The recent controversy on government intervention relating to airfares raises a broader question for us: how free are the markets in a deregulated set-up? The issue comes up since while deregulation has meant less direct intervention, there is a strong feeling that oligopolistic power is being exercised by market participants, especially when it is a sellers’ market. This has led to a reversal of stance by the government through selective intervention, either directly or through innuendo.
Let’s see the situation today. We have government intervention when airlines have jacked up their fares. Microfinance institutions have been under the scanner for charging higher interest rates while some time back, mutual funds came under pressure to terminate their commissions paid to the brokers. Banks are being told regularly to keep rates low for industry while high commodity prices have been frowned upon through invocation of the Essential Commodities Act and the ban on futures trading, even when supplies have played truant. Insurance companies have been subjected to a series of regulations on their Ulip schemes. Are we being averse to market play or is there something amiss in our markets?
Ever since we embarked on liberalisation in 1991-92, we have opened up sectors but been reluctant to let the market decide the prices. Further, the measures have been half-hearted as we are not willing to go back fully to the price control days. The airline issue is quite straightforward. The airlines are making losses and decided to increase their fares to improve profitability. The rationale is that if people are willing to pay, so be it. Normally, around 60-80% of the travel is on business account, and hence does not really make a difference.
If people don’t want to pay, they need not travel; and lower sales will automatically bring down airfares as the utilisation rate comes down and hence fares would be mean-reverting. Air travel, it must be remembered, cannot be treated as an essential service like, say, the railways; as in the past, when rates were high, few travelled and no one complained about high rates. Besides, today, with airports being renovated and user charges being heaped on the customers, no one has complained about tripling of charges on all services from parking to catering in these airports. Also, an anomaly is that if one looks at the total price paid on a ticket, the fare is less than the other fees and charges; and interestingly, the latter is not being questioned as it flows to other government entities.
At the broader level should players have the right to set their prices? A market works on the principle of there being a large number of buyers and sellers. Here no one influences the other’s decisions, and the solution is optimal. The problem is that in real life such markets are rare, as they tend to move towards an oligopolistic structure, given that infrastructure cannot afford to have many players. Therefore, we have a set of, say, 10 (airlines)-50 (banks) players that sell products to consumers. These services cannot unequivocally be called ‘essential’. Some services that require high overheads tend to be loss-making, and are on the lookout to increase their charges. When it is a government service, it is understood that losses are part of social expenditure. But when it is private, then the issue gets tricky.
Now, there are several user charges that have been raised as far as individuals are concerned, which can be said to be the result of near monopoly power. These include electricity and water charges, petro-products, MSPs (for farm products), milk, etc, where the prices keep increasing but are accepted as being non-exploiting. The question is, why should airlines be singled out?
In a free society, ideally, markets should be allowed to determine prices. When the market is supreme, cartels will not work when it comes to non-essential products and services as the customers have a choice not to use it. This becomes critical when it is an essential service, where regulation is called for. For essential services, there has to be a price ceiling, but then private operators would be less enthusiastic in case they are not remunerative.
However, a lacuna is the opacity of the pricing systems in all such services. Websites are rarely transparent and complicate matters. This has to be addressed and service providers should be asked to present the same in a rudimentary fashion. Today, the transparency in financial markets is through the fine-print, which is difficult both to read and understand.
At another level, in the case of the airlines, if the government is really keen on ensuring sanity in prices, it should have its own carrier offer the lowest rates to bring down prices of other airlines. That would really set an example for others.
Sunday, December 12, 2010
Great stuff, if it’s true: Editorial: Financial Express 1st Dcember 2010
GDP growth numbers, at 8.9%, have once again taken the analysts by surprise, even as the consensus was closer to the 8.5% mark, though the ministry of finance had earlier let it out that they were sanguine with the 8.8% growth number. Amid all the otherwise distressing news on the other fronts, the GDP growth number comes as a breath of fresh air. With the two so-called lean quarters showing growth of 8.9%, one cannot rule out growth closer to 9% by the end of the year, as the busy season comprises Q3 and Q4, which should be generally more active. We also have healthy stock markets, steady industrial growth, surplus capital inflows, a strong rupee, rising exports, orderly fiscal deficit, declining inflation rate, etc. Things can’t get any better; and it looks like it is time to open the bubbly. But maybe we should pause for a little bit longer for the party to begin. There are actually three points that are sort of perplexing.
The first is that some of the GDP numbers do not gel well. The IIP numbers for mining, manufacturing and electricity are lower than those in the GDP estimates, though, admittedly, the way of reckoning the same is different. Further, the construction sector seems to be booming at a time when the cement industry was in a dormant phase, which is not an aberration as the seasonal monsoon factor comes into play. These numbers are hard to reconcile. Given the track record of revisions, will there be some here? The second area is the statistical biases that will come into play from now on. Agriculture will do well in Q3 and Q4 because the performance was low last year and the ministry of agriculture is gung ho about performance and is already counting space in the warehouses for storing the procured cereals. In fact, while we may like to be happy over the resurgence in agriculture, going by the first advance estimates, the production numbers for cereals and some oilseeds like soybean are still lower than that in FY09. Hence, we may only be regaining lost ground. Industrial growth, on the other hand, has to come on top of very high growth rates witnessed from October 2009 onwards and will, hence, counter a downward bias notwithstanding healthy production numbers. The third issue is more serious. The revisions in Q1 estimates are hard to digest. Gross capital formation has increased from 31.2% to 35% and sector growth rates vary significantly across the spectrum. While the usage of the new WPI for deflating numbers is an okay enough explanation, 3.8% increase in capital formation still remains a mystery across revisions in numbers.
