banks to have higher quantity and quality of capital-asset ratios - even higher than Basel II ones; fundamental review of risk management models and practices; counter-cyclical capital buffers to be built up in good times, so that they can be drawn on in downturns, and reflected in published account estimates of future potential losses; a resolution regime which facilitates the orderly wind down of failed banks should be in place; a central role for much tighter regulation of liquidity; limits on leverage ratios; new capital and liquidity requirements to be designed to constrain commercial banks’ role in risky proprietary trading activities; greater reporting and diclosure requirements; greater coverage of deposit insurance; stricter supervision of rating agencies and more transparent information disclosure; netting, clearing and central counterparty in derivatives trading; greater regulation of executive compensation to to avoid incentives for undue risk taking; trans-national body for supervision of cross-border banks; offshore financial centres to be covered by global agreements on regulatory standards; collaborative macro-prudential analysis and the identification of policy measures by national and global regulatory institutions etc. It also calls for the establishment and effective operation of colleges of supervisors for the largest complex and cross-border financial institutions, and pre-emptive development of crisis coordination mechanisms and contingency plans between supervisors, central banks and finance ministries.

Chris Dillow raises some important concerns with the Turner recommendations.

Update 1
Thomas Palley has an excellent article in favor of asset based reserve requirements (ABRR) as the favored means of dfinancial market regulation.

Economic crisis and political instability beckons?

A report by the Economist Intelligence Unit (EIU) claims that the global economic crisis may be inducing social unrest and political instability in many countries. For the coming year 95 countries or so are judged to be at high risk of instability, compared with 35 in 2007. Bad governments and governance had left many unstable and economic downturn has only made the situation worse.

Apart from the immediate dangers of social unrest and political instability, it also points to three other dangers

1. Threats to democracy over and above outbreaks of political unrest - especially vulnerable areas are Latin America (which has a history of democracy reversals), eastern Europe (where democracy is only weakly consolidated) and Africa
2. A negative impact on economic policies and longer-term potential growth rates — in particular, there is a risk of a descent into protectionism, de-globalization, partial reversal of globalisation (globalisation in retreat) or its unwinding (globalisation sunk).
3. A host of geopolitical risks, including ultimately the outbreak of large-scale international conflicts.

Saturday, March 28, 2009

Global lender of last resort

Guillermo Calvo joins Dani Rodrik (and here) and Robert Mundell in calling for the setting up of a global lender of last resort, with capability to swiftly provide large enough sums of capital, to restore liquidity at times of crisis. All of them have argued that this institution should provide large enough liquidity facilities to protect emerging market economies from the risk of damaging sudden stops of capital inflows or delveraging as they have witnessed during the ongoing crisis and the East Asian currency crisis of the late nineties.

Deleveraging by financial institutions has devastated equity markets in emerging economies and deprived them of much needed private capital, the inflows of which fell from $928 billion in 2007 to $466 billion last year and is estimated to fall to $165 billion this year. The FIIs have fled to shore up the declining balance sheets of their beleaguered parent firms and the safety and liquidity of the American treasuries.

Just as Central Banks perform the role of lender of last resort to individual countries, there is need for a global lender of last resort to cushion economies, especially emerging and other smaller ones, from credit squeezes. This lender of last resort can even provide liquidity to private financial institutions and even entities in the shadow banking system.

Calvo argues that financial regulation without a global lender of last resort is meaningless as it still leaves the issue of credit supply during credit crunches unresolved. He proposes the creation of an Emerging Markets Fund (EMF), which would help stabilise their bond prices and insulate them from financial contagion. He also feels that such an international institution should be "endowed with considerably more firepower" than that presently available with the IMF. He argues that "liquidity crises requires that economies have rapid access to sums that are sufficient to meet short-term financial obligations, e.g., debt amortisations, and avoid a major collapse in aggregate demand".

Robert Mundell advocates a trillion dollar issue of Special Drawing Rights (SDRs), so as to provide public money to especially the smaller countries who do not have a lender of last resort. The amount 9.5 billion SDRs issued in 1970-72 would now be worth $270 billion.

Further, a global lender of last resort will reassure the emerging economies to undertake the fundamental structural reforms of their financial markets and discourage them from currency manipulations and accumulating massive surpluses.

Brad De Long, responding to Dani Rodrik's argument against strong trans-national financial regulatory institutions, says that since there are going to be sudden shocks to risk and duration tolerance on the part of global investors, we need a global institution to provide support for asset prices in an emergency — a global lender of last resort.

He writes that this institution should do two things, "First, it needs to be able to "print money" — to have its own liabilities be and be perceived to be the safest assets in the world so that when it borrows it calms markets by giving them more of the high-quality short-duration low-risk paper for which they suddenly have such a great craving. Second, it needs to know what it is buying—to have sufficient regulatory oversight and control over global finance to be able to limit the growth of potentially toxic assets beforehand and then to understand what prices it should offer when it does decide that it is time to support the market."

Friday, March 27, 2009

Balancing budget by selling power?

I have written at length about the distortions brought about by de-regulation in the electricity sector here and here. Now Businessline has more proof of the same - about how many eastern states have been cashing in on the power shortages elsewhere in the country.

The three main ways of short-term transfer of electricity between regions is through the bilateral route (directly between distribution companies and through power traders), through the two operational Power Exchanges (IEX and PXIL) and through the Unscheduled Interchange (UI) route (the incentive mechanism allowing inter-regional exchanges under the current Availability Based Tariff regime). In April-December, the weighted average sale price for electricity transacted through traders was Rs 7.90 per unit, through Power Exchanges was Rs 6.50 a unit, while that through the UI mechanism was Rs 5 a unit for the integrated NEW (North-East-West) grid.

Businessline reports that between April-January this fiscal, the states of Orissa, West Bengal, and Jharkhand exported close to 11,000 million units (MU) (of the total inter-regional exchanges of 19,181 MUs that took place in the period, they accounted for 10,839 MUs or 57% of the total exports) to other regions, although this has meant load-shedding in their respective States. Even on a conservative estimate, the power exports could have fetched them upwards of Rs 5,500 crore during the 10-month period, taking the average traded price at Rs 5 per unit. These states and others like Himachal Pradesh have been financing the state budgetary expenditures from selling power, even at the cost of imposing load relief on its own residents.

