When tide turns, central banks are caught swimming naked?

I have blogged here and here trying to put central banking in perspective. This is one more in that line. 

The world economy has experienced nearly four decades of extraordinary macroeconomic stability. Inflation has remained low and stable, except for the global financial crisis the financial markets have largely been benign, and the geo-political environment has been conducive. The global economic output and trade has expanded, asset markets have boomed and there has been massive wealth creation, and more people have been lifted out of poverty as never before. 

There have been several contributing secular trends. They range from advances in information and communications technology to massive container shipping carriers, from the spectacular growth of China to the only less impressive growth of India and other emerging economies, from trade liberalisation to globalised supply chains, from globally integrated markets in goods and services to skilled labour, from the savings glut in Asian economies to cross-border capital flows, and so on. The net result of all this has been sharply lower communication and transportation costs, numerous positive supply shocks, an abundance of cheap capital, and a global market for goods, services, skilled labour, and capital. 

Besides all these universal trends, some others have claimed credit for this period of remarkable stability and unprecedented economic growth. The loudest claimants have been central banks and their supporters. Researchers and commentators have marshalled impressive evidence and eloquently extolled the proficiency of independent technocrats pursuing policies grounded on orthodox economic models. This resonates with the dominant narrative of the wisdom of experts and the incompetence of politicians and bureaucrats, both in equal measure in opposite directions. The whimsical actions of leaders like Donald Trump and Recep Erdogan only reinforced these perceptions. Central bankers from Alan Greenspan to Raghuram Rajan have emerged as superstars, acclaimed for their expertise and calming presence. 

It has been argued that the long-period of macroeconomic stability was an outcome of the confidence among market participants in the central banks and their technical toolkits. It's claimed that the markets have confidence in the ability of central bankers to use inflation targeting framework to keep inflation under control. Similarly markets have confidence in central bank tools like quantitative targeting, forward guidance to maintain financial market stability. In fact, this argument has been taken to its logical conclusion - all good things that happen are the outcome of central bank policies, and all bad ones are due to politicians and bureaucrats interfering with the functioning of central banks. 

Sanna Marin, the prime minister of Finland, is only the latest non-expert to question central banks and their ideologues, 

There is something seriously wrong with the prevailing ideas of monetary policy when central banks protect their credibility by driving economies into recession.

All these raise some questions. Two sets in particular stand out.

The first concern the claims of causality. How do we know whether there is a causality or it's only a coincidental correlation between the macroeconomic stability of the last four decades and central bank policies? Is central bank actions the primary driver of macroeconomic stability, or are central banks  claiming a vastly disproportionate credit for outcomes determined by a rare confluence of factors? Or have central banks only contributed at the margins by not messing it up, just as politicians have allowed central banks their operational autonomy?

It's often said of many things that the good times exaggerate their relevance just as bad times expose their limitations. When the tide is high, we don't know who are swimming naked. There is a strong case that the same applies to central banks and their role in macroeconomic stabilisation, especially of the kind we have seen over the past four decades. 

Consider inflation targeting. For nearly a decade, central banks have failed on the downside in raising inflation to the 2% target. Now central banks are struggling on the upside of getting soaring inflation back to the target. In other words, central bankers have continuously got it badly wrong in their own inflation targeting for more than a decade!

In their pursuit of inflation, they kept interest rates too low for too long, thereby distorting incentives and spawning excesses. Even as its consequences have become all too apparent, nobody has had the intellectual honesty to acknowledge the failure of central banks to realise inflation despite extraordinary accommodation and their singular role in distorting the markets by inflating asset bubbles and unhealthy financial arbitrage practices.  

Now in their efforts to control galloping inflation, itself a consequence of the nearly a decade of monetary accommodation which has generated perverse incentives and entrenched distorted expectations among market participants, they are left with throwing everything at the problem. Economic growth and public suffering be damned, if theory tells that anchoring inflation expectations require raising rates steeply and quickly. Talk about getting it wrong twice in a row, and still claiming superior wisdom!

The second set of questions concern the so-called superiority of experts. How does technical expertise in macroeconomics endow anyone with the worldly wisdom to judge whether the market can be calmed with a 50 or 75 basis points cut, or two or three cuts in a row? In fact, how does mere technical expertise with limited or no practical market experience allow for judgements on interest rate decisions that seeks to control inflation without killing economic growth? It's almost like expecting Roger Federer's coach to replicate Federer's backhands in match play!

I'm inclined to argue that the market participants belief in central bank expertise is less about their actual confidence in the central banker's abilities or their belief in some technical models and more about their fear of politicians allowing political considerations to take supremacy in monetary policy decisions. It's more that the former would do less damage than the latter could potentially do. And the antics of politicians like Donald Trump and Recep Erdogan have done as much as could have to reinforce these fears. 

  

However, as inflation rears its ugly head, financial markets are roiled, and a set of geo-political dangers threaten to become the norm, the long period of Great Moderation may be in the rear-view mirror.  This does not mean a period of recession and stagnation beckons, but more likely a period of normal growth. One where all the fortuitously congruent powerful one-off drivers of growth of the last four decades have receded and the normal course of economic growth takes over. That should be a welcome development. 

Weekend reading links

1. Peter Thiel is Exhibit A on several things which are bad with our world. Foremost, he represents one of the totemic examples of elite capture of political power. He's also an exemplar for human cognitive failing in terms of expecting expertise and success in one field to be sufficient to make them successful in another field, especially on public issues. 

And he's backed by libertarian ideologues like Tyler Cowen at Marginal Revolution blog and George Mason University's Mercatus Centre, who has serious conflicts of interests involving Thiel, considers him one of the foremost public intellectuals alive. Sample this fawning introduction,

It’s been my view for years now that Peter Thiel is one of the greatest and most important public intellectuals of our entire time. Throughout the course of history, he will be recognized as such... Peter himself doesn’t need an introduction; he has a best-selling book. His role in PayPal, Facebook, Palantir, many other companies, is well known. Peter is a dynamo. There is no one like Peter.

2. India's Nifty stock index has comfortably outperformed its peers, including developed markets, in dollar returns over the last decade. 

