Industry's first quarter growth is closely linked to the full year's growth - in which case, write off this year.
With higher interest rates putting pressure on both the demand and supply sides, there is a lot of concern about whether industrial growth will pick up. On the demand side, fewer goods are demanded that depend on credit such as automobiles, consumer durable goods, and housing. This in turn affects the output of these industries, causing them to cut back on investment which slows down overall growth. On the supply side, higher interest rates make borrowing expensive and companies defer investment plans. Holding costs of inventory increase and affect the bottom lines of companies.
The most recent number for industrial growth has been put at 5.2 per cent for the first quarter of the year. What is one to make of it? Relative to last year, this number is quite low as it was 10.3 per cent last year. The high base year effect is a plausible explanation, though there is still considerable scepticism about this. Does this mean that growth will be low by the end of the year? At a theoretical level, the period up to August or so is considered to be the slack season because typically one would not be spending too much on consumption goods during this period. Normally, people spend more during the festival season that starts from August onwards. We have Raksha Bandhan, Janmashthami, Ganesh Chathurthi (in the west), Dassera, Diwali, Christmas, and New Year that are associated with festival spending. This happens all across the country where people invest in a variety of things, right from clothing for the family to dwellings. The idea being that purchasing is associated with an auspicious occasion.
As we move to rural areas, the harvest factor also plays a role. Typically the kharif harvest begins in October or so and goes on through till December. It begins again in the months of April and goes on till May when the rabi harvest begins. Therefore, spending again increases from the Baisakhi-Holi time, albeit at a slower rate since festival season is over. Against this background, the argument goes, one should not be startled at a lower industrial growth rate in the first quarter of the year as this is how it should be.
This was the school of thought for a long time when the RBI also called its credit policy the slack season policy from April to October and the subsequent period was called the busy season. In fact, in the past, there was a tendency for the RBI to try and complete 60-70 per cent of the government’s borrowing programme in the first half of the year when there was less demand from the commercial sector. However, in the last decade or so, the RBI has given up differentiating between the two seasons as the tendency for spending has evened out through the year. Therefore, demand for credit today is considered to be an element that needs to be monitored throughout the year and hence deserves attention. It is not surprising that the RBI has resorted to monetary action at any time of the year unlike in the past when the second half mattered more.
In fact, it is often said that the quickest way to gauge economic confidence levels in the country is to count the number of “sales” that are going on around in the country. Usually, as stated earlier, these discount sales are meant for the festival season where dealers compete to garner a greater share of the consumers’ wallet. However, this year, the competitive discount season has begun earlier for all the consumer goods segments. This holds for automobiles and housing projects too where the spectre of higher interest rates in the future is being used to attract customers to get into deals immediately. Independence Day has now become a landmark day for potential customers!
In this context it would be useful to see how annual growth in industrial output has behaved relative to the growth in the first quarter. More importantly, is it possible to conjecture the extent of overall growth based on the information of first quarter?
As can be seen from the table, there is very strong correlation between the growth rate witnessed in the first quarter of a year and the growth for the entire year (around 85 per cent). Low growth in the first quarter invariably translates into a low growth for the entire year, while a high growth rate may not necessarily do so. Hence, looking at a growth rate of 5.2 per cent in the first quarter, based on past experience, it may be conjectured that industrial growth for the entire year would be at best between 6.5 per cent and 7 per cent.
Coincidentally, the projections of the Economic Advisory Committee of the PMO (EAC) had scaled down GDP growth projection for the year to 7.7 per cent and that of industry to 7.5 per cent. This could be attributed to both the high interest rate regime as well as the high base year effect where industrial growth has been greater than 8 per cent for four successive years while peaking at 11.5 per cent in FY07.
In which case, we need to revisit the calculations for GDP growth this year, where the monsoon will be critical as agriculture will play a decisive role in determining the final figure. With a 7 per cent growth rate and a 20 per cent share in GDP, industry will contribute a maximum of 1.4 per cent to GDP growth, while agriculture with a share of 17 per cent will need to clock 4 per cent to add another 0.7 per cent. We would still be need services to grow by 9 per cent to end up with a final number of 7.8 per cent. Can this be done?
Thursday, August 28, 2008
Tuesday, August 26, 2008
After the Godzilla Effect: Financial Express: 26th August 2008
Banking was a rather somnolent business until 1992 when bankers simply waited for the customers to walk up to them, because the latter didn’t really have many choices. Then the force of competition ushered in by the implementation of the Narasimham Committee Report changed this landscape substantially. The entry of new private banks and the spread of foreign banks added momentum to these changes. But the strategies that initially took innovative routes have ironically returned to a pre-reforms mode typified by conservatism. Consider the following u-turns:
New private banks have usually been innovative trendsetters. They were the first ones to introduce technologies like ATMs and phone banking and Internet banking, which were swiftly accepted by their customers. Till a short time ago, there was immense competition among these banks to grab ATM leadership. First, ICICI Bank claimed this spot, but SBI soon let it be known that it was the one with the highest number of ATMs in the country. But now the RBI is encouraging banks to share their ATMs to save on equipment costs, and the numbers game has become non-existent.
Secondly, in the initial post-reforms phase, banks were keen to attract customers by giving out bundled products such as cards, loans etc. The idea was to reach out to as many customers as possible and garner market share. The move was towards mass banking. Today, however, banks want only high-end customers and have changed tracks.
On the lending side, banks initially went in for big-ticket customers as the Godzilla effect took shape. Corporates were segregated into large and small categories, with the focus being on the larger ones that were expected to help maintain better quality portfolios. While the private banks took the lead here, the public sector banks also followed the same route to keep in the race. Today banks have switched over to the SME route on the grounds that this is category with the larger potential, and also has a healthy track record.