The approaching elections and the huge stakes associated with provision of electricity have only exacerbated these trends. With peak power deficits mounting (due to coming summer and increased agriculture use), State governments, many of whom are ensconced on the free-power bandwagon, are going out of way and at any cost to ensure that the popular goodwill generated by "free power" are not frittered away on election eve. These states are on the market with a mandate to purchase power at any cost, an ideal situation for profiteering for traders, generators and even many of the aforementioned power exporting states. In fact, even as the elections approach, the prices on the firm and day ahead power from traders and day ahead power from exchanges, approaches Rs 12-14 per unit and is set to go even beyond.

Update 1
FE reports that Chhattisgarh, Delhi, Gujarat, West Bengal and Punjab have emerged as the top five states selling electricity with 71.19% of total volume. Rajasthan, Andhra Pradesh, Maharashtra, Karnataka and Tamil Nadu are the top five purchasers, with 73.05% of the total volume. In February, of the total electricity generation, 3935.62 mu (6.89%) was through short-term transactions, 2148.94 mu (3.76%) through bilateral transactions (traders and distribution companies), 1569.11 mu (2.75%) through unscheduled interchange (UI) and 217.57 mu (0.38%) through power exchanges. Of the total short-term transactions of electricity, 54.60% was traded through bilateral transactions, followed by 39.87% through UI and 5.53% through power exchanges.

Oil production declines and what it means for the future

Oil industry has certain peculiar characteristics which makes it even more vulnerable to price volatility. Consider the most recent experience.

Oil prices had fallen to very low levels in the early part of this decade. It was thought that the addition of new fields had generated excess capacity and a glut in production. At such low price levels, producers naturally had little incentive to invest in exploration and investing in improving the productivity of older fields.

Then came the seven year long increase in demand (a sustained rally unprecedented in the oil insudstry history), especially from China led emerging economies and the consumption boom in the US. The reduced investments in the late nineties, meant that the producers were in no position to ramp up production in response to the increased demand. The result - oil prices sky-rocket upwards in 2007-08, touching $147 per barrel in July 2008. The high prices made hitherto unproductive reserves like the Canadian coal tar sands economically attractive to extract.

Oil now costs $46.25 a barrel, down from a peak of more than $147, and natural gas costs just less than $4 per thousand cubic feet, down from a peak of more than $13. The global economic slowdown and impending recession has driven prices down, forcing producers to again cancel or postpone their investments in exploration and capacity expansion. Many oil companies have delayed drilling in different newer areas of the world, or abandoned expensive efforts to flush extra oil from aging fields. The large inventories and reserves have also contributed to depressing prices.

It is now being argued that these cutbacks mean that oil companies will be unable to respond quickly to a future economic recovery. The excess inventories and spare capacity can turn into a scarcity as the global economy starts recovering and demand picks up, leading to another round of price spikes. The investment cycle would then start ...

The NYT draws attention to a study by Cambridge Energy Research Associates which says that the potential drop in production capacity is a "powerful and long-lasting aftershock following the oil price collapse". The report says about 7.6 million barrels a day of future supplies are "at risk" of being deferred or canceled, like heavy oil or deepwater projects, and which could bring total supplies to 101.4 million barrels a day by 2014, against the capacity projections of 109 barrels a day. Production declined in 2008 and do the same this year too, putting great pressure on meeting supply projections. It estimates that as many as 35 new projects in nations belonging to the OPEC may be delayed by 2013.

To the extent that global demand slowdown has adversely affected the oil industry and its short and medium term future is tied with the global economic propsects, Daniel Yergin, noted oil expert, feels that oil prices will depend more on the G-20 than the OPEC. He said that is now between 6 million and 7 million barrels of spare production capacity for oil worldwide, and demand for crude has fallen by 1.8 million barrels a day so far in 2009, on top of a 550,000 barrel-a-day drop last year.

It now appears that natural gas too may be following in the footsteps of oil. The NYT reports that the drilling cutback has been particularly stark for natural gas. Gas exploration had soared in recent years after technology advances enabled the exploitation of gas trapped in huge shale beds found around Fort Worth, western Pennsylvania, upstate New York and elsewhere. But that boom has created such abundant supplies that companies are not only drilling less but also deciding not to pump from wells already drilled.

As can be seen, natural gas may be following in the footsteps of its twin brother, oil, with a global market and its version of the boom-bust cycles. Natural gas in the United States costs a little over $4 per thousand cubic feet, down from a peak of more than $13 last year. On average, world spot prices for liquefied natural gas cargoes have come down by more than two-thirds since last summer.

However, it is also possible that with new capacity capable of cooling and liquefying gas for export due to come on line this year just as the economies of the Asian and European countries that import them to run their industries are slowing, global natural gas trade may expand dramatically even as prices decline to their lowest levels.

The global capacity for liquefied natural gas exports of 200 million tons a year will increase by 25% with the completion of six new plants in Qatar, Russia, Indonesia and Yemen, totaling $48 billion in investments, and the upgrading of a seventh plant in Malaysia. More large plants are due on line in 2010 and 2011. This is a legacy of the economic boom of the past two decades, and the increased demand for natural gas in the face of rising oil prices, which led to a boom in investments in natural gas exploration and refining activities.

Update 1
Nice article that seeks to rebut the Malthusian peak oil hypothesis.

Update 2
Canadian oil tar sands - a hydrocarbon paste of clay, sand, water and, bitumen — can be separated from the granular stuff and eventually refined into a variety of petroleum products and has the potential to produce upwards of a trillion barrels of oil.

However extracting oil from these sands amounts to one of the most expensive methods to extract oil from under the soil. Besides, the need to pump in huge inputs of natural gas are needed to separate and process the bitumen, generates perhaps 30 percent more greenhouse gases than conventional oil extraction.