The first is that some of the GDP numbers do not gel well. The IIP numbers for mining, manufacturing and electricity are lower than those in the GDP estimates, though, admittedly, the way of reckoning the same is different. Further, the construction sector seems to be booming at a time when the cement industry was in a dormant phase, which is not an aberration as the seasonal monsoon factor comes into play. These numbers are hard to reconcile. Given the track record of revisions, will there be some here? The second area is the statistical biases that will come into play from now on. Agriculture will do well in Q3 and Q4 because the performance was low last year and the ministry of agriculture is gung ho about performance and is already counting space in the warehouses for storing the procured cereals. In fact, while we may like to be happy over the resurgence in agriculture, going by the first advance estimates, the production numbers for cereals and some oilseeds like soybean are still lower than that in FY09. Hence, we may only be regaining lost ground. Industrial growth, on the other hand, has to come on top of very high growth rates witnessed from October 2009 onwards and will, hence, counter a downward bias notwithstanding healthy production numbers. The third issue is more serious. The revisions in Q1 estimates are hard to digest. Gross capital formation has increased from 31.2% to 35% and sector growth rates vary significantly across the spectrum. While the usage of the new WPI for deflating numbers is an okay enough explanation, 3.8% increase in capital formation still remains a mystery across revisions in numbers.
Why are stock exchanges different, Dr Jalan? 25th November 2010 Financial Express
The Jalan Committee Report is well-timed as it comes when there is a lot happening in this space and there is need for clarity on the structures of MIIs (market infrastructure institutions). This is important as the structure that is decided for the stock exchanges would also set benchmarks for commodity exchanges too. Also, there has been an addition to the number of players in both the stock and commodity markets. The introduction of forex derivatives exchanges will logically lead the way to their trading in stocks, while the commodity space, though apparently saturated, has seen progressive interest in setting up new exchanges. There is apprehension that there could be a game being played wherein promoters may leverage their valuation and make a profitable exit.
In brief, the report talks of three things: profits being earned, ownership patterns involving an anchor investor and listing options for them. Logically, if they are not to be super-normal profit making, then it follows that there should be a regulated ownership structure to retain interest and as a corollary, public listing is out of place. Is this the best combination?
To begin with, is there a consensus on whether stock exchanges are MIIs that address social infrastructure? All financial intermediaries perform the function of transferring and allocating funds and stock exchanges are no different. They are not established by the government but by private firms and hence strictly cannot be compared with say a road, which serves the public at large. In fact, stock exchanges are more private as all participants are there to trade and make money, unlike a typical social infrastructure project. This is the starting point because the entire edifice is built on the underlying concept. Banks and insurance companies also do social good and facilitate transfer of funds and provide services to customers. But they are not guided by non-capitalist objectives. Why should stock exchanges be different?
This is important because the Committee is talking of MIIs not making supernormal profits. All financial institutions make lumpy investments and hence resemble infrastructure. But they operate for profit and we are past the nationalisation phase when such a thought could be justified. If this is so, can we really decide on whether they should earn x or y profits? Further, the nature of the business is such that once the costs are incurred, essentially technology, then there is really little incremental capital to be ploughed in and profits can be exponential, depending on the transactions. While the transaction cost can be regulated to prevent the buildup of monopoly power, the resulting profits cannot really be decided by any extraneous principle in a market economy. In fact, the report talks of surpluses going into an IPF or SGF. But, then we do not have such rules being imposed on banks and insurance companies. So why should it be so for exchanges where provisions are anyway made for these funds.
The need for an anchor investor is important and valid, given the investment being made and the number of players operating; it needs to offer strength and stability. This can be done if there is identification of an anchor investor. Banking is mature and hence the same may not hold. But for insurance, the public needs to be convinced about the credentials of people running the show to put in their funds. Therefore, having an anchor investor makes sense, especially if it is not an institution. The term of 10 years is again debatable and a longer term may be prescribed. But again, drawing an analogy from banks, insisting on an institution to be an anchor investor is hard as this would drive away private entrepreneurs. Therefore, while the lock-in period is justified, the nature of the promoter should be flexible to include any long term investor. Lastly, the listing or rather non-listing of exchanges is an interesting thought. Globally exchanges like the LSE or NASDAQ or NYSE are listed on themselves. The Committee has spoken of how a fall in their value can create turmoil at the exchange, which is fair enough. However, once we accept the concept of anchor investor—which ensures that fly-by-night operators seeking valuation are out of the ambit, then listing should be permitted as a diversified pattern helps the industry to grow. We have not seen any negative repercussions for banks on account of listing and, therefore, can translate the same logic to an exchange.
In a free market economy, enterprise should be allowed to flourish within the regulatory framework. Once the enterprise is non-government, one cannot lay down standards for profitability. The listing of any company should be permitted provided the rules are obeyed. The fact that we have anchor investors will ensure that enterprises are here to stay, which will provide comfort. The same should hold even for stock exchanges.
In brief, the report talks of three things: profits being earned, ownership patterns involving an anchor investor and listing options for them. Logically, if they are not to be super-normal profit making, then it follows that there should be a regulated ownership structure to retain interest and as a corollary, public listing is out of place. Is this the best combination?
To begin with, is there a consensus on whether stock exchanges are MIIs that address social infrastructure? All financial intermediaries perform the function of transferring and allocating funds and stock exchanges are no different. They are not established by the government but by private firms and hence strictly cannot be compared with say a road, which serves the public at large. In fact, stock exchanges are more private as all participants are there to trade and make money, unlike a typical social infrastructure project. This is the starting point because the entire edifice is built on the underlying concept. Banks and insurance companies also do social good and facilitate transfer of funds and provide services to customers. But they are not guided by non-capitalist objectives. Why should stock exchanges be different?