There was also a time when banks were rushing into the retail segment. The idea was that housing loans were safe bets with low default rates. Besides, as houses were hypothecated to banks, there was reason to believe that these loans could not go bad. Banks hence lent extensively to this sector and set up special divisions for the same. Low interest rates and longer tenures were the attractionsHowever, with interest rates climbing of late and the shadows of the sub-prime crisis hanging over us, banks are fast withdrawing from this segment. They are increasing rates to better protect their bottom lines, and trying to ensure better repayments by focussing on high-end customers.
Earlier, banks were offering variable lending schemes where borrowers had the choice of fixed and flexible interest rates. This was at a time when the flexible schemes made sense because rates were poised southwards. With interest rates going up lately, these options are hardly exercised anymore, and we are seeing only fixed rates in both the deposits and loans segments.
Also, in the post-reform period, the basic mantra for expansion has been one of taking over smaller banks in order to reap economies of scale: one got branches, customers, business and skilled staff through such mergers. Today the sector is wary of mergers, especially since there is now the possibility of foreign banks actually taking over Indian banks after 2009, when this sector is opened up.
These u-turns mean that the current landscape is characterised by well-diversified conventional portfolios and stable rates rather than variable rates. On the deposits side, customers are returning to the branches even though other modes have been remarkably well accepted. While mass banking is still the preferred choice today, class banking is increasingly being prioritised. In short, the overall approach to strategy appears to have come full circle, or almost.
New private banks have usually been innovative trendsetters. They were the first ones to introduce technologies like ATMs and phone banking and Internet banking, which were swiftly accepted by their customers. Till a short time ago, there was immense competition among these banks to grab ATM leadership. First, ICICI Bank claimed this spot, but SBI soon let it be known that it was the one with the highest number of ATMs in the country. But now the RBI is encouraging banks to share their ATMs to save on equipment costs, and the numbers game has become non-existent.
Secondly, in the initial post-reforms phase, banks were keen to attract customers by giving out bundled products such as cards, loans etc. The idea was to reach out to as many customers as possible and garner market share. The move was towards mass banking. Today, however, banks want only high-end customers and have changed tracks.
On the lending side, banks initially went in for big-ticket customers as the Godzilla effect took shape. Corporates were segregated into large and small categories, with the focus being on the larger ones that were expected to help maintain better quality portfolios. While the private banks took the lead here, the public sector banks also followed the same route to keep in the race. Today banks have switched over to the SME route on the grounds that this is category with the larger potential, and also has a healthy track record.
There was also a time when banks were rushing into the retail segment. The idea was that housing loans were safe bets with low default rates. Besides, as houses were hypothecated to banks, there was reason to believe that these loans could not go bad. Banks hence lent extensively to this sector and set up special divisions for the same. Low interest rates and longer tenures were the attractionsHowever, with interest rates climbing of late and the shadows of the sub-prime crisis hanging over us, banks are fast withdrawing from this segment. They are increasing rates to better protect their bottom lines, and trying to ensure better repayments by focussing on high-end customers.
Earlier, banks were offering variable lending schemes where borrowers had the choice of fixed and flexible interest rates. This was at a time when the flexible schemes made sense because rates were poised southwards. With interest rates going up lately, these options are hardly exercised anymore, and we are seeing only fixed rates in both the deposits and loans segments.
Also, in the post-reform period, the basic mantra for expansion has been one of taking over smaller banks in order to reap economies of scale: one got branches, customers, business and skilled staff through such mergers. Today the sector is wary of mergers, especially since there is now the possibility of foreign banks actually taking over Indian banks after 2009, when this sector is opened up.
These u-turns mean that the current landscape is characterised by well-diversified conventional portfolios and stable rates rather than variable rates. On the deposits side, customers are returning to the branches even though other modes have been remarkably well accepted. While mass banking is still the preferred choice today, class banking is increasingly being prioritised. In short, the overall approach to strategy appears to have come full circle, or almost.
Tuesday, August 12, 2008
Cracks in the Communist Citadel: 12th August 2008
The Chinese citadel appears to have finally developed some cracks. China is now a country that is looked at with a growing degree of suspicion. Curiously, the reasons are both political and economic, with the most recent trigger for dissatisfaction being Tibet. In fact, even the Olympics preparations were marred by tales of distress caused to the local population by the government to placate its own ego. Add to this the sympathies with rogue regimes in Sudan, Myanmar and North Korea, the scales get tipped even further.
With China’s progress now coming under the lens, there are some interesting facts which have been brought to the forefront. First, while Chinese economic numbers have always been suspicious, the theory now doing the rounds is that GDP growth numbers are overstated. This is so because they are collected from the provinces which have a tendency to over-report to be on the right side of the government. Further, growth in industrial production or services does not match with the overall growth numbers of the economy. The relevant question is, where is growth coming from?
Second, inflation numbers that have been quoted at low levels are being attributed to repression in areas of health, transport, education as they are state governed, which tends to understate the true picture. Food prices, too, are partly controlled and hence the country is buffered against the present inflation which has swept almost all nations.
Third, China is supposed to have started a new kind of colonialism wherein it consumes the bulk of natural resources available in the world. China accounts for half of the pork consumed, a third of steel produced, nearly 80% of the copper used, a quarter of aluminium consumed and half of total cereals produced in the world. Its consumption of imported soybean and crude oil has increased by 35 times since 1999. This was what colonialism was all about: in the 19th century it was through conquests, while it is legitimately done through the channel of foreign trade today.