In the 10 years to mid-October this year, Nifty returns stand at 124% against 54.5% for the Dax and 33.8% for China’s Shanghai Composite Index. The UK’s FTSE and Hang Seng generated negative returns of 8.4% and 12.8%, respectively... The Nifty outperformed its peers despite the Indian currency being the worst performer against the dollar in the 10-year period. The rupee depreciated 60% versus the dollar, against the euro’s 23% depreciation and the pound’s 27% decline. The yuan was pegged at 6-7 to a dollar while the Hong Kong dollar moved in a narrow 7.75 -7.87 during the period.

3. The recoveries from the IBC process have been declining

However, it's still superior to the other recovery mechanisms.

For the four years until 2020-21, the recovery from IBC averaged 43.5 per cent, compared to 26.4 per cent for ARCs, 4.5 per cent for debt recovery tribunals and 4.8 per cent for Lok Adalats... By March 2022, the IBC recovery rate had declined compared to previous years. The time taken for resolution had increased to 700 days, as against the envisaged time of 330 days.

4. As European countries grapple with high energy prices every country has some market intervention in place to cushion people. Martin Sandbu examines the most incentive compatible approach in this regard. He points to the need to retain the price signal incentive that can reduce gas consumption, and therefore prefers means-tested cash compensation. He writes about the likely German approach,

It seems an amount of gas — in general, 80 per cent of consumption — will be subsidised so as to cost no more than €120/MWh. A particularly nice feature of the German proposal is that you get to keep the whole rebate that secures the guaranteed price even if you manage to bring consumption down to less than 80 per cent (the full allocation). In theory, you could come out in profit if you reduced your energy use enough as explained here. The market incentive to economise never disappears... The German reference to past consumption is far from ideal, for example, because it favours those who could afford to be profligate with their energy use — a flat allowance based on household characteristics rather than past behaviour would be better.

See this explainer by Sebastian Dullien. 

5. Bank of Japan is the undisputed leader in pioneering new frontiers in monetary policy. The latest example is its unrelenting pursuit of monetary accommodation which was initiated in 2013 by Haruhiko Kuroda and Shinzo Abe. This is despite rising inflation, the Yen plunging to a 32-year low against the dollar, and reversals across the world. And the BoJ's policy has broad consensus within the country and unstinting support from the government of Fumio Kishida. 

There is an important nuance to BoJ's policy,

Japan wants good inflation — the kind created by lively consumer demand. But it has gotten bad inflation — the kind created by a strong dollar and supply shortfalls related to the pandemic and the war in Ukraine — and that is why the bank should stay the course... In Japan, however, there is broad agreement that — at least for now — a rate rise would do more harm than good. The Japanese economy, the world’s third largest, has barely returned to its prepandemic levels, and wages have stagnated despite a labor market so tight that unemployment remained below 3 percent during the pandemic’s worst months... While inflation pressures in the United States have been broadly distributed, in Japan they have primarily hit essentials like food and energy, for which demand is satisfied largely through imports. Inflation in Japan (excluding volatile fresh food prices) has reached 3 percent, the government reported on Friday, the highest since 1991, excluding a brief spike related to a 2014 tax increase. But stripped of food and energy, Japanese prices in September were just 1.8 percent higher over the last year. In the United States, that number was 6.6 percent...

Perhaps the largest contributor, however, is a public grown used to stable prices. Producer prices — a measure of inflation for companies’ goods and services — have climbed nearly 10 percent over the last year. But Japanese companies, unlike their American counterparts, have been reluctant to pass on those additional costs to consumers. That means much of the current inflation pressure is coming from the strong dollar and supply issues affecting imports — factors outside Japan and therefore outside the Bank of Japan’s control. Under those circumstances, bank officials “know full well that driving up interest rates is not going to attenuate those price pressures — it’s just going to push up business costs,” said Bill Mitchell, a professor of economics at the University of Newcastle in Australia.

Is Xi Jinping doing to China in slow motion what Putin did to Russia in a few months?

In a recent essay in The Foreign Policy magazine, Stephen Walt analysed why governments, even well-intentioned ones, make bad decisions. Top of the pile of iconic bad decisions was President Vladimir Putin's sudden decision to invade Ukraine. The decision to invade Ukraine has been followed by a series of equally bad decisions on managing the war and public relations. 

In less than six months, Russia's superpower glory has ignominiously come crashing down, irretrievably so for the foreseeable future. Its defence forces, considered second only to the US in terms of technology and capabilities, will never be seen with any awe. The latent fears of its Slavic neighbours in its near-abroad, which has subsided in the decades after the collapse of communism, is now back with full force. It's now inevitable that EU and NATO will encircle Russia, something which Putin has fought hardest to avoid. The country has lost its most important strategic lever over Europe, energy dependency. It has ensured that a generation or more of European leaders will think twice before engaging with Russia. It has ensured that its relationship with China is now one which is more of dependency than any reciprocity. Russia has become a rogue state to the western nations, similar to the likes of North Korea, Venezuela, and Iran. 

All these have happened in a few months, thereby making the original decision salient. However, what if a similar outcome emerges over a longer period of several years, but triggered by one decision? I cannot but not avoid drawing parallels with the election of Xi Jinping as China's President in 2013 and the series of actions that have since followed culminating in his coronation as President for an unprecedented third term. Incidentally, as if timed to perfection, just before the coronation, the US gifted President Xi with perhaps the most biting US sanctions on China till date. 

The latest US sanctions banning the export of equipment and services to semiconductor manufacturers in China is a clear signature of China's exclusion from the global economic system. The export controls ban the export to China of US semiconductor equipment that cannot be provided by any foreign competitor. See this explainer for its impact. They also impose a license requirement for exports of US tools or components to China-based fabrication plants that make advanced chips and for exports of items used to develop Chinese made chip production equipment. An FT editorial wrote,

Previous sanctions on Huawei almost broke the Chinese smartphone and network gear maker. The latest restrictions not only threaten entire sectors but Beijing’s broader policy goals too. The latest US measures include restrictions on the export of advanced chips used in artificial intelligence as well as curbs on the sale of chipmaking equipment to any Chinese company... Now mass production of any type of chip will become difficult. Local makers have been catching up rapidly with design and development aspects of chipmaking in recent years. But the final stage — making chips and etching the precise patterns on silicon wafers — remains highly reliant on imported gear. SMIC uses equipment made by US chip gear makers Lam Research and Applied Materials. Secondary sanctions would extend to Dutch peer ASML, the world’s biggest supplier of advanced chipmaking gear... The arrested development of local artificial intelligence, data centres, electric and smart cars sectors could easily prove to be the heaviest technological blow the US has meted out to China.