This is important because the Committee is talking of MIIs not making supernormal profits. All financial institutions make lumpy investments and hence resemble infrastructure. But they operate for profit and we are past the nationalisation phase when such a thought could be justified. If this is so, can we really decide on whether they should earn x or y profits? Further, the nature of the business is such that once the costs are incurred, essentially technology, then there is really little incremental capital to be ploughed in and profits can be exponential, depending on the transactions. While the transaction cost can be regulated to prevent the buildup of monopoly power, the resulting profits cannot really be decided by any extraneous principle in a market economy. In fact, the report talks of surpluses going into an IPF or SGF. But, then we do not have such rules being imposed on banks and insurance companies. So why should it be so for exchanges where provisions are anyway made for these funds.
The need for an anchor investor is important and valid, given the investment being made and the number of players operating; it needs to offer strength and stability. This can be done if there is identification of an anchor investor. Banking is mature and hence the same may not hold. But for insurance, the public needs to be convinced about the credentials of people running the show to put in their funds. Therefore, having an anchor investor makes sense, especially if it is not an institution. The term of 10 years is again debatable and a longer term may be prescribed. But again, drawing an analogy from banks, insisting on an institution to be an anchor investor is hard as this would drive away private entrepreneurs. Therefore, while the lock-in period is justified, the nature of the promoter should be flexible to include any long term investor. Lastly, the listing or rather non-listing of exchanges is an interesting thought. Globally exchanges like the LSE or NASDAQ or NYSE are listed on themselves. The Committee has spoken of how a fall in their value can create turmoil at the exchange, which is fair enough. However, once we accept the concept of anchor investor—which ensures that fly-by-night operators seeking valuation are out of the ambit, then listing should be permitted as a diversified pattern helps the industry to grow. We have not seen any negative repercussions for banks on account of listing and, therefore, can translate the same logic to an exchange.
In a free market economy, enterprise should be allowed to flourish within the regulatory framework. Once the enterprise is non-government, one cannot lay down standards for profitability. The listing of any company should be permitted provided the rules are obeyed. The fact that we have anchor investors will ensure that enterprises are here to stay, which will provide comfort. The same should hold even for stock exchanges.
Why MFIs deserve priority: Financial Express 23rd November 2010
When Muhammad Yunus won the Nobel Prize for his work in the microfinance sector, we all applauded. When SKS went public and succeeded, it was interpreted as the market vindication of the business model. But suddenly today it has become a dirty word. Are we over-reacting emotionally to a sound business proposition?
The media has been full of views of ‘assault’ on the ‘MFI model’ to such an extent that even the owners are talking of lowering rates and sounding apologetic of their businesses. The view here is that we need to treat the MFIs, as we do any other business, in a dispassionate manner.
One, we need to realise that in a market setup, every commercial enterprise runs for profit and not on philanthropic terms and there is nothing wrong with this. The government can afford schemes like NREGA, which spend without creating assets that placate the poor but not the fiscal numbers. But the MFIs should not be criticised for working for a profit. While their funds go to the poor, there is some good that happens, but considering that there are costs while carrying out this business, one cannot question a return.
Two, the return is considered to be very high, which in a way is true, but there could be a justification for the same. Today, they borrow at between 12-15% from banks, incur incidentals of 6-7%, and make provisions for NPA, CAR and insurance, which comes to another 3-4%. Intuitively, the cost could cross 20%. Now, the question is what should be the return for such an enterprise that will make a lending rate acceptable? Do we apply such standards for other industries that also provide goods and services to the poor? The answer is No. One may recollect that when the mobile telephony business commenced, costs were multiple times what we are paying today. The force of competition brought this down, and the same will hold for MFIs, if the system is allowed to grow.
Three, is the 30% interest rate high? One cannot give a clear answer here. Today commercial banks charge similar amounts on credit cards and while RBI has sounded them on being transparent, the charges are still usurious. If one is talking of transparency, it is another issue wherein the MFIs may be told to explain the product to the borrower, which incidentally is never done when selling credit cards by banks.
Four, using counter-intuitive logic, the fact that people are willing to pay, let’s say 30%, as interest for a loan of Rs 10,000 means that they are doing it willingly as there is no alternative. The moneylender charges higher rates and hence the MFI makes sense for them.
Five, can the loans being offered by MFIs be provided by banks? The answer is that it is not happening in any significant measure. Therefore, the fact that MFIs are entering a rather virgin terrain is quite commendable as others have consciously had limited exposure here. Curiously, the BC model being spoken of partly reflects what the MFIs may be doing on the lending side.
Six, the latest data provided by RBI shows that overall NPAs of banks are almost equally divided between the priority and non-priority sectors. Given that outstanding non-priority sector loans are around twice that of priority sector loans, the probability of a loan going bad in the priority sector is almost 70% more than that in non-priority sector. The MFI segment would carry higher risk and is less attractive for banks. Also, there is interest rate subvention to the extent of 2% on farm loans, which enables loans at 7%. No such facility is available for MFI loans.
Seven, the use of force for recoveries has come under criticism. There are three issues here. The first is that there are legal processes that can be invoked if something wrong is being done. Second, we have similar tales on commercial banks regarding consumer and auto loans, where coercive measures are used, which, however, do not provoke a similar response. Lastly, in India, as a rule, we are sympathetic to defaulters and hence apply a double standard when someone does not repay loans. Defaulters across all segments have the upper hand with their lenders, which is not sustainable if we want a strong financial system.
Admittedly, there is certainly a case for bringing in more regulation and transparency to the operation of MFIs. But given that there are no alternatives available for this section, we need to develop this area and move beyond the politicisation of the issue. We need not eulogise the MFI business as being fit for the Nobel Prize, but, to borrow words from the legendary rock band Pink Floyd, this is just another ‘brick in the wall’. As a corollary, Teacher, leave the kids (MFIs) alone.