The quality of the growth story does not look good as it involves the running of sweatshops where labour is virtually bonded to produce cheap goods while being kept at a subsistence level. Hence, the manner in which price competitiveness has been achieved would not be politically correct in a free society. Fifth, the quality of goods produced is not always world-class as has been seen in case... of electronics or even toys, where it was found that Chinese toys contain toxic substances. Sixth, China is one of the largest polluters in the world as its quest for industrial growth has led to the degradation of the air as well as water. Curiously, the power consumed in the steel industry is higher than what goes into households, and this has resulted in such degradation.
There are also other economic distortions that have resulted from the process of rapid growth, which will impact its own functioning, notwithstanding controls being exercised by the state. The first is, unbalanced growth in favour of industry which has lowered the quantity of arable land. Land was forcibly used for industrialisation as a result of which there is less space available for cultivation and greater demand for imports. At the same time, China has put restrictions at times on exports, thus tilting the global price scales. The demand for farm products, energy and minerals has pushed up global prices at a time when the world is struggling with a financial crisis and central banks are grappling with their monetary policies. Add to this the policy of not appreciating the currency and artificially pushing down the interest rates—-China has in fact encouraged indiscriminate lending by state-run banks, which have officially reported non-performing loans in the region of 5-10%, though analysts suspect it could be over 20%.
What then is one to make of the whole story? China remains a leader despite the political dogma which still is a hard nut to crack. Considering that future growth will still be driven from this side of the world, there is a need for introspection by the government about cleaning up the mess which is being created along the way as it is bound to rebound perversely at some point of time.
With China’s progress now coming under the lens, there are some interesting facts which have been brought to the forefront. First, while Chinese economic numbers have always been suspicious, the theory now doing the rounds is that GDP growth numbers are overstated. This is so because they are collected from the provinces which have a tendency to over-report to be on the right side of the government. Further, growth in industrial production or services does not match with the overall growth numbers of the economy. The relevant question is, where is growth coming from?
Second, inflation numbers that have been quoted at low levels are being attributed to repression in areas of health, transport, education as they are state governed, which tends to understate the true picture. Food prices, too, are partly controlled and hence the country is buffered against the present inflation which has swept almost all nations.
Third, China is supposed to have started a new kind of colonialism wherein it consumes the bulk of natural resources available in the world. China accounts for half of the pork consumed, a third of steel produced, nearly 80% of the copper used, a quarter of aluminium consumed and half of total cereals produced in the world. Its consumption of imported soybean and crude oil has increased by 35 times since 1999. This was what colonialism was all about: in the 19th century it was through conquests, while it is legitimately done through the channel of foreign trade today.
The quality of the growth story does not look good as it involves the running of sweatshops where labour is virtually bonded to produce cheap goods while being kept at a subsistence level. Hence, the manner in which price competitiveness has been achieved would not be politically correct in a free society. Fifth, the quality of goods produced is not always world-class as has been seen in case... of electronics or even toys, where it was found that Chinese toys contain toxic substances. Sixth, China is one of the largest polluters in the world as its quest for industrial growth has led to the degradation of the air as well as water. Curiously, the power consumed in the steel industry is higher than what goes into households, and this has resulted in such degradation.
There are also other economic distortions that have resulted from the process of rapid growth, which will impact its own functioning, notwithstanding controls being exercised by the state. The first is, unbalanced growth in favour of industry which has lowered the quantity of arable land. Land was forcibly used for industrialisation as a result of which there is less space available for cultivation and greater demand for imports. At the same time, China has put restrictions at times on exports, thus tilting the global price scales. The demand for farm products, energy and minerals has pushed up global prices at a time when the world is struggling with a financial crisis and central banks are grappling with their monetary policies. Add to this the policy of not appreciating the currency and artificially pushing down the interest rates—-China has in fact encouraged indiscriminate lending by state-run banks, which have officially reported non-performing loans in the region of 5-10%, though analysts suspect it could be over 20%.
What then is one to make of the whole story? China remains a leader despite the political dogma which still is a hard nut to crack. Considering that future growth will still be driven from this side of the world, there is a need for introspection by the government about cleaning up the mess which is being created along the way as it is bound to rebound perversely at some point of time.
Monday, August 4, 2008
Pains and Gains of Credit policy: Financial Express: 4th August 2008
This was one of the rare occasions when everybody got it wrong. Most economists and treasurers expected no change in the policy, while some of the more aggressive ones pitched for a repo rate hike. But, the RBI, which has developed a knack of surprising markets, which is what the Rational Expectations School would have supported, did the unexpected i.e. raising both the repo rate and the CRR. The markets, naturally were taken aback.
Taking any policy decision on the 29th was going to be a tough decision considering that the RBI had to really toss for either inflation or growth. Growth appears to be a downward path and inflation well entrenched at a double-digit mark. As neither lower growth nor high inflation are acceptable, especially since the next general elections will hopefully be held against the backdrop of these two numbers, the rational belief was that RBI would do nothing to hurt growth, while inflation would be guided by past policy decisions as well as improvement in real sector supplies.
By opting to increase the CRR and repo rate, RBI has made it clear that it is antagonistic towards inflation. Further, by talking of a rate of 7% towards the end of the year, it does hope that these measures work.
There are two parts to this story, which is the case with all monetary policies. One needs to closely look at both inflation and growth.
Inflation today is a cost-side driven phenomenon and therefore cannot be directly affected by monetary policy. If there are shortfalls in foodgrains production or oilseeds output, no amount of monetary tightening will help. Money supply growth is increasing but the growth in credit is more due to the higher lending to the oil companies rather than an industrial revival. In fact, as discussed later, industrial growth has slowed down. Such lending will carry on nonetheless as it has to be done.