This twitter thread says that by forcing all Americans working in Chinese semiconductor industry from leaving, the sanctions had done more than four years of Trump to "paralyse Chinese manufacturing" overnight.  

In his two-hour opening speech at the 20th Communist Party Congress, widely seen as his coronation for a historic third term, Xi focused on issues of national security and corruption, and the importance of state in the economy. He promised a larger role for socialism and the public sector. As the NYT wrote, this marked the clearest sign of China returning to its roots - "a state controlled economy that demands businesses conform to the aims of the Chinese Communist Party". He also emphasised that "state-owned capital and enterprises get stronger, do better, and grow bigger". 

From 2019 to 2021, state-owned enterprises acquired more than 110 publicly traded Chinese companies, valued at more than $83 billion, according to Price Waterhouse Coopers. Such acquisitions were rare before Mr. Xi took over in 2012; by then state-owned enterprises’ share of the economy had been declining.

This article explores the growing centralisation of powers and emergence of an authoritarian government which is now being considered less tolerant of dissent than even Russia and Iran. It speaks to three prominent Chinese academics who are now living in exile in the US,

They all believe that China, with its vast surveillance systems and punitive social control, now resembles Stalin’s Soviet Union and Mao’s China. In their view, even Russia and Iran have more space for dissent. 

This is a fascinating graphical feature on how Xi Jinping rose to power and his team of officials.  

For decades after Deng Xiaoping’s reforms in the 1990s, the leaders followed unwritten rules, such as ensuring a balance of ages and political factions across the highest echelons of the party and ceding their posts at the end of two five-year terms. This system had ensured peaceful transitions of power after 30 years of increasingly chaotic rule under Mao... This has prevented rival groups, or one individual leader, from becoming too influential. Xi has eliminated those restraints. He has achieved this by manipulating appointments to the upper echelons of the Chinese Communist party (CCP) and purging key rivals from the leadership. It is through his control of the personnel system and a sweeping corruption crackdown that he has been able to bulldoze the factions that once dominated the party, stacking key positions with loyalists and sidelining any potential challengers to his leadership...

Wang, a seasoned bureaucrat, was tapped to lead an unprecedented crackdown as Xi’s new anti-corruption tsar. The campaign was legitimised by rampant corruption across the party-state, but it soon became a tool for Xi to purge his political rivals... Among the first in a series of key military and political heavyweights to fall was Zhou Yongkang, the former head of China’s internal security apparatus and a supporter of Jiang. The arrest of Zhou shattered an unwritten rule since the end of the Cultural Revolution — under Xi, even incumbent or retired standing committee members were no longer untouchable.

This essay from Cai Xia, who for 15 years was a professor in the Central Party School, and who trained several of the current politburo standing committee, politburo and central committee members is a must read. Her prognosis is bleak,

Emboldened by the unprecedented additional term, Xi will likely tighten his grip even further domestically and raise his ambitions internationally. As Xi’s rule becomes more extreme, the infighting and resentment he has already triggered will only grow stronger. The competition between various factions within the party will get more intense, complicated, and brutal than ever before. At that point, China may experience a vicious cycle in which Xi reacts to the perceived sense of threat by taking ever bolder actions that generate even more pushback. Trapped in an echo chamber and desperately seeking redemption, he may even do something catastrophically ill advised, such as attack Taiwan. Xi may well ruin something China has earned over the course of four decades: a reputation for steady, competent leadership. In fact, he already has.

The article informs how Xi was a middling performer and how his princeling connections helped him at all levels of his rise up the Party hierarchy. It helped that many Party leaders held his father in high esteem. And Xi has repaid loyalty

After ejecting his rivals from key positions, Xi installed his own people. Xi’s lineage within the party is known as the “New Zhijiang Army.” The group consists of his former subordinates during his time as governor of Fujian and Zhejiang Provinces and even university classmates and old friends going back to middle school. Since assuming power, Xi has quickly promoted his acolytes, often beyond their level of competence. His roommate from his days at Tsinghua University, Chen Xi, was named head of the CCP’s Organization Department, a position that comes with a seat on the Politburo and the power to decide who can move up the hierarchy. Yet Chen has no relevant qualifications: his five immediate predecessors had experience with local party affairs, whereas he spent nearly all his career at Tsinghua University.

In this context, I have described the actions of President Xi as the "Xi Jinping turn", the latest example of the recurrent "bad emperor" problem the country has faced in its long history. I had identified at least four big problems with the Xi Jinping turn - roll-back of economic liberalisation and capitalism with Chinese characteristics, replacement of supremacy of the Communist Part with that of the President and associated centralisation of powers, abandoning of peaceful co-existence with outside work and adoption of needless aggression by the PLA and its wolf-warrior diplomats, and the grandiose and poorly executed Belt and Road Initiative project. This post summarises the problems created under Xi and has links to several other related posts. 

A recent FT long read expressed concern at the centralisation of power in Xi's hands. The latest is the decision to convert all agricultural fields to growing rice and wheat in the name of food security,

A rural entrepreneur in central Hubei province told the FT that he laid off 20 of his 40 workers this year after the authorities told him to turn his nursery into paddy fields. “Eight of them had been living in poverty when I hired them,” he said. “Now they are poor again thanks to President Xi’s food security drive.” A county official in Zhejiang province, where Xi served as the party’s top official from 2002 to 2007, says that he and others had no choice but to implement the government’s food security policy.. For at least one farmer in Jinhua, a city in Zhejiang famous for its flower industry, China’s leader is even more powerful than the weather. “Since ancient times, the weather was Chinese farmers’ biggest worry,” says the farmer, who was forced to close his 600 mu (100 acre) tree and plant nursery in Jinhua this year and has switched to rice. “Now our biggest risk is government policy. You never know when your farm or nursery, which until a few years ago received policy support, will become illegal,” he says.

The results of these and other decisions of President Xi could be catastrophic, 

It could dull the dynamism that has been China’s hallmark since economic reforms began more than four decades ago. And it could deprive China of the mechanisms for self-correction that the Communist party has put in place in recent decades — exposing the life of a nation of 1.4bn people to the whims of a single leader. 