The media has been full of views of ‘assault’ on the ‘MFI model’ to such an extent that even the owners are talking of lowering rates and sounding apologetic of their businesses. The view here is that we need to treat the MFIs, as we do any other business, in a dispassionate manner.
One, we need to realise that in a market setup, every commercial enterprise runs for profit and not on philanthropic terms and there is nothing wrong with this. The government can afford schemes like NREGA, which spend without creating assets that placate the poor but not the fiscal numbers. But the MFIs should not be criticised for working for a profit. While their funds go to the poor, there is some good that happens, but considering that there are costs while carrying out this business, one cannot question a return.
Two, the return is considered to be very high, which in a way is true, but there could be a justification for the same. Today, they borrow at between 12-15% from banks, incur incidentals of 6-7%, and make provisions for NPA, CAR and insurance, which comes to another 3-4%. Intuitively, the cost could cross 20%. Now, the question is what should be the return for such an enterprise that will make a lending rate acceptable? Do we apply such standards for other industries that also provide goods and services to the poor? The answer is No. One may recollect that when the mobile telephony business commenced, costs were multiple times what we are paying today. The force of competition brought this down, and the same will hold for MFIs, if the system is allowed to grow.
Three, is the 30% interest rate high? One cannot give a clear answer here. Today commercial banks charge similar amounts on credit cards and while RBI has sounded them on being transparent, the charges are still usurious. If one is talking of transparency, it is another issue wherein the MFIs may be told to explain the product to the borrower, which incidentally is never done when selling credit cards by banks.
Four, using counter-intuitive logic, the fact that people are willing to pay, let’s say 30%, as interest for a loan of Rs 10,000 means that they are doing it willingly as there is no alternative. The moneylender charges higher rates and hence the MFI makes sense for them.
Five, can the loans being offered by MFIs be provided by banks? The answer is that it is not happening in any significant measure. Therefore, the fact that MFIs are entering a rather virgin terrain is quite commendable as others have consciously had limited exposure here. Curiously, the BC model being spoken of partly reflects what the MFIs may be doing on the lending side.
Six, the latest data provided by RBI shows that overall NPAs of banks are almost equally divided between the priority and non-priority sectors. Given that outstanding non-priority sector loans are around twice that of priority sector loans, the probability of a loan going bad in the priority sector is almost 70% more than that in non-priority sector. The MFI segment would carry higher risk and is less attractive for banks. Also, there is interest rate subvention to the extent of 2% on farm loans, which enables loans at 7%. No such facility is available for MFI loans.
Seven, the use of force for recoveries has come under criticism. There are three issues here. The first is that there are legal processes that can be invoked if something wrong is being done. Second, we have similar tales on commercial banks regarding consumer and auto loans, where coercive measures are used, which, however, do not provoke a similar response. Lastly, in India, as a rule, we are sympathetic to defaulters and hence apply a double standard when someone does not repay loans. Defaulters across all segments have the upper hand with their lenders, which is not sustainable if we want a strong financial system.
Admittedly, there is certainly a case for bringing in more regulation and transparency to the operation of MFIs. But given that there are no alternatives available for this section, we need to develop this area and move beyond the politicisation of the issue. We need not eulogise the MFI business as being fit for the Nobel Prize, but, to borrow words from the legendary rock band Pink Floyd, this is just another ‘brick in the wall’. As a corollary, Teacher, leave the kids (MFIs) alone.
What drives stock indices? A reality check: Economic Times 17th November 2010
The India shining story is often linked with the reflection seen in these numbers. At the same time, sceptics hold that the market is sentiment-driven and hence, at times, even good news on the economy front can be overwhelmed by random events. The market buzz on hiking of interest rates could lead to a decline in the market when economic conditions are otherwise sanguine. What really is the true picture?
The right way to go about this exercise is a regression analysis looking at changes in the Sensex and juxtaposing them with economic variables which prima facie have a bearing. The variables that can affect the market mood are growth in credit, industrial growth, capital issues, inflation, FII investments, exchange rate movements, changes in forex reserves and mutual funds investments.
The period chosen is from April 2006 to September 2010 and data has been reckoned on a monthly basis. This takes care of the day to day aberrations in the stock market movements. It has been noticed that even on a daily basis news affects the Sensex only momentarily which is generally mean reverting by the end of the day.
The multivariate regression model gives some interesting results. The first is that growth in credit, industrial production, exchange rate and changes in forex reserves do not really affect the Sensex. In fact, industrial production growth has a negative effect on the Sensex (though it is not significant, meaning the relation is spurious). The sign is also negative for the exchange rate suggesting that a falling rupee pushes down the market mood. Usually one would associate credit growth to mirror industrial buoyancy, but when it comes to the market, it doesn’t really matter.
How about the significant variables? The other four variables are significant. Higher inflation actually pushes back the Sensex and goes with a negative sign, which makes sense. But it questions the thought that the stock market buffers one from inflation. Primary issues have a negative relation with the Sensex, which is not what one would expect as the two are expected to move in consonance as IPOs become more visible when the market is on the rise. The other two important variables are net FII and mutual fund investments, which have coefficients of 0.003 and 0.00097. A net inflow of $1 million of FII funds leads to 0.003% increase in the Sensex or $1 billion implies 3% increase in the same. The impact of mutual funds is more muted with the coefficient being 0.00097. While these numbers by themselves are not sacrosanct, the major takeaway is that these four variables explain 48% of the variation in the Sensex, also called the coefficient of determination. What does this mean?