There can be two explanations behind raising interest rates to control inflation. The first is that inflation has now reached a stage where there are negative real interest rates. With inflation ruling at 12% a deposit holder with an interest rate of 10% is actually still in the negative territory by 2%. But, by raising the interest rates by 50 bps we are only narrowing the gap and not eliminating the same. In fact, if this is going to be a policy decision, then there are hard times signalled for the future. The second reason could be that RBI would like to stifle inflationary expectations such that overall spending through borrowing is curbed, which will moderate the build-up of demand-pull forces. The thought process here is that inflation as such is not as dangerous as inflationary expectations. If all expect inflation to go up, and then inflation will move up - a self-fulfilling prophecy. By raising rates now, people will automatically spend less, thus either reducing demand or deferring the same, both of which will lead to lower inflation. This is the approach the European Central Bank has also taken when increasing its benchmark rate a while ago.
However, what is interesting here is that since March 31, 2008, RBI has increased the CRR by 125 bps and the repo rate by 75 bps (before this policy). But, inflation has not really come down and remains in the double-digit level. While it is not clear as to the exact time taken for these measures to bear fruition, it is felt that the period would vary between 2-4 months. Therefore, if these rate hikes have to work, they should be doing so now.
The second part of the story is growth, and industrial advance has been tardy during the first two months of the year, and the symptoms are not too encouraging. There are no real signs of large investment taking place. Overall corporate performance appears to have slowed down this year and the increasing interest rate regime is part of this story. By raising rates further, there is a possibility of the slowdown becoming more acute.
High interest rates affect the industry on both the demand and supply sides. On the supply side higher rates increases costs for companies, which may prompt them to defer investment plans, especially if growth is already sluggish.
On the demand side, interest rates affect consumer behaviour. Two major boosters for industrial growth on the demand side come from mortgage finance and auto cum consumer durable loans. When people borrow smaller quantities of money when rates go up, then the demand for housing comes down. This has a backward linkage effect on the cement, steel, machinery and electrical equipment sectors. Lower demand for consumer durable goods and automobiles will again affect the auto and ancillary sectors, durables segment, steel, glass, machinery and electrical equipment industries thus calling... for a review in expansion plans.
RBI has hence, definitely opted for the inflation path and has put the growth objective on the sidelines. But, the perplexing part of the policy has been the move to increase the CRR. Banks presently are facing a shortage of funds and are making use of the LAF facility to the tune of around Rs 30,000 crore. By raising this rate, RBI will be forcing banks to borrow more from the RBI through the repo window where there will be paying a higher price. It is hence a double whammy for the banks that have fewer resources to lend as RBI is impounding resources on which no interest is being paid. Further, they have to borrow the same funds from RBI at a higher rate now through the repo window.
What are the likely effects of these moves? The first is that the banks' profitability will be affected as their cost of funds goes up and they have to book losses on their investment portfolios. The industry will invest less now, which will impact overall GDP growth. Inflation may be tempered, but that will mainly be due to better supply conditions and only partly due to the monetary squeeze. Individuals however, can be happy that they are less worse-off than that before as their real interest loss narrows down. But no real gainers, only losers.
Taking any policy decision on the 29th was going to be a tough decision considering that the RBI had to really toss for either inflation or growth. Growth appears to be a downward path and inflation well entrenched at a double-digit mark. As neither lower growth nor high inflation are acceptable, especially since the next general elections will hopefully be held against the backdrop of these two numbers, the rational belief was that RBI would do nothing to hurt growth, while inflation would be guided by past policy decisions as well as improvement in real sector supplies.
By opting to increase the CRR and repo rate, RBI has made it clear that it is antagonistic towards inflation. Further, by talking of a rate of 7% towards the end of the year, it does hope that these measures work.
There are two parts to this story, which is the case with all monetary policies. One needs to closely look at both inflation and growth.
Inflation today is a cost-side driven phenomenon and therefore cannot be directly affected by monetary policy. If there are shortfalls in foodgrains production or oilseeds output, no amount of monetary tightening will help. Money supply growth is increasing but the growth in credit is more due to the higher lending to the oil companies rather than an industrial revival. In fact, as discussed later, industrial growth has slowed down. Such lending will carry on nonetheless as it has to be done.
There can be two explanations behind raising interest rates to control inflation. The first is that inflation has now reached a stage where there are negative real interest rates. With inflation ruling at 12% a deposit holder with an interest rate of 10% is actually still in the negative territory by 2%. But, by raising the interest rates by 50 bps we are only narrowing the gap and not eliminating the same. In fact, if this is going to be a policy decision, then there are hard times signalled for the future. The second reason could be that RBI would like to stifle inflationary expectations such that overall spending through borrowing is curbed, which will moderate the build-up of demand-pull forces. The thought process here is that inflation as such is not as dangerous as inflationary expectations. If all expect inflation to go up, and then inflation will move up - a self-fulfilling prophecy. By raising rates now, people will automatically spend less, thus either reducing demand or deferring the same, both of which will lead to lower inflation. This is the approach the European Central Bank has also taken when increasing its benchmark rate a while ago.
However, what is interesting here is that since March 31, 2008, RBI has increased the CRR by 125 bps and the repo rate by 75 bps (before this policy). But, inflation has not really come down and remains in the double-digit level. While it is not clear as to the exact time taken for these measures to bear fruition, it is felt that the period would vary between 2-4 months. Therefore, if these rate hikes have to work, they should be doing so now.