The new farming edicts (to grow only rice and wheat) are in keeping with a number of other policy decisions, in areas ranging from the technology and property sectors to Covid-19, in which the costs increasingly appear to outweigh the benefits. There is mounting evidence that Xi’s dominance over the party since he came to power in 2012 — and the party’s increasing dominance over the economy and civil society — has made it much harder for China to modify, let alone reverse, potentially damaging decisions.

The bad decisions by Presidents Xi and Putin have converged in the now infamous "friendship without limits", whose limits were brutally exposed even before the ink went dry. I had blogged here about how the Ukraine invasion and the limitless friendship did incalculable damage to China. 

President Xi Jinping's legacy would be that he has single-handedly ensured China's isolation from the mainstream global economic system, and with that perhaps capped the country's future economic prospects.

Update 1 (22.10.2022)

Dramatic scenes of Hu Jintao being apparently reluctantly escorted out of the stage by two stewards. He also removed Li Keqiang and Wang Yang from the seven-member Politburo Standing Committee, replacing them with four new members, all close allies. These four, with Xi, anti-corruption Czar Zhao Leji and ideological guru Wang Huning, will now form a team full of Xi's men. One of the four, Shanghai Party boss Li Qiang, who oversaw a disastrous and unpopular Covid lockdown in the city, is likely to become the premier. More than half the members of the 24 member Politburo were also replaced. 

Kevin Rudd analyses the work report presented by Xi to the 20th Party Congress and concludes a definitive break with the past and a shift towards a statist and insular dispensation going forward aimed at making China the pre-eminent regional and global power by mid-century. 

It suggests a continuing drift away from market principles towards the more comfortable disciplines of state direction and control. While it does make reference to an earlier party mantra of “giving full play to the role of the market in resource application”, this continues to be tempered by reference to the need for “a decisive role being played by the state”. Also notable is an emphasis on national self-reliance in science and technology, the “strategic” allocation of resources for the development of new technologies and the central deployment of human capital, rather than allowing talent to move according to the competitive opportunities of the market. Add to this a call to “increase the security and resilience of China’s own industrial supply chains” in anticipation of future national security interruption...

But the most disturbing feature is the analysis of China’s rapidly evolving external strategic environment. In previous party congress reports dating back to the 1990s, there has been a standard reference to “peace and development” as the major underlying trend of our times. Until now, a benign external environment was long seen by Deng Xiaoping and his successors as underpinning China’s ability to focus almost exclusively on economic development... The absence of external threat was seen as fundamental to an almost exclusive emphasis on growth. The emphasis of Xi’s latest report is very different. These standard phrases have been dropped. It is now clear that the Chinese Communist party no longer rules out the possibility of a major war in the foreseeable future. Xi describes a “severe and complex international situation”. The party, he says, must be “prepared for dangers in peacetime” as well as “preparing for the storm”. And in doing so, Xi calls on the CCP to continue to adhere to “the spirit of struggle”. The next five years, he declares, are “critical” for the continued building of a powerful Chinese nation. He calls for “an increased capacity for the army to win”; an “increased proportion of new combat forces”; and for the promotion of “actual combat training for the military”... The central message to take away from the report is that Xi’s definition of national security has replaced the economy as China’s central focus for the future.

Some lessons from the UK political crisis

The events that have unfolded on UK's leadership transition and the bungled mini-budget over the last month or so is teachable in many respects. 

It started with a leadership revolt ousting the dysfunctional administration of Boris Johnson. In the long-drawn leadership contest, Conservative Party members elected Liz Truss. The vote was premised on her opponent Rishi Sunak as being seen as too liberal and Truss being the true Conservative. She appointed Kwasi Kwarteng, with whom she had collaborated a decade earlier in writing a book extolling supply-side tax cuts to "Unchain Brittania". In late September, the duo announced their mini-budget which entailed several tax cuts without any clear expenditure reduction proposals. The measures were universally condemned as never before by economists including by the IMF. The markets reacted by driving down the pound, British gilts and stock market. 

The duo first retreated by reversing the cut to marginal tax rate. This did not stop the revolt nor did the market pressure decrease, forcing Truss to sack Kwarteng, after 38 days in power, the shortest tenure in UK Treasury in two centuries. With Jeremy Hunt, a member regarded as belonging to the left-wing of the Conservative party taking over as the Chancellor, there is now the strong likelihood that the entire set of tax cuts look set to be reversed. Hunt has already indicated that the government went "too fast, too far" with the mini-budget. In fact, instead of just tax cuts, the Truss administration could end up enacting tax increases when he lays down the Budget later this month! 

That would be an almighty U-turn, and make Truss's continuation almost untenable.

Some observations:

1. The importance of political management before governments take major decisions. In this case, pretty much the entire Conservative party has gone up in arms against the mini-budget. This gives the impression that the decisions were taken without any internal consultations by a duo who were bent on implementing their ideological agenda immediately after taking over. The revolt in the Party has been near total and now threatens to unseat Truss herself. 

2. It's inconceivable that the mini-budget was not designed with the help of consultants and, more importantly, right-wing ideologues. The Institute of Economic Affairs has been identified as being involved. None of these consultants and ideologues (like this one) will ever be held accountable for the abject failure of their prescriptions on a market-test. They'll continue to peddle their ideologies. Academics, think-tanks, and consultants (experts in general) face no accountability for actual performance of their ideas. 

3. The timing of the mini-budget could not have been worse. The British economy was already facing strong headwinds, inflation was running riot, and a recession was imminent. The British citizens were already struggling with astronomical increases in energy prices. The global economic prospects too were weak, perhaps positioned on a cliff edge. Geo-political uncertainties around Ukraine and China-US Cold War added to the problems. It's staggering that the duo thought that they could pull this off at this time. 

4. The turmoil in the British gilt markets was another sobering reminder to governments everywhere about the extent of influence markets exercise over the economy. This "market restraint" on government policies means that governments of any ideological dispensation should think twice before taking important decisions. There should be a very strong basis for those which are radical breaks from status quo. Despite professions to the contrary by right-wing ideologues, markets are not ideological, but practical. 