This implies that roughly half of the variation in the stock indices is driven by economic factors, while the rest is guided by sentiments that cannot really be explained. Therefore, when we talk of market sentiment which is positive or negative, it is really a collection of different trading thoughts that are not amenable to statistical calculation.
The implication is significant as it also means that we should not get swayed by this index in terms of being reflective of something dramatic in the economy. Maybe, this is why the stock market gyrations are often associated with the human emotion of exuberance — albeit irrational, when things move downwards.
The other important metric that can be examined within the world of econometrics is causation. While FIIs and mutual funds appear to be drivers of the market in statistical terms, is it possible to say that they cause the Sensex to move? The Granger Causality tests carried out do not show a relation either ways — FIIs or mutual funds causing the Sensex to move or the Sensex causing these flows to expand or contract. What all this means is that the stock market movements will remain an enigma for the statistically minded investor where economic fundamentals explain part of the story, while the rest will remain the proverbial mystery.
The right way to go about this exercise is a regression analysis looking at changes in the Sensex and juxtaposing them with economic variables which prima facie have a bearing. The variables that can affect the market mood are growth in credit, industrial growth, capital issues, inflation, FII investments, exchange rate movements, changes in forex reserves and mutual funds investments.
The period chosen is from April 2006 to September 2010 and data has been reckoned on a monthly basis. This takes care of the day to day aberrations in the stock market movements. It has been noticed that even on a daily basis news affects the Sensex only momentarily which is generally mean reverting by the end of the day.
The multivariate regression model gives some interesting results. The first is that growth in credit, industrial production, exchange rate and changes in forex reserves do not really affect the Sensex. In fact, industrial production growth has a negative effect on the Sensex (though it is not significant, meaning the relation is spurious). The sign is also negative for the exchange rate suggesting that a falling rupee pushes down the market mood. Usually one would associate credit growth to mirror industrial buoyancy, but when it comes to the market, it doesn’t really matter.
How about the significant variables? The other four variables are significant. Higher inflation actually pushes back the Sensex and goes with a negative sign, which makes sense. But it questions the thought that the stock market buffers one from inflation. Primary issues have a negative relation with the Sensex, which is not what one would expect as the two are expected to move in consonance as IPOs become more visible when the market is on the rise. The other two important variables are net FII and mutual fund investments, which have coefficients of 0.003 and 0.00097. A net inflow of $1 million of FII funds leads to 0.003% increase in the Sensex or $1 billion implies 3% increase in the same. The impact of mutual funds is more muted with the coefficient being 0.00097. While these numbers by themselves are not sacrosanct, the major takeaway is that these four variables explain 48% of the variation in the Sensex, also called the coefficient of determination. What does this mean?
This implies that roughly half of the variation in the stock indices is driven by economic factors, while the rest is guided by sentiments that cannot really be explained. Therefore, when we talk of market sentiment which is positive or negative, it is really a collection of different trading thoughts that are not amenable to statistical calculation.
The implication is significant as it also means that we should not get swayed by this index in terms of being reflective of something dramatic in the economy. Maybe, this is why the stock market gyrations are often associated with the human emotion of exuberance — albeit irrational, when things move downwards.
The other important metric that can be examined within the world of econometrics is causation. While FIIs and mutual funds appear to be drivers of the market in statistical terms, is it possible to say that they cause the Sensex to move? The Granger Causality tests carried out do not show a relation either ways — FIIs or mutual funds causing the Sensex to move or the Sensex causing these flows to expand or contract. What all this means is that the stock market movements will remain an enigma for the statistically minded investor where economic fundamentals explain part of the story, while the rest will remain the proverbial mystery.
Spit and polish: Financial Express Editorial 13th November 2010
Did we really expect the G20 meet to provide solutions to the present
problems of currency wars that are dominating our mindspace? The
answer is probably no, because issues that have not been sorted out
over months cannot be resolved in two days. But, if we have to take a
positive view of things, then we can say that this meet got the
concerned parties together to at least agree that there is a problem
that has to be sorted out. As there are two diametrically opposite
stances taken by the US and the emerging markets (also sensationalised
to a Barack Obama vs Hu Jintao conflict), the solution, if at all, was
going to be a compromise. The communiqué is naturally filled with
bromides and motherhood statements that, at best, cogently state the
obvious. The joint statement blows hot and cold on the actual action
points. There is agreement not to have competitive devaluations, and
Obama has reiterated that exchange rates should reflect reality. By
harping on sustainable growth, the US has in a way defended the QE2
and other actions that may follow to resuscitate the US economy. But a
kind of blinking green light has been provided for (developing)
countries to consider capital controls when there are currency issues.
Five areas have been brought into focus for policy debate under the
indicative guidelines that were issued: monetary issues, exchange
rates, trade and development, fiscal and financial reforms. But we
still have no idea as to how these objectives are to be met as there
has been no numbers attached to any goal. That would have meant
commitment and in such gatherings, no country would like to shoulder
this responsibility.