The second part of the story is growth, and industrial advance has been tardy during the first two months of the year, and the symptoms are not too encouraging. There are no real signs of large investment taking place. Overall corporate performance appears to have slowed down this year and the increasing interest rate regime is part of this story. By raising rates further, there is a possibility of the slowdown becoming more acute.
High interest rates affect the industry on both the demand and supply sides. On the supply side higher rates increases costs for companies, which may prompt them to defer investment plans, especially if growth is already sluggish.
On the demand side, interest rates affect consumer behaviour. Two major boosters for industrial growth on the demand side come from mortgage finance and auto cum consumer durable loans. When people borrow smaller quantities of money when rates go up, then the demand for housing comes down. This has a backward linkage effect on the cement, steel, machinery and electrical equipment sectors. Lower demand for consumer durable goods and automobiles will again affect the auto and ancillary sectors, durables segment, steel, glass, machinery and electrical equipment industries thus calling... for a review in expansion plans.
RBI has hence, definitely opted for the inflation path and has put the growth objective on the sidelines. But, the perplexing part of the policy has been the move to increase the CRR. Banks presently are facing a shortage of funds and are making use of the LAF facility to the tune of around Rs 30,000 crore. By raising this rate, RBI will be forcing banks to borrow more from the RBI through the repo window where there will be paying a higher price. It is hence a double whammy for the banks that have fewer resources to lend as RBI is impounding resources on which no interest is being paid. Further, they have to borrow the same funds from RBI at a higher rate now through the repo window.
What are the likely effects of these moves? The first is that the banks' profitability will be affected as their cost of funds goes up and they have to book losses on their investment portfolios. The industry will invest less now, which will impact overall GDP growth. Inflation may be tempered, but that will mainly be due to better supply conditions and only partly due to the monetary squeeze. Individuals however, can be happy that they are less worse-off than that before as their real interest loss narrows down. But no real gainers, only losers.
Saturday, July 19, 2008
Mortgaged to the hilt: DNA: 19th July 2008
The collapse of Fannie Mae and Freddie Mac has vital lessons for India
Fannie Mae (Federal National Mortgage Association) and Freddie Mac (Federal Home Mortgage Corporation) are the two largest mortgage finance companies in the USA, established respectively in 1938 and 1970. While they are owned by ordinary shareholders, they have the unique backing of the government and are called Government Sponsored Entities (GSEs). This means that they are supported by the Federal Reserve and the government and are entitled to lines of credit and a bailout in case of a crisis. More importantly they are exempted from taxes and outside SEC (Securities Exchange Commission) oversight.
The two firms do not lend directly to home owners. They instead buy mortgages from approved lenders and then sell them on to investors. They guarantee or own roughly half of the $12 trillion US mortgage market. These are the two ways in which they make money. Almost all US mortgage lenders, from huge financial institutions like Citigroup to small, local banks, rely on Fannie Mae and Freddie Mac to keep up their businesses. Lenders look to them for the funds they need to meet consumer demand for home mortgages. By linking mortgage lenders with investors, the two firms keep money available at a low cost. These companies buy mortgages from banks and take on the risks of possible defaults — allowing banks to make even more mortgages.
The sub-prime crisis centred on a housing collapse due to reckless lending encouraged by a benign interest rate regime. When interest rates rose and borrowers faced higher outflows, they began to default. The process of securitisation fostered by these cousins made the process complex as the originators of the loans got mixed up and the final investors lost badly. Fannie Mae and Freddie Mac made losses of around $11 bn in the last three quarters. Further, news spread that they were under-capitalised, meaning they would have to go to the market for capital infusion. But, when an institution is under-capitalised and making losses, no one is willing to invest in their equity. This created the panic.
The implications of a collapse are serious. If these two entities are not able to borrow from the market or can do so only at a high cost, then the market senses trouble and would be wary of lending to those seeking housing loans. Housing has been a major stimulant for the US economy and the present slowdown could be largely attributable to the collapse in this business. This led to the eventual crisis as their share prices tumbled as investors lost confidence in these institutions.
The basic paradox here is that these two GSEs are considered to be too large to fail (we heard that of Enron earlier) and simultaneously considered too large to rescue. Therefore, direct government action was mandatory to retain market confidence. This was done in three ways. First, the Treasury decided to buy a stake in their equity to augment capital. Then, the New York Fed chipped in by providing a line of credit and third was the imposition of a condition where the Fed would henceforth have oversight of their operations.The story of these cousins is pertinent to us because mortgage finance has been gaining in importance in India over the last five years. However the share of these loans in total bank credit is only about 15 per cent. Housing finance companies on their part have been relatively more conservative with their lending operations and are well capitalised.
But the issue is broader. In a rising interest rate scenario, we always run the risk of defaults and the institutions would come under pressure as losses mount when defaults take place. Today the ratio of Non-performing assets to total loans is around 1 per cent in this segment, which is low. Further, the securitisation habit, which transfers risks to other entities and can make the originator a bit callous, has not really caught on as yet. Our public sector banks — GSEs in the US sense — broadly resemble the Freddie-Fannie cousins, but there is a critical difference. Public sector banks are well regulated by the RBI which has imposed prudential lending norms, absent in case of the American counterparts.
The Freddie Mac and Fannie Mae episode sends a warning signal across the world and highlights the importance of regulation in the financial business.Regulation of GSEs becomes more critical because, there could be a tendency for such institutions to slip into somnolence and hence become reckless especially if they are sure that they will be bailed out by the government.