5. Every financial crisis has its trigger lurking in some dark corner of the financial markets. The trigger this time was an implosion among pension funds who had been using liability driven instruments (LDI) to hedge against declines in bond prices. In the UK, LDIs have quadrupled from £400 billion in 2011 to £1.6 trillion by 2021. Sample this,

Coming into 2022, the DB pension market had grown to £1.8 tn and LCP estimates that around 85 per cent of liabilities were hedged using LDI programs.

Since corporate balance sheets have to show pension liabilities on mark-to-market basis, pension funds are forced to constantly rebalance their portfolios. This, in turn, makes them rely on derivative instruments like LDIs as insurance-type contracts to match the shortfall between their assets (bonds etc) and liabilities (pension payouts). Pension funds have to post additional cash as collateral against their LDI derivatives when the underlying bond prices decline. Once the yields on gilts rose sharply, the margin calls for cash collaterals increased steeply. This left pension funds scrambling for cash to cover their positions. 

This is a good summary of what happened,

But when UK bond yields rocketed in just a few trading sessions, it triggered emergency collateral calls for pension funds to cover their LDI-related derivatives in a matter of hours, as rising yields mean the value of bonds falls. Pension funds struggled to find the cash in such a short time, forcing some to sell gilts, thereby putting further downward pressure on the bond market... Other assets like property and corporate bonds are also being sold to raise cash, but these can be harder to sell in a hurry and some are being sold at hefty discounts... To manage the instability in markets, the Bank of England has pledged to buy gilts worth 65 billion pounds in a scheme designed to take pressure off the pension funds.

In the days ahead regulators will follow-up by mandating higher capital buffers for pension funds etc holding LDIs. But how much is adequate enough?

6. The squeeze felt in the bond markets is also a reflection of the deficiency of deep enough market makers. The regulatory changes after the financial crisis had forced banks to retreat from market making operations, leaving investment banks and other financial intermediaries to perform this role. And they have repeatedly found inadequate in such market making role. 

7. The turmoil should also have been predictable. After all, for several years now, central bank purchases of bonds had kept yields at ultra-low levels. It was only to be expected that a roll-back of the purchases, howsoever calibrated, should have its knock-on effects on market sentiments. Given the excessive extremes to which bond prices had strayed, the reversal is generating a symmetrically excessive recalibration to the other extreme. The much dreaded duration risks are now surfacing. 

8. A less discussed aspect of the whole episode has been the quiet firmness of the Governor of Bank of England, Andrew Bailey. While the BoE was forced to intervene with a bond-buying program to backstop the bond market crash, it sought to limit any moral hazard by insisting that it's only for a very short period. Bailey refused to extend the bond-buying, thereby sealing Kwarteng's fate. Score one for institutional autonomy and quiet firmness (the test of which is that it does not get widely discussed). 

9. Bailey's task was cut out - prevent moral hazard while limiting market instability. The closure of bond-buying program forced pension funds to reduce their derivatives exposure. An alternative liquidity facility was created to take the place of the bond-buying program so as to backstop the markets in a less direct manner. It'll be remarkable if the UK assets are becalmed by this tight-rope walking. Talking about doing just about enough?

10. The right-wing may have done Britain a favour with this fiasco. It has perhaps nipped in the bud any nascent signs of a return to supply-side economics. Politically too, even though there's time, the scale of the disaster may have sealed the Conservative Party's reign on power in the next elections. Conservatives are now nearly 30 points below Labour in opinion polls. 

11. Finally, the leadership vacuum in UK is stunning. As FT wrote recently, since David Cameron, the UK's leadership roll call - Theresa May, Boris Johnson, and Liz Truss - look less than ordinary and resembles Italy's rotating cast of leaders. The cupboard looks barren. 

Update 1 (22.10.2022)

The lettuce did last longer, as Truss resigned after 44 days in power, the shortest tenure by a British PM. FT summarised it well,

Truss had subjected Britain to a high-borrowing, tax-cutting, libertarian experiment which fell apart on its first contact with reality. The markets recoiled, Tory poll ratings collapsed and her government imploded.

The Truss regime took the right-wing project to its extremes,

Right from the start, Truss had a fragile political base. Although she did not win the support of a majority of Tory MPs in the leadership contest, she immediately introduced a range of radical policies, which had been years in development by rightwing think-tanks and propounded by Tory supporting newspapers, but which had not been endorsed by the electorate. It was the culmination of the Brexit project supported by many on the right, which linked notions of “sovereignty” with the idea that once freed from the EU — viewed on the right as a supranational, regulatory monster — Britain could chart a route to a future as a small state, low tax, lightly regulated economy... former prime minister Boris Johnson had... picked fights with many of the country’s institutions: the BBC, the judiciary, even parliament itself were judged to be standing in the way. Truss went further, attacking the British economic institutions that serve as a guardrail against reckless policymaking and to maintain market confidence: the Bank of England, the Treasury and the independent Office for Budget Responsibility... Truss set about cutting taxes on the wealthy... Regulations, like EU directives that protected wildlife habitats from development, were to be repealed in “investment zones”. Developers would be freed from stipulations that they should include affordable homes in their plans. An EU cap on bankers’ bonuses was scrapped. Fracking for shale gas would resume.

It did not realise that neither the markets nor the Conservative Party itself was ready for this degree of free-market,

Truss said she was ready to be “unpopular” but had not anticipated that her programme would make her that unpopular. Conservation groups vowed “direct action”, the markets took fright at Truss’s massive borrowing plans and started a fire sale of UK gilts, and the prime minister’s approval ratings plummeted to record lows. Even Truss started to recognise the limits of the government’s approach. When Jacob Rees-Mogg, the Brexit-supporting business secretary, proposed a bonfire of EU workplace rights, an ally of Truss described the ideas as “half-baked and unworkable”. City of London regulators pushed back against her drive to water down EU financial rules.

And the regime may have done enough damage to put back the right-wing experiment by several years or even decades,  

One Tory MP said simply: “She has ruined it for the Brexit project and free marketeers for a generation.”... her new chancellor, Jeremy Hunt, ripped up most of the unfunded tax cuts. A new era of fiscal conservatism, embedding the right’s hated “Treasury orthodoxy”, has been decreed by the markets and whoever becomes the next prime minister is likely to pay obeisance to them.