Were there any good takeaways from this meet? Obama averred that
nothing that is done in such meets would be dramatic, while the UK PM
David Cameron maintained that pressures over currencies and trade
imbalances can never be solved overnight. French President Nicolas
Sarkozy, who takes over G20 leadership next year, felt that the summit
had allayed the tension that existed before its start, which was an
achievement. Also, China nodded at the indicative guidelines and
maintained that the polices that it was pursuing were anyway always
consistent with these guidelines! More specifically, while there were
fractious discussions for these two days, the good thing was that
these had not broken up into acrimony. Remember WTO? The focus will
now shift to 2011, which will be important for two deadlocked
issues—WTO and, now, G20.
problems of currency wars that are dominating our mindspace? The
answer is probably no, because issues that have not been sorted out
over months cannot be resolved in two days. But, if we have to take a
positive view of things, then we can say that this meet got the
concerned parties together to at least agree that there is a problem
that has to be sorted out. As there are two diametrically opposite
stances taken by the US and the emerging markets (also sensationalised
to a Barack Obama vs Hu Jintao conflict), the solution, if at all, was
going to be a compromise. The communiqué is naturally filled with
bromides and motherhood statements that, at best, cogently state the
obvious. The joint statement blows hot and cold on the actual action
points. There is agreement not to have competitive devaluations, and
Obama has reiterated that exchange rates should reflect reality. By
harping on sustainable growth, the US has in a way defended the QE2
and other actions that may follow to resuscitate the US economy. But a
kind of blinking green light has been provided for (developing)
countries to consider capital controls when there are currency issues.
Five areas have been brought into focus for policy debate under the
indicative guidelines that were issued: monetary issues, exchange
rates, trade and development, fiscal and financial reforms. But we
still have no idea as to how these objectives are to be met as there
has been no numbers attached to any goal. That would have meant
commitment and in such gatherings, no country would like to shoulder
this responsibility.
Were there any good takeaways from this meet? Obama averred that
nothing that is done in such meets would be dramatic, while the UK PM
David Cameron maintained that pressures over currencies and trade
imbalances can never be solved overnight. French President Nicolas
Sarkozy, who takes over G20 leadership next year, felt that the summit
had allayed the tension that existed before its start, which was an
achievement. Also, China nodded at the indicative guidelines and
maintained that the polices that it was pursuing were anyway always
consistent with these guidelines! More specifically, while there were
fractious discussions for these two days, the good thing was that
these had not broken up into acrimony. Remember WTO? The focus will
now shift to 2011, which will be important for two deadlocked
issues—WTO and, now, G20.
Fool’s gold standard: Financial Express 11th November 2010
There is a distinct feeling of déjà vu with Robert Zoellick broaching the idea of returning to the gold standard. The concern emanating from the current global monetary disorder is quite palpable, especially after the US has gone in for quantitative easing, round two (QE2). Curiously, the financial crisis has led to a new generation of policy stances beginning with Basel-III, QE2 and now possibly GS-2, which makes the shadows longer than the subjects. What are we talking of?
Today almost everyone is questioning the basis of having the dollar as the reserve currency as it has violated the tenets of an ideal ‘anchor’ that should support the global monetary system. The US has been quite brash, burdening the other nations with the onus of adjustment, which has prompted possible policy responses that, in turn, are being frowned upon by the West.
Robert Zoellick, in an op-ed article in FT, has made a reference to bringing in more currencies for better monetary cooperation and, as a corollary, suggested that along with the dollar, euro, renminbi, pound and yen, we could bring in gold. Gold could be used to assess market expectations for inflation, deflation and future currency values.
It may be recollected that after WW2, currencies were linked to the dollar, which had its value fixed to gold at $35/ounce. This did not work as the US walked out of this in 1971, which led to BW-II (Bretton Woods). Now, Zoellick has suggested that we could consider going back to such an anchor as gold is today viewed as good as currency. In fact, it is held as a substitute for the dollar and there is an inverse relation between the two—when the dollar drops, the price of gold goes up, as investors move from the dollar to gold. Will this work?
The value of the dollar has slid by 13%, helping US exports but troubling its partners. QE2 only exacerbates the situation as other nations have to adjust to tackling these inflows. Quite clearly, one country’s problems cannot be allowed to become major hindrances for the rest of the world. In fact, today currencies are vulnerable to the whims of governments, which are being driven by inward-looking policies, so much so that monetary policy has become politicised. It is for this reason that there is this talk of currencies being linked once again to gold.
The problem with this approach is that one cannot link the entire monetary system of the world to a metal that has a limited and fixed supply. Countries would lose control over domestic policy in times of crisis. If expanding money supply was strictly linked to the quantity of gold held by governments, Keynesian reflation would be ruled out, thus leading to a chaotic situation. Also, making gold the reserve currency would lead to large-scale hoarding of the metal, which, in turn, would lead to considerable volatility in the monetary conditions across the world. In fact, there is divided opinion over the speculative nature of gold wherein trading in paper gold through the derivative market influences the current price, which is driven by investors (read speculators). The reserve currency cannot have its price driven by this class.
India, for one, would be in a peculiar situation where it is the largest consumer of gold (20% share), which also gets hoarded automatically in the form of jewellery. Linking such hoarded gold to policy would be a mammoth task. Therefore, making gold the reserve currency may not really be tenable for central banks across the world.
Can gold really anchor expectations of inflation or deflation or currency movements? The answer is a shoulder shrug as linking currencies with gold will actually restrict policy flexibility. The biggest problem for a reformed gold standard would be the mismatch between the value of official gold holdings and the size of the monetary system. In 2008, the values of the two were $1,300 billion and $61,000 billion, respectively. Such a peg can be destabilising for any currency if others failed to sustain domestic monetary and financial stability, leading to dramatic flows of gold between currencies that are better managed, thus changing their relative values.
However, the fundamental issue remains that we need to have a system in which countries should not be able to manipulate their currency or money supply to the detriment of other nations. The SDR is a solution but can gold be a part of this basket? The fact that there is perfect correlation with the dollar, would actually make the mathematics convoluted and hence the idea may be brushed aside as being a theoretical novelty, which does not have practical applicability in a world that has become more complex than it was in 1945. We have moved on.
Today almost everyone is questioning the basis of having the dollar as the reserve currency as it has violated the tenets of an ideal ‘anchor’ that should support the global monetary system. The US has been quite brash, burdening the other nations with the onus of adjustment, which has prompted possible policy responses that, in turn, are being frowned upon by the West.