Fannie Mae (Federal National Mortgage Association) and Freddie Mac (Federal Home Mortgage Corporation) are the two largest mortgage finance companies in the USA, established respectively in 1938 and 1970. While they are owned by ordinary shareholders, they have the unique backing of the government and are called Government Sponsored Entities (GSEs). This means that they are supported by the Federal Reserve and the government and are entitled to lines of credit and a bailout in case of a crisis. More importantly they are exempted from taxes and outside SEC (Securities Exchange Commission) oversight.
The two firms do not lend directly to home owners. They instead buy mortgages from approved lenders and then sell them on to investors. They guarantee or own roughly half of the $12 trillion US mortgage market. These are the two ways in which they make money. Almost all US mortgage lenders, from huge financial institutions like Citigroup to small, local banks, rely on Fannie Mae and Freddie Mac to keep up their businesses. Lenders look to them for the funds they need to meet consumer demand for home mortgages. By linking mortgage lenders with investors, the two firms keep money available at a low cost. These companies buy mortgages from banks and take on the risks of possible defaults — allowing banks to make even more mortgages.
The sub-prime crisis centred on a housing collapse due to reckless lending encouraged by a benign interest rate regime. When interest rates rose and borrowers faced higher outflows, they began to default. The process of securitisation fostered by these cousins made the process complex as the originators of the loans got mixed up and the final investors lost badly. Fannie Mae and Freddie Mac made losses of around $11 bn in the last three quarters. Further, news spread that they were under-capitalised, meaning they would have to go to the market for capital infusion. But, when an institution is under-capitalised and making losses, no one is willing to invest in their equity. This created the panic.
The implications of a collapse are serious. If these two entities are not able to borrow from the market or can do so only at a high cost, then the market senses trouble and would be wary of lending to those seeking housing loans. Housing has been a major stimulant for the US economy and the present slowdown could be largely attributable to the collapse in this business. This led to the eventual crisis as their share prices tumbled as investors lost confidence in these institutions.
The basic paradox here is that these two GSEs are considered to be too large to fail (we heard that of Enron earlier) and simultaneously considered too large to rescue. Therefore, direct government action was mandatory to retain market confidence. This was done in three ways. First, the Treasury decided to buy a stake in their equity to augment capital. Then, the New York Fed chipped in by providing a line of credit and third was the imposition of a condition where the Fed would henceforth have oversight of their operations.The story of these cousins is pertinent to us because mortgage finance has been gaining in importance in India over the last five years. However the share of these loans in total bank credit is only about 15 per cent. Housing finance companies on their part have been relatively more conservative with their lending operations and are well capitalised.
But the issue is broader. In a rising interest rate scenario, we always run the risk of defaults and the institutions would come under pressure as losses mount when defaults take place. Today the ratio of Non-performing assets to total loans is around 1 per cent in this segment, which is low. Further, the securitisation habit, which transfers risks to other entities and can make the originator a bit callous, has not really caught on as yet. Our public sector banks — GSEs in the US sense — broadly resemble the Freddie-Fannie cousins, but there is a critical difference. Public sector banks are well regulated by the RBI which has imposed prudential lending norms, absent in case of the American counterparts.
The Freddie Mac and Fannie Mae episode sends a warning signal across the world and highlights the importance of regulation in the financial business.Regulation of GSEs becomes more critical because, there could be a tendency for such institutions to slip into somnolence and hence become reckless especially if they are sure that they will be bailed out by the government.
Friday, July 18, 2008
Is Stagflation on the Horizon: Buisness Line: 18th July 2008
To contain cost-push inflation a demand-pull solution is being used by central banks. This has the potential to slow down growth.
Stagflation is a phenomenon which surfaced in the 1970s when the world went through the first oil crisis. Curiously this was also the beginning of the temporary end of Keynesianism because it was shown for the first time that inflation and unemployment can coexist.
We are now in the midst of another oil crisis and the question which is being raised is whether we are moving towards stagflation once more. The question is germane to most countries, especially the US, the UK, the Euro zone and India. The responses of monetary authorities have, however, been disparate.Global phenomenon
The rise in inflation is a concern everywhere, and is truly a global phenomenon. The US is worried, and so are the ECB (European Central Bank) and BoE (Bank of England). We in India are petrified of double digit inflation but seem to have reconciled to it after the initial umbrage.
It is agreed that inflation is a cost-push phenomenon with higher oil and food prices driving it up. And it is also accepted, albeit very reluctantly, that there is little that can be done as both food and oil prices are outside the purview of policy action in the short run.
There appears to be no solution to the oil price crisis as new highs are reached. Food prices remain an enigma, with dwindling stocks leading to riots in Mexico, Morocco, Uzbekistan, Yemen, Guinea, Mauritania and Senegal. The rich nations are also worried on account of the diversion of land to produce crops for bio-fuels. Tough stance
In this situation, most central banks have taken a tough stance, of increasing interest rates to control inflation. The ECB has done it and the RBI is doing the same. However, the Fed remains un-nerved and the BoE is not reducing the rates any further.
Inflation is just above 4 per cent in the US and is inching towards this mark in the Euro zone, which is well above the 2 per cent norm that has to be pursued. In the UK inflation is around 3.5 per cent while it is getting close to 12 per cent in India. GDP growth expectations vary, from 7-8 per cent in India to 1.7 per cent in the UK and the Euro zone; it is expected to be lower at 1.4 per cent in the US.
The central banks are in the process of tightening the monetary tools, such as interest rates and reserves. What happens when interest rates are raised? Consumption and investment get curtailed, and this could lead to a cut back in production and accumulation of stocks. Under such circumstances, labour is released leading to higher unemployment. While this is an extreme situation, there would definitely be a slowdown in employment growth. Back to 1970s?