Also this from Timothy Garton Ash in the Times,

“The Conservatives are never going to recover the coherence that will make for good governance,” said Timothy Garton Ash, a professor of European studies at Oxford University. “This is a party that is tearing itself apart.” He traced the party’s unraveling from the 2016 referendum, called by Mr. Cameron, through Mrs. May’s futile efforts to craft a softer form of Brexit, to the uncompromising “hard Brexit” of Mr. Johnson, and finally to Ms. Truss’s experiment in trickle-down economics, which he said bore all of the hallmarks of Brexit thinking, from the derision of expert opinion to the disregard of Britain’s neighbors and the market. “It’s taking the logic of Brexit to the absurd,” said Professor Garton Ash, who has long lamented the vote to leave.

Weekend reading links

1. Interesting graphic which shows that India's current account deficit is now the third highest since 1990!

But while it's far better than 1991, in 2013 the country's external debt situation was about as good as it's now. 

2. New project announcements in India continue their downward trend, both in the government and especially private sectors. 

3. Vietnam is racing ahead of India in attracting manufacturers diversifying under the China-plus-one strategy.  

4. Fascinating infographic that highlights the economics of Costco's rotisserie chicken. Its price has not been raised from $4.99 for 3-lb piece since 2000 and is a loss leader for Costco. However, the company places rotisserie chicken at the back of the store, so that customers have to travel 60% of the store to be able to buy it (thereby increasing the likelihood of other purchases by them). 

5. Notwithstanding the Kwarteng-Truss dissonance, Rana Faroohar says industrial policy is back,

According to a senior administration official I interviewed recently, business leaders are coming to Washington and asking for a signal in the noise of deglobalisation — should they be in Vietnam, Mexico, South Carolina? Should they put investment into clean technology or biotech, or both? They are also looking for increased public support for more domestic production in the wake of the semiconductor industry’s multibillion-dollar boost.

6. AK Bhattacharya makes a point on the rising GST revenues,

Even as total GST in April-September 2022 grew by 31 per cent, the component of integrated GST or IGST levied on imports increased by 44 per cent. In other words, the share of IGST on imports in total GST rose to 27 per cent. This share was 25 per cent in the whole of 2021-22 and even lower at 22 per cent in 2019-20. It is now becoming increasingly clear that rising imports have played a significant role in sustaining the buoyancy in revenues from the GST.

7. Vivek Kaul reinforces the K-shaped recovery argument on Indian economy. 

8. Ruchir Sharma questions the conventional wisdom in the US that a strong dollar is disinflationary,

Imports amount to 12 per cent of gross domestic product in the US, about a third the average for developed countries, and have a minor effect on US prices. More importantly, the dominant dollar is used to price most global goods including 95 per cent of US imports. Thus a change in the value of the dollar does little to change the price Americans pay for these imports. This immunity is rare. Other countries pay more bills in foreign currencies and are more vulnerable to currency swings. When the dollar falls by one per cent, inflation rises in the US by just 0.03 per cent. When other currencies fall that far, inflation rises three times faster in other developed economies, and up to six times faster in emerging economies.

Instead he points to the economic risks of a strong dollar,

The key point is that the Biden administration could help to weaken the dollar without undermining the Fed’s effort to contain US inflation. In fact, America faces less risk from the dollar’s imaginary impact on US inflation than from its proven impact on the global economy. Before last week the dollar had spiked more than 20 per cent in 12 months, matching or exceeding surges that accompanied the last seven major global financial meltdowns going back to the Latin American debt crisis of the early 1990s, and including the dotcom bust of 2001 and the global financial crisis of 2008. These crises engulfed multiple countries including the US, disproving another piece of received American wisdom — that a strong dollar is a “problem” only for the rest of the world... the dollar remains at irrational highs — by one measure nearly 40 per cent more expensive than at any point since 1980 — and a further rise could trigger a global recession.

He therefore proposes a US-led effort to weaken the dollar,

Since central banks including the Fed cannot — should not — stop raising interest rates until inflation is clearly under control, co-ordinated selling is the only tool left to ease the dollar-induced stresses still visible worldwide, from low-income countries to Europe. US-led efforts to weaken the dollar have generally proved successful in the post-Bretton Woods era, particularly when these conditions are met: the dollar is seriously overvalued; speculators are heavily long the dollar; co-ordinated government intervention hits markets as a surprise; and central banks’ monetary policy is pushing currencies in the same direction. Today chances of success are good.

Not sure whether this will have receptive years in the US Treasury and Fed.

9. The Guardian has a long read on Blackstone and its residential housing investments, and how it met its match in Denmark. The PE firm has a $320 bn real estate portfolio in its total of $881 bn assets under management. It's the largest landlord in several countries, including the US. Its housing investments have been controversial,

After the financial crisis, the industry started eyeing up the places where people lived. In the US, as more and more people found themselves unable to pay their mortgages, thousands of houses became available at discounted prices. In spring 2012, Blackstone dispatched employees to hoover up such properties. It founded a subsidiary, Invitation Homes, to manage its new kingdom of houses, which spanned from Seattle to Atlanta... The firm looked for two- or three-bedroom houses in sunnier climes where an economic recovery seemed more likely. It avoided struggling cities such as Detroit or Cleveland. Invitation Homes hired local agents who knew every detail about the neighbourhood, right down to whether a street had a “weird church” or a rundown shopping parade on it... Some people who lived in Invitation Homes’ properties told journalists that it had hiked rents, seemed to scrimp on maintenance costs and imposed punitive fees on tenants. The company’s business model appeared to depend on maximising rent and fees while reducing the cost of maintenance. In this dispassionate equation, tenants seemed to be the ones who lost out... Blackstone would start to buy housing in “tier-one” cities that were home to the “industries of the future”: science, tech and creative fields.

10. Chris Miller in FT on the reshaping of technology supply chains due to the US sanctions on exports of chip making components to China. 