Robert Zoellick, in an op-ed article in FT, has made a reference to bringing in more currencies for better monetary cooperation and, as a corollary, suggested that along with the dollar, euro, renminbi, pound and yen, we could bring in gold. Gold could be used to assess market expectations for inflation, deflation and future currency values.
It may be recollected that after WW2, currencies were linked to the dollar, which had its value fixed to gold at $35/ounce. This did not work as the US walked out of this in 1971, which led to BW-II (Bretton Woods). Now, Zoellick has suggested that we could consider going back to such an anchor as gold is today viewed as good as currency. In fact, it is held as a substitute for the dollar and there is an inverse relation between the two—when the dollar drops, the price of gold goes up, as investors move from the dollar to gold. Will this work?
The value of the dollar has slid by 13%, helping US exports but troubling its partners. QE2 only exacerbates the situation as other nations have to adjust to tackling these inflows. Quite clearly, one country’s problems cannot be allowed to become major hindrances for the rest of the world. In fact, today currencies are vulnerable to the whims of governments, which are being driven by inward-looking policies, so much so that monetary policy has become politicised. It is for this reason that there is this talk of currencies being linked once again to gold.
The problem with this approach is that one cannot link the entire monetary system of the world to a metal that has a limited and fixed supply. Countries would lose control over domestic policy in times of crisis. If expanding money supply was strictly linked to the quantity of gold held by governments, Keynesian reflation would be ruled out, thus leading to a chaotic situation. Also, making gold the reserve currency would lead to large-scale hoarding of the metal, which, in turn, would lead to considerable volatility in the monetary conditions across the world. In fact, there is divided opinion over the speculative nature of gold wherein trading in paper gold through the derivative market influences the current price, which is driven by investors (read speculators). The reserve currency cannot have its price driven by this class.
India, for one, would be in a peculiar situation where it is the largest consumer of gold (20% share), which also gets hoarded automatically in the form of jewellery. Linking such hoarded gold to policy would be a mammoth task. Therefore, making gold the reserve currency may not really be tenable for central banks across the world.
Can gold really anchor expectations of inflation or deflation or currency movements? The answer is a shoulder shrug as linking currencies with gold will actually restrict policy flexibility. The biggest problem for a reformed gold standard would be the mismatch between the value of official gold holdings and the size of the monetary system. In 2008, the values of the two were $1,300 billion and $61,000 billion, respectively. Such a peg can be destabilising for any currency if others failed to sustain domestic monetary and financial stability, leading to dramatic flows of gold between currencies that are better managed, thus changing their relative values.
However, the fundamental issue remains that we need to have a system in which countries should not be able to manipulate their currency or money supply to the detriment of other nations. The SDR is a solution but can gold be a part of this basket? The fact that there is perfect correlation with the dollar, would actually make the mathematics convoluted and hence the idea may be brushed aside as being a theoretical novelty, which does not have practical applicability in a world that has become more complex than it was in 1945. We have moved on.
Dealing with Surpluses: Business Standard: 30th october 2010
The combined surplus cost of forex, money and commodity markets can be interpreted as the cost of stability and security
The era of socialistic economics typified a country with perennial shortages where success was measured by having enough to go by. Things have changed after reforms were introduced, which evolved in an era of globalisation when India has turned around to become a dominant force in the global economic space. Shortages have given way to surpluses quite often. The question that has arisen is whether or not we have learnt to live with surpluses and, as a corollary, the cost attached to those surpluses.
Three markets that come to mind when we talk of surpluses pertain to forex, money and foodgrain (commodities). In the past, we had shortages and the solution was straightforward: have exchange controls, print more money and import foodgrain. With surpluses, we can sit back and watch them grow, but the cost could be significant.
The forex market has seen our reserves grow substantially over the years and was around $255 billion by March 2010. The trade deficit is no longer a critical factor since software receipts, foreign institutional investors (FII) and foreign direct investment (FDI) inflows have more than made up for this deficit. While there has been debate over what should be done with these forex reserves, the Reserve Bank of India (RBI) has, as a prudent measure, parked them essentially in safe havens of Federal bonds, other central banks, the Bank of International Settlements and so on. This ensures that the money is safe.
The RBI Annual Report for FY10 states that the return on these reserves in the form of investments fell about 200 basis points in FY10 due to the global recession and the decision across the developed world to retain interest rates at a low level. Now, assuming that the prudential limit for forex reserves is four months of our imports, which in turn could be around $350 billion this year provided they grow by over 20 per cent, it works out to around $115 billion, which implies a surplus of $140 billion in our reserves. If a further provision of 50 per cent is made for short-term debt, which is around $50 billion, we would still have a surplus of $115 billion. The imputed cost of 2 per cent would mean a loss of around Rs 10,580 crore (based on an exchange rate of Rs 46/$). This is the cost of security on the external front.
If a commercial rate were applied to these surpluses, the cost would be even higher, though there would be a risk attached. Forex reserves also run the risk of losing value, which will happen every time the rupee appreciates considering that most of our reserves are in dollar assets. Hence, the RBI has to protect the rupee from appreciating in the interests of exporters as well as forex reserves.
Money market intervention is necessary for all central banks to control interest rates. Ideally, there should be intervention only when there is a high level of volatility in the call market. There were times when the rates would come close to zero or cross 100 per cent when there were acute shortages. The RBI would then try and draw out liquidity or supply it through the rediscounting window to stabilise rates. However, over time the RBI has fixed the upper and lower bands of the repo and reverse repo rates. While there are two views on this issue, the RBI does bear a cost when there are surpluses in the system. For example, in FY10, there were surpluses of an average of Rs 1,00,000 crore a day that went into the reverse repo auctions. Providing this window to banks cost the system Rs 3,250 crore, which may be interpreted as being the cost of monetary stability. At the other end, a continuous shortage of liquidity in the form of borrowing from the RBI through the repo means a subsidy to banks since the repo rate at, say, 5.75 per cent protects them from higher market rates.