Thursday, March 26, 2009

Geithner Plan as the second-best solution?

The critical issue in any banking system bailout is to get toxic assets off bank balance sheets and thereby remove the uncertainty about counterparty risks, recapitalize banks and get them to resume their normal borrowing and lending activities, and thereby break the de-leveraging feedback loop, restore confidence and normalcy in the credit markets.

The original Paulson Plan sought to buy up illiquid mortgage backed securities by conducting direct auctions. Then came a series of course corrections (and here) which led to equity injections with varying scope (to include other types of assets) and conditionalities.

The latest version of bank bailout plan, part of the Financial Stability Plan of the Obama administration, the Geithner Plan (simple explanation here), seeks to rope in private investors, both individually and through institutional funds, to participate in purchases of toxic assets with the incentive of dominant government stakes (both equity and debt) and non-recourse loans.

Paul Krugman has argued that the fundamental issue at hand, that is driving the debate on bailout plans, is a choice between two contrasting assessments of the health of the banking system. The Paulson Plan and now the Geithner Plan rest on the assumption that there’s nothing fundamentally wrong with the financial system, there are only misunderstood assets (as opposed to bad assets), and if investors were somehow made to share this belief, the banking system would get back to normalcy.

In contrast, if the assets are bad, and cannot be restored back to their old values, then all bailout money will only go down the drain. If this is the case (as it increasingly appears so since the underlying real estate values are unlikely to get back to their old inflated values any time soon), it is argued that nationalization is the most effective and optimal solution, with the least cost for tax-payers. In other words, the choice of options appears to boil down to one between a liquidity and solvency crisis, a result of a self-fulfilling panic or fundamentally bad investments.

Mark Thoma triggered off a debate (and here and here) on the bank bailout plans in the blogosphere by his posts comparing the markets for distressed assets with that for toxic cars. In either case, there are three choices - government to directly purchase the illiquid assets; government to subsidize and incentivize private investors to buy up these assets; and government to take over the institutions selling these products after wiping off their shareholders, stress test the purchases, write off the bad ones, and sell the rest back to the public.

The first two options come up against the uncertainty about price of the underlying asset and the extent of the problem. How much to pay or subsidize and for how many assets? The danger is two-fold - overpaying (more than what could be recovered by selling it after normalcy is restored) for the assets causing loss to the tax payer, and/or underpaying so that the cash injection is inadequate to repair the bank balance sheet and a turnaround. Supporters would however argue that if somehow the price paid is reasonable and normalcy is restored in the credit markets once liquidity is established, the government can recover its investments and even make handsome profits. The third solution, while suffering from all the same problems has the advantage of minimizing the costs to tax payer and providing a dose of certainty as to what will be the climax.

Mark Thoma again put the debate in proper perspective in an excellent post here, and argues that there is no definitively good plan and all the three, with "proper tweaks", could work. He also draws attention to the political difficulty in pushing through a nationalization solution. He writes about sticking with Geithner Plan, despite his preference for nationalization, "Trying to change it now would delay the plan for too long and more delay is absolutely the wrong step to take. There's still time for minor changes to improve the program as we go along, and it will be important to implement mid course corrections, but like it or not this is the plan we are going with and the important thing now is to do the best that we can to try and make it work." Brad De Long (and here) too takes much the same view.

Calculated Risk, as always is excellent, in describing the Geithner Plan as "sub-optimal, but... probably the best we can get in the current environment" and a "European style put option". It zeroes in on the problem with the Geithner plan as "that it incentivizes investors to pay more than market value for toxic assets by providing a non-recourse loan and with below market interest rates. The investors do not receive this incentive, the banks do. And the taxpayers pay it, so this is a transfer of wealth from taxpayers to the shareholders of the banks. This can be thought of as a European style put option - it can only be exercised at expiration. The taxpayers will pay the price of the option in the future, the investors receive any future benefit, and the banks receive the current value of the option in cash. Geithner apparently believes the future value will be zero, and that is a possibility. If so, this is a great plan - if not, the taxpayers will pay that future value."

Paul Krugman, Simon Johnson (and here), William Buiter, Steve Waldman, and Matt Yglesias have blogged about the Geithner Plan. NYT carries a debate among some of the aforementioned here. Nouriel Roubini finds some promise in the Geithner Plan.

It is now well established that the perverse incentives for agents within the financial sector and poor system design in the financial sector played a central role in bringing about the crisis. As the aforementioned economists and others point out, the problem with the second best solution like the Geithner Plan is that it leaves all the incentives and the institutional framework that caused the problem in the first place intact and risks losing a great opportunity, with the political momentum going, to reform the financial system. It also leaves intact the big banking behemoths, now ever larger thanks to the forced mergers, whose size carry inherent conflicts of interests and perverse incentives.

It is clear that if the present momentum is not seized to fundamentally restructure the banking system, we may have missed a historic opportunity. Even if the Geithner Plan were to engineer the miracle and stage a recovery, absent these fundamental reforms, it would leave the seeds for a more pernicious variant of moral hazard and set the stage for an even more devastating crisis in the future.

On a note of caution, as Calculated Risk pointed out, the Geithner Plan is vulnerable to being gamed or arbitraged by the participating banks. Naked Capitalism provides the ways in which this can be done.

The problem of bank spreads

One of the biggest challenges before the RBI is to get the banks to pass on the benefits of the repo rate cuts to borrowers by way of lower lending rates. It now appears that India is not the only country grappling with the problem of high spreads between lending and deposit rates. Russia and especially Brazil have much the same problem. It has become so acute in Brazil that the government was reportedly considering directing state owned banks to take over some small private banks and lend at lower rates.

Wednesday, March 25, 2009

Making money in recession - hedge funds in 2008

The NYT draws attention to a survey of hedge funds by the Institutional Investor’s Alpha magazine, which finds that even as the economy and financial markets slipped into recession, the 25 top hedge fund managers reaped a total of $11.6 billion in pay, which was however about half the $22.5 billion the top 25 earned in 2007. The performance of these 25 have to be seen in the context of hedge funds losing 18% on average as investors withdrew money en masse.