Therefore, there would be a throwback to the 1970s, with high inflation, low growth and unemployment. The route, however, would be slightly different. In the 1970s, the oil shock caused GDP to fall and unemployment to increase. The governments increased expenditure to prop up the economy. But this did not lead to higher production and resulted in inflation. Today, higher oil prices have not resulted in low growth — in fact growth in 2006 and 2007 has been fairly satisfactory throughout the world.
However, to contain cost-push inflation a demand-pull solution is being used by central banks, which has the potential to slow down growth.
The explanation given by most central banks is that what matters more today is not inflation so much as inflationary expectations.
Central bank action sends strong signals to the people that it is keen to protect the price level and, hence, ensure stability. This counters the higher spending that comes into play when wages rise in response to inflation.
But if one looks at the Federal Reserve, it has taken a more liberal view and prefers to protect growth even if it means a little more inflation. The initial conditions in the US were different from those in the ECB zone or India, as it was buffeted by the financial crisis which threatened the edifice of growth. The priority was to bring about growth at any cost (elections too are around the corner) which made the Fed reduce interest rates to 2 per cent.
After embarking on such a path, it would have been difficult to take an aggressive stance on inflation. The best that it is doing today to counter inflation is not to lower rates further. There were expectations of the Fed lowering interest rates further given the rather nebulous growth prospects in the economy.
The ECB is more worried about the inflation rate being twice the acceptable level and has evidently put growth as a secondary objective. Therefore, one may expect the ECB to raise rates further in the course of the year if inflation continues to bite. The BoE has resisted the urge to lower interest rates and has preferred to take the more conservative route of neutrality in the present circumstances. Inflation concerns
The RBI, on the other hand, has little choice as inflation is a major concern and is politically unpalatable. Hence, with growth being less of a concern and inflation the major stumbling block it is not surprising that the focus has been on inflation. But this runs the threat of slowing down the economy and leading to a near stagflation state as the growth projections have now slipped to 7-8 per cent from 8.5-9 per cent.
Hence, while technically it may not be a recession, which in the West is defined as two successive quarters of negative growth, such a slowdown would mirror the effects of a recession.
Thus one does witness a varied set of reactions from central banks across the world motivated by different concerns. There is really no unique approach to a common problem: one size cannot fit all.
Stagflation is a phenomenon which surfaced in the 1970s when the world went through the first oil crisis. Curiously this was also the beginning of the temporary end of Keynesianism because it was shown for the first time that inflation and unemployment can coexist.
We are now in the midst of another oil crisis and the question which is being raised is whether we are moving towards stagflation once more. The question is germane to most countries, especially the US, the UK, the Euro zone and India. The responses of monetary authorities have, however, been disparate.Global phenomenon
The rise in inflation is a concern everywhere, and is truly a global phenomenon. The US is worried, and so are the ECB (European Central Bank) and BoE (Bank of England). We in India are petrified of double digit inflation but seem to have reconciled to it after the initial umbrage.
It is agreed that inflation is a cost-push phenomenon with higher oil and food prices driving it up. And it is also accepted, albeit very reluctantly, that there is little that can be done as both food and oil prices are outside the purview of policy action in the short run.
There appears to be no solution to the oil price crisis as new highs are reached. Food prices remain an enigma, with dwindling stocks leading to riots in Mexico, Morocco, Uzbekistan, Yemen, Guinea, Mauritania and Senegal. The rich nations are also worried on account of the diversion of land to produce crops for bio-fuels. Tough stance
In this situation, most central banks have taken a tough stance, of increasing interest rates to control inflation. The ECB has done it and the RBI is doing the same. However, the Fed remains un-nerved and the BoE is not reducing the rates any further.
Inflation is just above 4 per cent in the US and is inching towards this mark in the Euro zone, which is well above the 2 per cent norm that has to be pursued. In the UK inflation is around 3.5 per cent while it is getting close to 12 per cent in India. GDP growth expectations vary, from 7-8 per cent in India to 1.7 per cent in the UK and the Euro zone; it is expected to be lower at 1.4 per cent in the US.
The central banks are in the process of tightening the monetary tools, such as interest rates and reserves. What happens when interest rates are raised? Consumption and investment get curtailed, and this could lead to a cut back in production and accumulation of stocks. Under such circumstances, labour is released leading to higher unemployment. While this is an extreme situation, there would definitely be a slowdown in employment growth. Back to 1970s?
Therefore, there would be a throwback to the 1970s, with high inflation, low growth and unemployment. The route, however, would be slightly different. In the 1970s, the oil shock caused GDP to fall and unemployment to increase. The governments increased expenditure to prop up the economy. But this did not lead to higher production and resulted in inflation. Today, higher oil prices have not resulted in low growth — in fact growth in 2006 and 2007 has been fairly satisfactory throughout the world.
However, to contain cost-push inflation a demand-pull solution is being used by central banks, which has the potential to slow down growth.
The explanation given by most central banks is that what matters more today is not inflation so much as inflationary expectations.
Central bank action sends strong signals to the people that it is keen to protect the price level and, hence, ensure stability. This counters the higher spending that comes into play when wages rise in response to inflation.
But if one looks at the Federal Reserve, it has taken a more liberal view and prefers to protect growth even if it means a little more inflation. The initial conditions in the US were different from those in the ECB zone or India, as it was buffeted by the financial crisis which threatened the edifice of growth. The priority was to bring about growth at any cost (elections too are around the corner) which made the Fed reduce interest rates to 2 per cent.
After embarking on such a path, it would have been difficult to take an aggressive stance on inflation. The best that it is doing today to counter inflation is not to lower rates further. There were expectations of the Fed lowering interest rates further given the rather nebulous growth prospects in the economy.