Previously, almost all of TSMC’s recent investment was in Taiwan or China. Now it is diversifying its fabrication footprint, building a new chip fab in Japan and exploring one in Singapore, too. TSMC’s change in tack is driven by subsidies from these governments as well as political pressure to reduce the concentration of chipmaking along the Taiwan Strait. In corporate boardrooms as well as defence ministries, concern is growing that mutually assured economic destruction may not keep the peace in the Taiwan Strait. Multinational businesses have invested many billions of dollars in both Taiwan and China on the assumption that war is simply too costly... Some foreign chip companies with facilities in China are paying the price for failing to anticipate these new restrictions. SK Hynix, one of South Korea’s two major memory chip producers, is now restricted from upgrading critical lithography equipment in its plant in Wuxi, China, which will prevent it from producing next generation chips there... As the location of semiconductor fabrication shifts, the production of chipmaking materials and supplies will, too... Apple, whose finely tuned supply chains shape how the entire industry sources components, is increasing device assembly in Vietnam and India. The biggest signal is that Apple may use different components for phones intended for Chinese customers than those sold abroad. Apple has told US legislators that it will only use YMTC’s memory chips in phones it sells within China. Operating separate “China” and “non-China” supply chains is the definition of decoupling.

11. Bill Harris, the founding CEO of PayPal, has an oped in FT on the so called fintech revolution,

Moderate and middle-income families — those making $25,000 to $75,000 a year — account for 46mn US households. Two-thirds of these families live pay cheque to pay cheque, and two-thirds report feeling “uneasy” about their financial situation... The explosion of financial products has saddled millions of ordinary Americans with traditional accounts, payment accounts and new or alternative offerings — too many complicated products with hidden fees that can cost hundreds of dollars a year. Many customers in this segment of the market have accounts at both a traditional bank and an online neobank, with multiple debit cards. About 80 per cent have at least one credit card. And too many fall into the trap of expensive overdrafts — 18 per cent of all bank account holders pay 91 per cent of the fees. American households spent close to $11bn on overdraft fees last year. There are a baffling number of ways to make payments — via an automated clearing house, prepaid cards, debit and credit cards and online payment accounts. New ways to pay at ecommerce sites add to the confusion. Half of Americans now use Buy Now Pay Later (BNPL) services like Affirm, Klarna and PayPal Credit. Many use alternative financial products such as payday loans which, in addition to carrying effective interest rates of 400-600 per cent, typically consist of a series of two-week loans over multiple months. Fintechs have brought this “short-term small-dollar” lending online. And some are peddling crypto to those who can least afford it.

His conclusion is sobering, 

The fintech explosion, which was heralded as a solution to the money problems of ordinary Americans, has too often made their difficulties worse. The proliferation of products creates confusion rather than clarity, and people have too many accounts and apps and bits of money strewn across the digital domain. We need fewer, simpler products — single apps that address multiple needs and deliver a straightforward user experience. In other words, to return to the days of offering a central place to manage — and understand — how much you have and how much you owe. 

12. Kanika Datta calls out the European hypocrisy in their condemnation of Qatar's human rights record and calls for various forms of protest during the World Cup football tournament there next month. 

The Lille mayor’s wholesale condemnation of the Qatar World Cup is a little thick considering France’s biggest club, PSG is owned by a prominent Qatari family. Manchester City wins the English Premier League with almost clockwork regularity thanks to the humungous investments by UAE’s Sheikh Mansour. Underwhelming Newcastle United recently became Europe’s richest club after it was acquired by a Saudi Arabia-led consortium, including that country’s sovereign wealth fund... Chelsea became an EPL topper thanks to the colossal amounts of money one of Vladimir Putin’s chief cronies, Roman Abramovich, poured into it for almost a decade. He was ejected only when Mr Putin invaded Ukraine.

13. Sandeep Goyal writes about how Gen Z has come to view full stops as a sign of passive aggression.

Strange as it may seem, millennials and Gen Zhave of late started to have an issue with people finishing text messages with a full stop. Calls are in fact being made for full stops to be made “illegal” at the end of text messages as they are seen to be an act of muted aggression! A recent study by Binghamton University in New York found texts ending with a full stop as being seen as “less sincere” than messages that do not end with a dot... What is wrong with putting a full stop at the end of a sentence? For Gen Z, the full stop seems to mean “mad” or “serious”, or so research shows. The full stop is an “act of aggression”, almost like slamming the door in one’s face. With young people today, sending a message to someone invariably means breaking up one’s thoughts in such a way that each thought is sent out as a new message. The message is all that is relevant; anything additional included in the message can take on an additional interpretation. Gen Z today would have you believe that the problem arises when you have a positive message ending with a full stop. That makes the message serious despite the positivity of the content. It is the juxtaposition of the positivity and the full stop that creates a sense of “passive aggression”.

Another example of woke gone rogue?

The misleading theory of doing development

From an FT Alphaville column,

There’s a fellow called Telfer who makes more pork pies than anybody else in the bloody world, old boy. So the Americans went and asked him how he did it — incentive schemes, graduated bonuses, productivity scales, vacation benefits, you know the kind of thing. “No,” he kept saying, “no, I never do anything like that, no, I just let ‘em turn the bloody things out as best they can. Oh, now I come to think of it, there is just one thing — every so often I goes down to the yard and I bawls, ‘Faster, you fuckers!’”

Terry-Thomas, as quoted in Kingsley Amis, Memoirs (1991)

There is so much earthly wisdom here. It's obviously provocative, and that's the point given the pendulum has swung universally to management driven narratives on execution. And nowhere is this more relevant than in development and public policy. It started with the private sector based new public management approaches and now represents the innovation and disruption discourse of technology start-ups. I have blogged on multiple occasions on this issue. 

It's natural for outsiders, especially those working in the private sector and in the academia, to be attracted by these narratives. There are three biases at play here. One, human mind is seamlessly attracted to logically consistent analysis of problems and solutions and struggle to comprehend and accept idiosyncratic explanations. Second, human mind tends to find new ideas as attractive as they find old and current practices boring. Three, we have an innate tendency to want to solve all our problems and that too immediately, or at least in some finite time.    

The nature of private sector activities and incentives in workplace environments allow these biases to play out. Besides, the nature of the problems as well as the general environment and incentives in the private sector (for-profit and non-profit) are suited to respond effectively to the lingo of management theories and startup innovation. Therefore, like in the private sector, it has become an entrenched belief that development problems and their solutions too should have logical basis and these problems demand disruptive and innovative solutions. 

For sure, as I have blogged earlier here and here, in the case of common public policy challenges we face innovation can help. But it's relevant mostly only at the margins. Similarly, idiosyncratic factors arising out of context, local cultures and practices, behavioural biases, and political economy are critical in solving development problems. Worse still, many of these problems have no immediate solutions. Meaningful enough solutions lie in development and economic growth. 