Four of them made more than a billion in 2008 - James H. Simons of Renaissance Technologies, earned $2.5 billion running computer-driven trading strategies; John A. Paulson gained $2 bn by betting against the housing market; John D Arnold of Centaurus Energy made $1.5 bn; and George Soros pulled in $1.1 billion.

Impact on emerging economies

The ongoing crisis offers conclusive evidence of the fact that globalization and increasing economic inter-connectedness among the economies of the world have left left everyone - developed and developing economies, rich and poor, urban and rural - vulnerable to the vagaries of global economic events and forces. The Economist outlines a few of the problems facing emerging economies

1. It has devastated equity markets in emerging economies and deprived them of much needed private capital, the inflows of which fell from $928 billion in 2007 to $466 billion last year and is estimated to fall to $165 billion this year. In 2007 African countries raised $6.5 billion in international bonds, trivial in global terms but not to Africa. In 2008, they raised nothing.

2. Remittances are a major source of income for many developing economies, accounting for 45% of GDP in Tajikistan, 38% in Moldova and 24% in Lebanon and Guyana. These were rising fast in 2005-07 and was worth $300 billion in 2008, more than aid. Now, with emigrant domestic helps and oil and construction workers in many emerging economies being laid off, these inflows are dwindling.

3. Aid, which in any case was plateauing in 2005-07, is estimated to fall by about a fifth, or $20 billion, this year.

4. Commodity exports generate a major share of income for most African economies. The double effect of declining exports and falling commodity prices have hit them hard.

American imports from middle-income countries fell 3% in the year to November 2008. But imports from poor countries fell 6%; those from sub-Saharan Africa, 12%. The African Development Bank says African current accounts, in surplus by 3.8% of GDP in 2007, will be 6% in the red this year. The fall in commodity prices puts further pressure on African budgets, already hit by declining aid, which have accordingly swung from a healthy surplus of 3% of GDP in 2007 to a forecast deficit of the same amount in 2009. This leaves no room for economic stimulus.

5. As capital inflows and export earnings vanish, poor countries face a mountain of debt: $2.5 trillion-3 trillion of emerging-market debt falls due in 2009 — as much as the American and European budget deficits, plus Europe’s bank bailout costs. The World Bank puts emerging markets’ financing shortfall between $270 billion and $700 billion.

6. Martin Ravallion estimates that 65m people will fall below the $2-a-day poverty line this year, 12m more than he had expected a month ago; 53m will fall below the level of absolute poverty, which is $1.25 a day—compared with 46m expected last month. In contrast, roughly one person in six in emerging markets had raised themselves above the $2-a-day poverty line in 2005. The World Bank reckons that between 200,000 and 400,000 more children will die every year between now and 2015 than would have perished without the crisis.

Tuesday, March 24, 2009

Mundell on who and what caused the crisis and the way out

Dani Rodrik points attention to an excellent and informative presentation given by Robert Mundell on the financial crisis and the international monetary system. Prof Mundell touches on several interesting and controversial issues like the role of soaring dollar, decision to let Lehman fail, dated spending vouchers, nationalization, euro-dollar currency system, a global lender of last resort, global currency etc.

1. The soaring dollar (the dollar appreciation overvalued US dollar assets including all fixed income securities and mortgages, tipping Lehman Bros and other banks over the edge) and falling gold price in August-September 2008, were symptoms of a shortage of tight money (despite the low interest rates) and dollar liquidity. "Had the FED recognized this shortage and bought foreign exchange to prevent the appreciation, there would probably have been no financial crisis in the fall. The Federal Reserve cut off the economic recovery in 2008(2) and tipped the economy into recession and financial crisis".

2. He claims that there was a recovery in the second half of 2008 in the US, with growth of 2.8%, which was nipped off by the policies of the government and the Fed. The decision to let Lehman fail exacerbated the crisis, greatly increasing the demand for money further, creating the casualties that followed. The failire to effectively intervene to stem the rise of dollar exacerbated the liquidity squeeze.

3. The five goats that caused the crisis
a) Lewis Ranieri - the bond trader who is credited to be the "father of securitized mortgages"
b) Bill Clinton - for repealing the Glass-Steagal Act, "prompting the era of the superbank and primed the sub-prime pump" and liberalizing the norms for mortgage lending.
c) Alan Greenspan - for keeping interest rates too low, dollar too weak, for too long, leading the housing bubble to develop; supporting sub-prime lending and variable rate mortgages; and defending derivatives.
d) Maurice Greenberg (AIG founder) - for conducting vast business in credit default
swaps (CDS) and mass multiples of derivatives.
e) Ben Bernanake - for allowing dollar to soar as the euro fell from above $1.60 in June to below $1.30 in October 08 and failing to appreciate that this appreciation would freeze the credit markets causing extreme shortage of dollar liquidity.
f) Hank Paulson - for letting Lehman fail and failing to recognize the consequences of dollar appreciation.

4. The five "trouble makers" were - securitization of mortgages (cut link between issuers and holders); derivatives (created new systemic risks);Credit-Default-Swaps (enabled insurance without ownership); Mark-to-Market Accounting Rules (created intertemporal instability in balance sheets); and Variable Rate Mortgages

5. He gives six prescriptions for the crisis
a) Issue $500 bn Dated Spending Vouchers (to expire in 3 months) to increase effective demand. Retailers would use the executed vouchers as tax credits.
b) Cut corporation tax rates from 35% to 15% to allow recapitalization of corporations and increase competitiveness.
c) Government takeover and restructuring of insolvent banks for subsequent privatization to rehabilitate the banking system.
d) Stabilize dollar-euro rate with the euro fixed at limits between $1.20 and $1.40 to avoid beggar-thy-neighbor exchange rate opportunism. The stabilization can be done gradually by creating a band of fluctuation at the margins of which the banks intervene and then narrow the band as the FRB and ECB get more comfortable at coordinating monetary policies. The dollar-euro rate to be the new anchor for the international monetary system around which an international currency can be based.
e) Establish an International Macroeconomic Advisory Council as a global version of the Volcker-Chaired Obama Advisory Council to deal with the coordination of international macroeconomic policies.
f) Issue 1 Trillion SDRS to IMF members in proportion to quotas or according to a new formula introduced to distribute the seigniorage more equitably. This would provide public money to especially the smaller countries who do not have a lender of last resort. It would also prevent the collapse of the banking systems in the rest of the world.