The ECB is more worried about the inflation rate being twice the acceptable level and has evidently put growth as a secondary objective. Therefore, one may expect the ECB to raise rates further in the course of the year if inflation continues to bite. The BoE has resisted the urge to lower interest rates and has preferred to take the more conservative route of neutrality in the present circumstances. Inflation concerns
The RBI, on the other hand, has little choice as inflation is a major concern and is politically unpalatable. Hence, with growth being less of a concern and inflation the major stumbling block it is not surprising that the focus has been on inflation. But this runs the threat of slowing down the economy and leading to a near stagflation state as the growth projections have now slipped to 7-8 per cent from 8.5-9 per cent.
Hence, while technically it may not be a recession, which in the West is defined as two successive quarters of negative growth, such a slowdown would mirror the effects of a recession.
Thus one does witness a varied set of reactions from central banks across the world motivated by different concerns. There is really no unique approach to a common problem: one size cannot fit all.
State-sponsored inflation: Economic Times: 18th July 2008
Inflation is becoming progressively a major concern since the number has reached crazy heights; and the more pessimistic ones are already likening this situation to the pre-reforms crisis phase. All possible options have been explored to tackle inflation. The CRR and repo rates have been relentlessly raised. Imports have been liberalised and exports curtailed. Stock limits have been applied for essential commodities. Tariffs have been reduced and even futures trading in some commodities have been banned. Yet, there seems to be no respite from inflation, which has been driven by fundamentals as well as global factors. In this milieu the role of government has escaped attention. The purpose here is to examine the possible inadvertent part played by the government in fuelling inflation, which may be called ‘state-sponsored inflation’. Government here should not be interpreted as the existing or past governments, but simply as the entity which runs the country and has economic policies to support its functioning. The approach is from the theoretical angle and there are no political undertones as this would hold good for governments anywhere in the world. The government comes into the picture several ways. To begin with, it controls the prices of several essential goods comprising the wholesale price index (WPI). There is the MSP (minimum support price) which is announced for several crops every year, at the time of sowing. The idea is that the farmers should be aware of the price to be received at harvest time. It is calculated by the Commission on Costs and Prices (CACP), which determines the price based on several parameters such as price last year, cost of cultivation, cost of living, relative prices of other crops, etc. This is fixed for all major crops including cereals, pulses, oilseeds and fibres. It is active mainly in rice and wheat and to an extent in cotton and sugarcane. But, this sets the tone for prices in the market as a floor is set by the government itself. Curiously, today the build up of excess buffer stocks when production has peaked has created a shortage in the market for foodgrains as prices are increasing. Now, products such as rice, wheat, cotton and sugarcane have a weight of 6.79% in the WPI and directly enter the inflation basket. So, when the MSP of rice or wheat is increased, one may expect the inflation numbers to move upwards. If others like coarse cereals, pulses and oilseeds are added, then the weight goes up by 3.89%. For the last season, the MSPs of paddy, bajra, maize, ragi, arhar, moong, urad, masoor and barely were raised by over 10%. Intuitively, one can guess the impact on inflation. Therefore, in the agri-sphere, one can say that 10.68% of the 22.03% weight of primary articles has a strong government influence. The entire mineral oils group which has a weight of 6.99% is dormant as long as the government decides not to change their administered prices. But, the moment it does, then the prices for the entire group moves up by varying degrees. This component is nearly 50% of the entire group of fuel products in the WPI. Here the government faces a conundrum. If fuel prices are not raised or the MSP is increased, then the subsidy bill goes up, pushing the fiscal balances into jeopardy. If the government adjusts fuel price, then inflation goes out of hand. In fact, while the direct impact of fuel prices is 6.99%, the indirect effect is even higher as fuel products go as feedstock into products such as fertilisers, pesticides and other chemicals which in turn add to the cost of cultivation. Also as transportation costs go up, the prices of all commodities in the WPI would move up as transportation is part of all costs of production. Hence, the indirect impact can be even more severe than the direct impact, which is hard to quantify. Within the manufactured products group, sugar (where the price is controlled partially) accounts for 3.62% of the WPI. Besides, as the SMP (statutory minimum price) of sugarcane is increased, the price of sugar goes up. The other route for state sponsored inflation is taxation. Today, total indirect taxes, which fall essentially on manufactured goods (a very small part goes on agri-products) account for around 30% of value added in manufacturing. And given that manufactured goods have a weight of 63.75% in the WPI, we are really speaking of another 19% of inflation being driven by government policy. Taxes have been moving down in the past, but, prices generally tend to be sticky in the downward direction. Also with the exception of probably the consumer goods industry, the lower tax benefits are seldom passed to the consumer. What does all this add up to? Around 21% of the WPI is directly influenced by government action where the actual impetus is provided by the state. The government has a problem here since in the agricultural sector, where farming is the only means of livelihood for workers, an increase in MSP is the only way to protect against core inflation. Since productivity is low and there is no significant increase in acreage under cultivation, farmers would slip into poverty in the absence of such increases in prices. If we add the other 19% taxation effect, the government can actually move 40% of the inflation numbers directly. The indirect impact would be hard to quantify as all components are inter-related: higher taxes on steel push up the price of automobiles, engineering goods and so on. On a conservative side, the indirect effects of all these components especially fuel and agri-products could influence another 10% of the price index. This means that almost 50% of the WPI is under the purview of the government. Hence, it can be seen that one of the dominant causes of inflation is the government and such state-sponsored inflation cannot be escaped. All these monetary policy measures or bans may just be like chasing a crooked shadow, especially since the genesis of the irksome double- digit inflation rate, ironically, lies within.
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