The third market relates to commodities, where the government comes into the picture in the process of procuring foodgrain and then stocking it or distributing it. Since the procurement scheme is an open-ended one, the Food Corporation of India perforce has to take in what is offered. This being the case, it has stocked 58 million tonne as on July 2010 against a buffer norm of 32 million tonne, stored, which means there is a surplus of 12 million tonne of rice and 14 million tonne of wheat.
Rice is procured at Rs 10,000 per tonne and wheat at Rs 11,000 per tonne. The combined cost of these surplus foodgrain is Rs 27,400 crore. The government borrows from the banks (food credit) at, say, 10 per cent per annum, which means a cost of Rs 2,740 crore. To this one must add the other costs of procurement: Rs 2,890 a tonne for rice and Rs 2,120 for wheat, which indicates a cost of Rs 6,500 crore. The stocking of excess grains works out to a little over Rs 9,200 crore.
If all these three costs are summed, it would work out to between Rs 23,000 crore and Rs 25,000 crore a year, which is significant in a framework that is committed to the market mechanism. This can be interpreted as the cost of security or stability that is being borne by different arms of the government. There is ideologically nothing wrong or right about this expenditure, though it may be useful to revisit these policies and costs.
The era of socialistic economics typified a country with perennial shortages where success was measured by having enough to go by. Things have changed after reforms were introduced, which evolved in an era of globalisation when India has turned around to become a dominant force in the global economic space. Shortages have given way to surpluses quite often. The question that has arisen is whether or not we have learnt to live with surpluses and, as a corollary, the cost attached to those surpluses.
Three markets that come to mind when we talk of surpluses pertain to forex, money and foodgrain (commodities). In the past, we had shortages and the solution was straightforward: have exchange controls, print more money and import foodgrain. With surpluses, we can sit back and watch them grow, but the cost could be significant.
The forex market has seen our reserves grow substantially over the years and was around $255 billion by March 2010. The trade deficit is no longer a critical factor since software receipts, foreign institutional investors (FII) and foreign direct investment (FDI) inflows have more than made up for this deficit. While there has been debate over what should be done with these forex reserves, the Reserve Bank of India (RBI) has, as a prudent measure, parked them essentially in safe havens of Federal bonds, other central banks, the Bank of International Settlements and so on. This ensures that the money is safe.
The RBI Annual Report for FY10 states that the return on these reserves in the form of investments fell about 200 basis points in FY10 due to the global recession and the decision across the developed world to retain interest rates at a low level. Now, assuming that the prudential limit for forex reserves is four months of our imports, which in turn could be around $350 billion this year provided they grow by over 20 per cent, it works out to around $115 billion, which implies a surplus of $140 billion in our reserves. If a further provision of 50 per cent is made for short-term debt, which is around $50 billion, we would still have a surplus of $115 billion. The imputed cost of 2 per cent would mean a loss of around Rs 10,580 crore (based on an exchange rate of Rs 46/$). This is the cost of security on the external front.
If a commercial rate were applied to these surpluses, the cost would be even higher, though there would be a risk attached. Forex reserves also run the risk of losing value, which will happen every time the rupee appreciates considering that most of our reserves are in dollar assets. Hence, the RBI has to protect the rupee from appreciating in the interests of exporters as well as forex reserves.
Money market intervention is necessary for all central banks to control interest rates. Ideally, there should be intervention only when there is a high level of volatility in the call market. There were times when the rates would come close to zero or cross 100 per cent when there were acute shortages. The RBI would then try and draw out liquidity or supply it through the rediscounting window to stabilise rates. However, over time the RBI has fixed the upper and lower bands of the repo and reverse repo rates. While there are two views on this issue, the RBI does bear a cost when there are surpluses in the system. For example, in FY10, there were surpluses of an average of Rs 1,00,000 crore a day that went into the reverse repo auctions. Providing this window to banks cost the system Rs 3,250 crore, which may be interpreted as being the cost of monetary stability. At the other end, a continuous shortage of liquidity in the form of borrowing from the RBI through the repo means a subsidy to banks since the repo rate at, say, 5.75 per cent protects them from higher market rates.
The third market relates to commodities, where the government comes into the picture in the process of procuring foodgrain and then stocking it or distributing it. Since the procurement scheme is an open-ended one, the Food Corporation of India perforce has to take in what is offered. This being the case, it has stocked 58 million tonne as on July 2010 against a buffer norm of 32 million tonne, stored, which means there is a surplus of 12 million tonne of rice and 14 million tonne of wheat.
Rice is procured at Rs 10,000 per tonne and wheat at Rs 11,000 per tonne. The combined cost of these surplus foodgrain is Rs 27,400 crore. The government borrows from the banks (food credit) at, say, 10 per cent per annum, which means a cost of Rs 2,740 crore. To this one must add the other costs of procurement: Rs 2,890 a tonne for rice and Rs 2,120 for wheat, which indicates a cost of Rs 6,500 crore. The stocking of excess grains works out to a little over Rs 9,200 crore.
If all these three costs are summed, it would work out to between Rs 23,000 crore and Rs 25,000 crore a year, which is significant in a framework that is committed to the market mechanism. This can be interpreted as the cost of security or stability that is being borne by different arms of the government. There is ideologically nothing wrong or right about this expenditure, though it may be useful to revisit these policies and costs.
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