6. He advocates a global currency, if need be among the Asian economies, as the long run goal. He also prefers a single unit for quoting prices on major commodities, a common unit for denominating debts, a common rate of inflation for participating countries, a common interest rate on risk-free assets, and a global business cycle.

Monday, March 23, 2009

IPL - A case of externalities unaccounted for?

I am an inveterate fan of cricket, so don't get me wrong on this. There seems to be something wrong about the economics of holding cricket matches in India.

The uncertainty and debate surrounding the holding of Indian Premier League (IPL) cricket matches during the time of general elections in India throws up a few interesting issues. Amidst the debate about national pride, the ability of Indian state to provide security against terror attacks, the relative importance of cricket and elections, and a host of other issues, it is often overlooked that that big cricket matches (tests, one-dayers, T-20, and even exhibition events) have substantial externalities that make these events effectively public functions/events.

It cannot be denied that international cricket matches have long since ceased to be mere private commercial events organized by a private sporting body (the Board of Control for Cricket in India or BCCI) and viewed by ticket paying audience. Hidden from public view is the fact that cricket matches involve massive mobilization of logistics by the local administration. Everything from medical care and sanitation, provision of drinking water, arranging parking facilities (in most venues), and police bandobust to avoid stampedes and security at the stadium become the responsibility of the district administration. Massive numbers of police and other personnel are mobilized for the smooth conduct of these matches. The heightened security dimension only adds to the responsibilities of the state. That most states have demanded central paramilitary forces to assist them in conduct of the IPL games this year, is a testament to the extent of security force mobilization that is required.

In other words, cricket matches generate substantial externalities, whose costs are most often borne by those other than the organizers. As with all such externalities, the incentives get distorted if their costs are not internalized. The present confusion surrounding the IPL is a classic example of how the distortions in incentives can produce undesirable outcomes. The scheduling of the IPL matches in April-May period, despite the prior knowledge that general elections would be held at the same time, came naturally to the organizers since they were indifferent to the costs of such a decision.

After all, security and the other massive logistics were externalities to be borne by someone else. In fact, security and other external concerns are rarely under consideration when the organizers schedule the fixtures, which are then presented as a fait accompli to the local administration. If the costs of holding a cricket match were internalized, the organizers would have had to account for the heightened security concerns and take decisions after due consultations with the government.

Further, internalizing the costs of holding cricket matches includes not only paying user charges for the services utilized, but also arranging adequate parking facilities, providing good quality seating and other facilities to spectators, other public utility logistics within the stadium etc. Given the revenues generated by the sport and the huge commercial interest (after all if there were no money, businesses would not bid spectacular sums for IPL players), it is imperative that these external costs are internalized.

It is not for nothing that the local cricket associations in most bigger cities are headed by either the District Collector or Superintendent or Commissioner of Police. This, mutually beneficial arrangement (wherever the official is a cricket fan), effectively co-opts the local government administration into the cricket establishment, thereby blurring the lines between the public and private dimensions of holding a cricket match. The generous doling out of VIP passes and box seats to opinion makers takes the sting out of any major public opposition to the huge costs imposed on the public exchequer by cricket matches.

We need to bear in mind that while the players on the field play cricket and provide public entertainment, and that too for a price paid by each member of the audience, what goes outside the field is a commercial activity, more so in events like the IPL. It is unfair on the society at large, especially those not enamoured by the game, to let the private organizers of such events free-ride on public resources.

Sunday, March 22, 2009

Toxic assets relief plan (FSP) details

The NYT and WSJ have details of the much-delayed, revised version of TARP (or the Financial Stability Plan, FSP), the Geithner Toxic Assets Plan, which is to be announced early next week. Essentially, the plan is to create funds in which private investors put in a small amounts of their own money, and in return get large, non-recourse loans from the taxpayer, with which to buy bad assets. They are, as expected, in line with the Obama administration's reluctance to seize "zombie banks" and embrace nationalization of insolvent banks.

It was originally proposed under the FSP to provide government capital and government financing to help leverage private capital on a massive scale, of more than $500 bn and even a $1 trillion, to help get private markets working again. This fund, targeted at distresssed assets, was to facilitate private capital regenerate the frozen market for the real estate related assets, thereby creating a market-based valuation mechanism for them. All the proposals now being considered are based on the assumption that it is possible to revive the markets and restore the prices of the now distressed assets.

James Kwak sums up the three components being suggested as being part of the proposal,

1. The FDIC will create a new entity (an "aggregator bank") to buy troubled loans, with the government contributing up to 80% of the capital and the remainder coming from the private sector. The Fed or the FDIC would then provide low interest (1.5-3%) non-recourse loans for up to 85% of the total funding (NYT), or guarantees against falling asset values (WSJ), which more or less amount to the same thing.
2. Treasury will create multiple new public-private investment funds to buy troubled securities, with Treasury contributing 50% of the capital and the rest coming from the private sector. It’s not clear from the news stories, but I think it’s highly likely that these funds will also benefit from either non-recourse loans or asset guarantees.
3. The Term Asset-Backed Securities Loan Facility (TALF) is a program under which the Fed was already planning to buy up to $1 trillion of newly-issued, asset-backed securities (backed by car loans, credit card receivables, mortgages, etc.). The idea was to stimulate new lending in these categories. This program will be expanded to allow the Fed to buy "legacy" assets - those issued prior to the crisis. This enables the Fed to buy toxic assets off of bank balance sheets.