Precious little has changed over time in how we teach kids, acquire skills, treat patients, acquire nutritional food habits, maintain cleanliness and hygiene, adopt good farming practices, control traffic congestion and so on. Solutions on all these problems have to account for their idiosyncratic factors. Technology innovations can generally help only in marginally supporting the traditional approaches of development. Further, many of these problems will get resolved gradually over time and new solution approaches will become possible on the way. 

These are really hard insights to comprehend, much less internalise. In its absence, we'll be led by our biases in applying misleading approaches to development problems.   

Ten observations on large urban renewal projects

Urban renewal projects are a recurrent topic in this blog. This was the last post about the redevelopment of Midtown Manhattan around the Penn Station. 

The FT reports of the inauguration of the redeveloped 1930s era Battersea Power Station complex in London after a £9 billion regeneration project that would contain homes, offices, and shops. The 42-acre site is redeveloped by Battersea Power Station Development Company, which is owned by a Malaysian Pension Fund. The project has been under development for nearly 40 years since the power generation from the plant stopped in 1983. 

A brief description of the development,

The 42-acre site, which includes a number of residential and office blocks as well as 250 shops, cafés and restaurants, a theatre, hotel and public space, as a “new town centre for London”. The building’s old turbine halls have been converted into an upmarket retail space — with luxury brands such as Cartier and Rolex, alongside Adidas and Superdry — that takes up the majority of space on the ground floor. With Westfield shopping centres in the west and east of London, the former coal-fired power station will become the southern point on a triangle of malls, with the West End nearby...

Apple has taken six floors of offices in the renovated power station in what is one of the biggest leasing deals in London in recent years... Above Apple’s offices, the building houses 254 residential apartments and a roof garden. One of its four white chimneys, a legacy of its days as a working power station, has a glass lift to the top that will be open to — and paid for — by the public. The original power station started producing electricity in 1935. The art deco architecture of the time is well preserved in one half of the building and most clearly seen in a control room that is being turned into an events space. Its panels once controlled the power for a fifth of London, and include a board labelled Carnaby Street 2 that once linked to Buckingham Palace. The other half of the building was added after the second world war, by which time architectural trends had moved to the 1950s-era steel and “space age”. This corresponding control centre will be converted into a 1950s-themed bar.

This is the short history of the redevelopment efforts,  

The plans for the power station site, which is owned by a consortium of Malaysian investors and developers, will finally see the building brought back to use for the first time since the power was cut off in 1983. In the past, the building has attracted owners from Hong Kong, Ireland and the UK, with various aspirations to turn it into a theme park, hotel and even the base of a 300m glass chimney. But the site has largely remained untouched over the decades as its owners have either gone bust or sold out — in the 1990s it was even left without a roof for a period after the project ran out of funding. The Malaysian-pension fund backed consortium bought the site in 2012 from its receivers for £400mn. The new project has already attracted criticism over its lack of affordable housing, fuelling concerns over the number of empty flats built along a stretch of the Thames that is already blighted by soulless blocks... planning consent for the remainder of the site, which had previously featured “some really very large buildings”, had been updated to give greater flexibility in terms of future use, building shape and size, “which is useful at a time when the developers’ crystal ball is a bit foggy”.

London is remarkable for the number and scale of its redevelopments - King's Cross, Victoria Station, London Bridge, Liverpool Street, Greenwich etc.

This is a teachable example and points to several insights that are relevant for all redevelopment projects.  

1. Such projects are always long in cooking and take a very long time to get cooked. It will take-off only when there is a confluence of policies, developers, market prospects, social acceptance, and political support for the project. It's only natural that it takes long years for such confluence to materialise. 

2. Not just the financial life of these projects (time to recover investments), even the project development phase span multiple business cycles. Besides, the project revenue streams and their revenues are uncertain at the beginning and emerge only over time. This demands visionary investors with very high risk-appetite. The high risk nature also means that the patient long-term investors who wait out should be allowed to reap high returns. 

3. Infrastructure or other funds, with multiple investors and long investment time frames, are best placed to assume these project risks. Besides they are also more likely (than large property or infrastructure development companies) to hire professional managers and be comfortable with arms-length ownership. Since their incentives are aligned towards maximising value capture, they are likely to procure the best professionals with the capabilities to market the project aggressively by forging networks and creating eco-systems (critical to maximising value capture). Such arms-length relationships are generally difficult for large property or other infrastructure contractors. 

4. Given the long gestation and the tenuous viability of these projects, especially in their development phase and early years, it's natural that these projects will involve periodic renegotiations and requests for public support. Governments and the society at large should be open to considering these requests. The environment of vigilance enquiries and media trials are a big deterrent to such projects. 

5. The uncertainties and long-gestation mean that such projects invariably involve multiple takeouts, even during the development phase, involving different categories of investors. So flexible and complex financing structures are essential. 

6. Urban planning instruments and property tax concessions are critical in shaping the financial viability and the development trajectory of these projects. Since unlike public finance investments these instruments do not involve budget allocations (though they involve revenues foregone), governments have significant flexibility in deploying them. And since they generally involve concessions on recurring revenues and the value capture on the property investments is generally back-ended, these are financially significant for the project. 

7. Apart from planning instruments, infrastructure connectivity public investments are critical to their success. In fact, all the aforementioned examples from London revolve around the old metro railway stations. The metro station and its connectivity provides the anchor around which the entire redevelopment  happens. 

8. Such projects invariably create a vocal constituency of opponents who mobilise political support against it. While the majority of population would welcome these projects, their diffuse and weak support is more than overwhelmed by the concentrated and loud opposition by the small minority. The strengths of the opposition and support waxes and wanes over time. The developers should have the appetite to ride out these political cycles.

9. The scale and very nature of these projects mean that they are less about infrastructure development but more about branding and marketing, creating eco-systems and jobs, and catalysing activities that contribute to the development not only the project area but of its larger conurbation. This cannot be undertaken by non-local project entities, but have to be led entities grounded in the local government and community. This is an important reminder about one of the important weaknesses of the railways station development projects undertaken by Government of India through a distant central government entity called RLDA as primarily a station rebuilding project.  

10. Finally, these projects require high quality and deeply committed long-term leadership, with the vision to plan for and wait out business cycles.