Kwak's assessment : "In the best-case scenario: (a) the government’s willingness to bear most of the risk encourages private investors to bid enough to get the banks to sell; (b) the economy recovers and the assets increase in price from the prices paid; (c) the investment funds pay back the Fed (which makes a small spread between the interest rate and the Fed’s low cost of money); and (d) the government gets some of the upside through its capital investments. (I think the main purpose of that government capital is to deflect the criticism that all of the upside belongs to the private sector.) In the worst-case scenario, the market stays stuck because the banks have unrealistic reserve prices. Perhaps the idea is that, in that case, the TALF will allow the government to (over)pay whatever it takes to bail out the banks."

Most of the criticism is directed at the first and second components of the Plan. Paul Krugman (and here and here) describes these plans as victory for the "zombie banks". He writes, "Treasury has decided that what we have is nothing but a confidence problem, which it proposes to cure by creating massive moral hazard. This plan will produce big gains for banks that didn’t actually need any help; it will, however, do little to reassure the public about banks that are seriously undercapitalized." More from Krugman here, as he describes thie Geithner proposal as equivalent to "cash for trash".

Since private investors would be contributing as little as 3% of the total share (one-sixth share of the 15% equity) and the government as much as 97%, and therefore having almost no skin in the game, it is being hoped that these investors can pay a higher than market price for the toxic assets (since there is little downside risk). Calculated Risk therefore says that "this amounts to a direct subsidy from the taxpayers to the banks".

Mark Thoma criticises these as give-aways to failed private banks, "The main objection is that the government will (in essence) overpay for these assets, and that will cost the taxpayers money. In the meantime, the banks - which get a windfall from the overpayment for the assets - could recover and do just fine. If the administration insists on moving in this direction rather than adopting a version of the Swedish plan, why not require some insurance against future taxpayer losses, e.g. require firms participating in the bailout to sacrifice future equity shares equal to the value of any losses that fall on taxpayers? There are probably better ways to structure this, but having such insurance in place could help with the politics of the bailout which the administration does not seem to get."

Naked Capitalism too is critical of the Geithner Plan, and other views are summarized here. Brad De Long has an FAQ of the proposals here.

In an earlier post, I had written about the Bebchuk Plan and its variants, which sought to establish many competing privately managed funds, financed with both private and public capital, to buy up the distressed assets. Then the bailout money can be allocated to these competing funds using an appropriately designed market mechanism, so as to ensure that the tax-payers get the best deal possible.

However, the fundamental issue of how to place a value on mortgage-related assets that have not been traded for months, that is at the ehart of any acceptable bailout plan, remains unresolved. The Geithner Plan does not address the central question of how to bridge the divide between what the banks want to sell the assets for and what investors are willing to pay for them. The government hopes that the subsidies it provides to investors are so rich that they will be willing to risk overpaying somewhat for the assets.

Update 1
Tim Geithner himself described the Public-Private Investment Program (PPIP), which will purchase real-estate related loans from banks and securities from the broader markets initially for $500 billion with the potential to expand up to $1 trillion over time, as having three design features,

"First, they will use government resources in the form of capital from the Treasury, and debt financing from the FDIC and Federal Reserve, to mobilize capital from private investors. Second, the PPIP will ensure that private-sector participants share the risks alongside the taxpayer, and that the taxpayer shares in the profits from these investments. These funds will be open to investors of all types, such as pension funds, so that a broad range of Americans can participate. Third, private-sector purchasers will establish the value of the loans and securities purchased under the program, which will protect the government from overpaying for these assets."

About its objective, he writes that "by providing a market for these assets that does not now exist, this program will help improve asset values, increase lending capacity by banks, and reduce uncertainty about the scale of losses on bank balance sheets. The ability to sell assets to this fund will make it easier for banks to raise private capital, which will accelerate their ability to replace the capital investments provided by the Treasury."

The attraction for private investors will be the low interest loans (effective loan subsidy) with its non-recourse nature and with limited share in the downside. The possibility of the government lending nearly 95% of the money for any investment is another major attraction.

The only investors, other than pension funds and insurance companies, with the sort of funds to participate in this program are hedge funds, private equity firms and sovereign wealth funds. These investors may be put off by the compensation caps and strict disclosure and governance rules that are likely to come with these proposals.

Update 2
More details of the Plan.

1. The FDIC would oversee a program in which banks offer bundles of whole mortgages for sale to investors, by means of an auction for each bank portfolio. The crucial incentive for investors — traditional fund managers, hedge funds, private equity funds, pension funds and possibly even banks — is that the government would lend as much as 85% of the purchase price for each portfolio of mortgages. On top of that, the Treasury would invest one dollar of taxpayer money for every dollar of private equity capital to cover the remaining 15% of the portfolio’s purchase price. The arrangement is similar to some of the distressed-asset sales arranged by the Resolution Trust Corporation for cleaning up the savings-and-loan debacle of the early 1990s.

2. The Treasury would help finance a series of public-private investment funds to buy up unwanted mortgage-backed securities, or pools of mortgages that have been packaged into bonds with a credit rating.

These two programs alone could buy $500 billion to $1 trillion worth of troubled assets. The Treasury would kick in $75 billion to $100 billion from TARP as equity.

3. The Treasury could pump almost $1 trillion more into the toxic-asset effort through a program called the Term Asset-Backed Securities Loan Facility, or TALF, a joint venture with the Federal Reserve. This program, which became operational last week, was originally created to help finance mostly new consumer loans and also some new business lending.

Securitization and risk

Securitization (practice of parcelling and selling loans to other investors) has been blamed, along with leverage, as being the prime responsible for inflating the sub-prime and other derivative bubbles. Though it was meant to disperse risks associated with bank lending among those better able to absorb risks and losses, Hyun Song Shin argues that securitization undermined financial stability by actually concentrating risks in the banking sector.

He writes, "Banks wanted to increase their leverage – to become more indebted – so as to spice up their short-term profit. So, rather than dispersing risks evenly throughout the economy, banks (and other financial intermediaries) bought each other’s securities with borrowed money. As a result, far from dispersing risks, securitisation had the perverse effect of concentrating all the risks in the banking system itself."

As studies show, approximately $1.4 trillion total exposure to subprime mortgages, around half of the potential losses were borne by US leveraged financial institutions, such as commercial banks, securities firms, and hedge funds. Including foreign leveraged institutions, the total exposure of leveraged financial institutions rises to two-thirds. So, far from passing on the bad loan to the greater fool next in the chain, the most sophisticated financial institutions amassed the largest holdings of the bad assets. The graphic below captures the story nicely.

Rising deficits and the risks in the US economy

The US Congressional Budget Office (CBO) has estimated that the White House’s tax and spending plans would create deficits totaling $2.3 trillion more than the president’s budget projected for the next decade. This coupled with the looming deficits in Medicare and Social Security, makes the medium and long term propsects for American budget balance bleak.

While the Obama budget predicts total deficits for the next decade of nearly $7 trillion, the CBO estimates it to be nearly $9.3 trillion. The annual deficits for much of the next decade are estimated by the CBO to be in the range of 4-5% of GDP, an unsustainable figure. The budget projections are based on the optimistic assumptions that the economic recovery would bring in enough revenues to cover up the accumulated deficits of the next couple of years.

As Roger Lowenstein puts it in persepctive, "over the past half century and regardless of the party in power, federal tax receipts have usually provided 80 to 90% of the money needed to fill the budget; thus, the government has had to borrow only the remaining fraction. But this year, it will need to borrow 45% (assuming a deficit of $1.75 trillion), virtually half, of what it is projected to spend."

The sharp rise in the prices of the 30 year US Treasury Bonds, reflected in the fall in yields below 3%, and warned as a possible speculative bubble by Warren Buffet, is in many ways a reflection of the long term risk perception of the US economy. The Treasuries reflect the full faith and credit of the US government and its economy, and has for long been considered the ultimate "risk-free" investment. But the global credit crunch and spiralling counter-party risk perceptions which drove global investors (and especially emerging market Central Banks) to flee to the relative safety and liquidity of the US Treasury Bonds, driving up their prices (and their yields to post-Depression lows), have cast serious doubts about the "risk-free" assumption.

These T-Bond sales have been financing the burgeoning US deficits, and the low yields have helped the Obama administration sustain its stimulus spending plans. But, as Mohamed El-Erian, chief executive of the bond house Pimco says, were the Fed to absorb surplus Treasuries, the government would, in fact, merely be "printing money", with the attendant dangers of a textbook case of inflation and erosion in the real values of the T-Bond investments as the economy rebounds.

Saturday, March 21, 2009

Health Tourism

Medical tourism, where patients from developed countries seek cheap treatment alternatives in developing countries, has for sometime now been acknowledged as a sunrise sector with enormous potential for India. A rapidly increasing number of patients from US and elsewhere have been flocking to countries like India, Thailand, Singapore, Ireland, Turkey, Cota Rica, in search of treatments like dental implants, hip and knee replacements, heart valve replacements and bypass surgery, often at a fraction of the cost (as indicated in the graphic below) in their home country.

Deflation in India - an extension of the index debate?

In many respects, the debate about deflation dangers in India is exaggerated or premature, though given the state of the global economy, one can never be sure of what lies ahead. This debate is also a result of the problems in constructing an accurate inflation measure for an economy as complex as India. This has been discussed earlier here and here.

The annual Wholesale Price Index (WPI) based inflation for the week ended March 7, touched its lowest in over thirty years to 0.44%, down from 2.43% for the previous week, falling across the board for all items.

This declines is however not reflected on the annual Consumer Price Index (CPI) based inflation rates — be it for industrial workers (IW), agricultural labourers (AL) or urban non-manual employees (UNME) — all of which have actually gone up since September 2008.

Despite the fall in WPI, the essential requirements like foodgrains, energy, basic services etc have clocked high relatively year-on-year inflation rates. In primary articles, the year-on-year inflation dipped to 4.4% this week against 5.8% the previous week, for food articles it fell to 7.4% from 8.3%, for fuel and power group it fell further to minus 6% from minus 5.1%, and for manufactured products it fell to 1.3% from 4%.

The WPI, with its distribution of weights, is a more accurate reflection of the national economy, while the CPI, for different categories of population - urban non-manual employees, industrial workers, agricultural labor - is a more accurate representation of the impact of price changes on the common man. However, the popular debate on inflation, especially in the last few months, has been hijacked by the WPI based figure, whose weekly release also contributes to its salience. The CPI figures are released monthly.

The complex and segmented nature of the Indian economy and the pre-dominance of local factors and the importance of temporary supply disruptions makes a pan-Indian indicator for inflation extremely difficult to construct. Further, the fact that the overwhelming majority of population, in both urban and rural areas, spend more than three-quarters of their income on just the essentials - food, energy, rent, basic services, utilities etc - means that conventional wisdom in inflation indices may not carry much relevance. The numerous imperfections in the price transmission mechanism from wholesale to retail level, is yet another reason for such indices, especially on the consumer side, not being able to accurately capture the inflation picture.

Further, in this case it is also being argued that the high inflation base last year coupled with the relative stability and slight decline this year has contributed to the low inflation rates this year.

Friday, March 20, 2009

Electricity de-regulation parable!

As the summer and agriculture harvest season approaches, the demand for electricity is shooting through the roof. Expectedly, the prices of electricity traded in the spot markets and the newly created power exchanges have sky-rocketed to the ranges of Rs 11-14 per unit (the maximum charged price on the end-user is only in the range of Rs 5-7). There is nothing to be surprised if prices go over the roof in the coming days and months, as this parable illustrates.

Once upon a time there was a fast growing country called Emergonia, whose people consumed widgets for their survival. It had a population of 10000 and there were ten widget makers who competed to supply widgets to their customers. Widgets, being an essential commodity, its market was tightly regulated by a Widget Regulatory Commission (WRC) of Emergonia. Widget makers had to enter into widget purchase agreements (WPAs), containing supply price details, with consumer associations (and buyers are all organized into such associations) so as to obtain permits to start business.

The demand for widgets suddenly increases and the ten widget makers, for various reasons (both natural and artificial entry-barriers), are unable to meet the demand. The shortage of as essential a commodity as widgets leads to a crisis, forcing the rulers of Emergonia to look outside for solutions.

They hear about the apparent success of Marketonia in increasing the production of widgets by de-regulation of the industry. Marketonia had set up trading exchanges, where people could enter into short-term, day-ahead, contracts to buy widgets from licensed traders, who in turn had contracts to take supply from widget makers.

So one fine day, Emergonia decided to set up a trading exchange, the Widget Trading Exchange (WTX) of Emergonia, and all new widget makers (and some older ones) were granted permission to sell varying shares of their produce in WTX. It also de-regulated the process of obtaining licenses to set up widget factories. However, the stiff qualification norms meant that only ten traders got licenses for widget trading. Further, since the construction and commissioning of a widget factory takes a few years, there was limited actual addition of widgets into the market in the short and even medium-term.

In the meantime, as Emergonia strived to catch up with other developed economies like Marketonia, the demand for widgets kept increasing exponentially. With an eye on the forthcoming elections, the new government of Emergonia gave a big filip to widget demand by providing widgets for free to the poorest 30% of the population of Emergonia! On an estimated total demand for widgets of about 1 million, the actual supply was only 0.8 million, of which 0.7 million was being supplied through the old-fashioned bi-lateral contracts and the remaining traded in the WTX.

The results were a fait accompli. The ten traders and their suppliers (some of the existing and a few new producers) had a field day making spectacular profits out of the demand-supply gap. Worse still, four of the ten traders entered into an informal understanding to fix trading prices. Further, since many of those issued permits to set up new widget factories were already owners of older plants which had also obtained permission to sell a share of their production in WTX (and they were profitting handsomely from the scarcity induced high prices), they were in no hurry to commission their new plants. The market collapsed in the face of the huge demand-supply gaps and sky-rocketing prices and left the residents (and government) of Emergonia fighting for survival. And the election results were predictable...

Then came the post-mortem. It revealed that the apparent success of Marketonia with de-regulation and trading was just that - apparent! Thanks to the time-warp in which the rulers (and more importantly the other stakeholders) of Emergonia had wrapped themselves in, they were unaware of the ultimate results of the Marketonian experiment!

Now replace Marketonia with California, Emergonia with India, widgets with electricity and we have the story (including the not-so-far future) of electricity de-regulation in India!

Thursday, March 19, 2009

Mint op-ed on global economic crisis

Here is my Mint op-ed on the circumstances that triggered the global economic crisis and the challenges that will strain global leaders in the days ahead.

More unconventional monetary policy responses

The Fed announces more unconventional responses, by deciding to pump an extra $1 trillion into the financial system by purchasing long term Treasury bonds and mortgage securities. This decision makes the Fed a buyer of long-term government bonds rather than the short-term debt that it typically buys and sells to help control the money supply (first time in over 50 years it is buying long term securities), in the hope that it will push down long term interest rates on all types of loans, especially home mortgages.

The plan consists of two parts - an additional purchase of $750 billion worth of government-guaranteed mortgage-backed securities on top of the $500 billion that the Fed is already in the process of buying, and purchase of $300 billion worth of longer-term Treasury securities over the next six months. The first is part of an effort by the Fed to act as a lender of last resort in a frozen credit market, while the second is part of attempts to bring down long term interest rates.

These expansions would expand the Fed's balance sheet to well past $3 trillion, from $900 bn in Spetember 2008. Including this, the government has made commitments of about $9.9 trillion and spent $2.2 trillion. This includes $5.4 trillion in direct investments in financial institutions, purchases of high grade corporate debt and mortgage backed securities issued by Fannie Mae, Freddie Mac and Ginnie Mae; and $2.3 trillion in overnight lending to banks, including extending terms to as many as 90 days and allowing borrowing by other financial institutions; $2.1 trillion in insuring debt issued by financial institutions and guaranteeing poorly performing assets owned by banks and Fannie Mae and Freddie Mac.

However, the magnitude of the expansion, which amounts to virtually printing money and increasing the money supply, raises concerns about the long term prospects, especially inflationary expectations and the value of dollar. Reactions from economists here.

Wednesday, March 18, 2009

Protectionism on the rise?

Real Time Economics draws attention to a World Bank report which claims that 17 of the G-20 countries have erected new trade restrictions over the past few months. It finds that developed countries have relied exclusively on subsidies, imposing 12 such measures, while nearly half of the 35 measures adopted by developing countries were tariffs. Subsidies to prop up the auto sector amount to $48 billion, with high-income countries accounting for $43 billion of that, including $17.4 billion in the U.S. alone.

Barry Eichengreen and Douglas Irwin draw on the experience of the Great Depression to argue that the only way for countries to avoid the spectre of protectionism is to co-ordinate their fiscal and monetary policies.

They write that monetary stimulus generally benefitted the initaiting country but had a negative impact on its trade partners, "The positive impact on its neighbours of the faster growth induced by the shift to 'cheap money' was dominated by the negative impact of the tendency for its currency to depreciate when it cut interest rates. Thus, stimulus in one country increased the pressure for its neighbours to respond in protectionist fashion."

As Paul Krugman said earlier, the problem with fiscal policies are that its positive policy externalities and attempts by countries to capture it locally, would lead to protectionist policies. The "Buy American" provision in the Obama administration's fiscal stimulus plan is only the most recent example. Eichengreen and Irwin write,

"Fiscal stimulus in one country benefits its neighbours as well. The direct impact through faster growth and more import demand is positive, while the indirect impact via upward pressure on world interest rates that crowd out investment at home and abroad is negligible under current conditions. When a country applies fiscal stimulus, other countries are able to export more to it, so they have no reason to respond in a protectionist fashion. The problem, to the contrary, is that the country applying the stimulus worries that benefits will spill out to its free-riding neighbours. Fiscal stimulus is not costless – it means incurring public debt that will have to be serviced by the children and grandchildren of the citizens of the country initiating the policy. Insofar as more spending includes more spending on imports, there is the temptation for that country to resort to 'Buy America' provisions and their foreign equivalents."