The evolution of microfinance in India can be put in a theoretical context. There is a case of the existence of 'asymmetric information' where the lender has little in his armory to know that the borrower will repay the loan. In the absence of a clear credit evaluation process, this asymmetry will continue to exist. When there is such asymmetry in availability of information, we run the risk of 'adverse selection'. As long as we are dealing with communities that are known to perform, it will work. But, as we scale up this trust model, then we run the risk of selecting the wrong people.
This triggers default and the reason attributed can be high rates being charged in the face of adverse economic conditions for the borrowers. This has a backward linkage with the MFI and lending bank creating financial chaos. The MFIs cannot use strong-arm techniques to recover money. Borrowers now know that if they borrow, they do not have to repay as there is a constituency which will speak for them when the time comes. This raises the issue of 'moral hazard'.
The MFI's Yunus model appeared to be a panacea for the so-called unbankable people and the rate of 30% charged did not raise a stink as these poor people were anyway borrowing from the moneylender at a higher rate. As they had no collateral to offer except peer pressure, banks did not find this social collateral acceptable. With an increase in suicides on account of strong-arm tactics used by the MFIs for non-repayment of loans, regulatory action is being taken to bring this system back on the rails. Is there any alternative way out?
There are some interesting models being experimented with to make MFI credit work. Some of the names that come to mind are Rangde and Milaap - both are startups that have pursued some innovative techniques. The model here aims at targeting investors who are willing to put in money with no expectation of a return on capital or a minimal of 2%. Funds gathered are then lent to MFIs or NGOs that have been carefully screened on the basis of past performance.
The final cost to the borrower varies from 8% (for Rangde) to 12-18% (Milaap). Basically, these startups cover their costs with zero profit. The MFIs add their cost to this and are able to lend money at a substantially lower rate than other MFIs. This model has worked with virtually negligible NPAs and is able to deliver credit at a cost comparable with what, say an SME, gets funds from a bank.
In the earlier system, MFIs had a genuine point of paying substantially high cost for credit from banks, which actually pushed up costs. The lower cost of final credit here is evidently due to sourcing of cheaper funds from investors. Prima facie, there is nothing amiss in this model as the organisations are registered with the RBI and their activities are known. But the issue is whether this model is scalable. Tackling communities within specific geographies is easier to accomplish than widening the canvas.
Where does one get such philanthropic funds from to scale up operations? And further, while the model has worked well so far, it still does not tackle the problems of asymmetric information, adverse selection and the moral hazard. Banks with their superior credit evaluation skill-sets still encounter problems of NPAs in the organised sector where information is relatively more transparent. Logically, it appears that the system has to crack at some point of time, either in flow of funds or NPAs.
The thought which comes here is to address the two issues together: cost of funds and adverse selection. A way out is to first make relatively large sets of funds available for this purpose. The government is evidently the entity that can make these sources available as philanthropy has its limits. Corporates would prefer to create trusts with their names embossed rather than donate anonymously to these organisations.
While there will be some noise on the fiscal front, central and state governments can actually proportionately keep aside these funds for this purpose. Besides, the government is already subsidising agriculture by keeping rates at 7% and taking on the interest rate differential burden of banks. In fact, given the success of entities like Rangde and Milaap, these could be one-time allocations for specific geographies as it may be assumed that the money would largely return to the lending institution.
These funds could be given to either banks or panchayats or organisations like Milaap and Rangde. Banks have the skill-sets of evaluation and are located in rural areas. With funds coming in at zero cost, they could actually lend to MFIs or directly to the borrowers at a low cost.
Panchayats would be another option, given that they actually have knowledge of their people and hence the issues of asymmetric information and adverse selections are simultaneously addressed here. For governments, these are capital expenditures and hence will be analogous to the project expenditures incurred by them. For society, the basic lending cost of say 8-18% charged by banks to the MFIs actually comes down substantially, which can make a difference.
Quite clearly, the MFI space is one of interest and challenge as it offers better living standards to the poor people. Solutions need to be found within the contours of retaining the sanctity of the financial system in which they operate. Organisations like Rangde and Milaap need to be complimented for showing the way and we need to embellish their operational models with strong financial support to ensure that they are sustainable and scalable.
Wednesday, August 24, 2011
Comforting if the ‘ifs’ hold: Financial Express 6th August 2011
One issue which has been a matter of conjecture even more than whether or not Lady Gaga performs in Mumbai is the true state of the economy. There are a plethora of estimates from various agencies, which, though useful, are utterly confusing, given the wide ranges. Therefore, it is only appropriate that the Prime Minister’s Economic Advisory Council (PMEAC) has come up its forecasts. Coming from the PMO, it appears to be relatively more authentic as the government certainly knows more than others on the data as well as its own finances and policies.
Let us see how we should read between the numbers presented by the PMEAC. Bringing down the GDP growth rate to 8.2% from 9% assumed in the Budget is realistic, but what is important is as to how this number would affect other variables. In particular, the fiscal numbers deserve scrutiny at a time when the fiscal deficit ratio has been increased marginally from 4.6% to 4.7% of GDP. Is this possible? There are two parts to this ratio, the numerator and denominator. The denominator has been assumed to remain unchanged with growth of 14% in nominal terms for GDP at market prices, which can be broken up into 8.2% real GDP growth and 5.8% inflation. But, by the government’s own admission, the inflation rate will remain at 9% till October and come down to 6.5% by March 2012. If this is so, then the average for the year has to be higher at around 8%, which will mean growth of around 16% in nominal GDP.
The slippage in fiscal deficit has been assumed to be just 0.1%, which amounts to around R9,000 crore; this is difficult because of three reasons. The first is that the government has given away around R50,000 crore in taxes on oil products. Second, lower GDP growth will mean lower production too. In particular, industry is to grow by 7.2% now, which will lower excise and corporate tax collections. Third, the Budget talks of R40,000 crore of disinvestment, which may not happen as the market so far has been at best stagnant. Therefore, the fiscal deficit ratio has to be higher than 4.7% if ceteris paribus conditions prevail.
The only way to meet this mark is for further expenditure cuts, which cannot be ruled out as this was also done in FY11. If this happens, then we can see infrastructure growth taking a back seat, as this is normally the area where allocations are reduced to meet fiscal targets. But, based on the GDP sectoral projections made by the PMEAC, the sector, community and personal services, is to actually grow at a higher rate of 8.5%. Therefore, we have the curious case of one part of the trinity—fiscal deficit, government expenditure or GDP (nominal) actually moving out of the loop as internal consistency is difficult.
The growth rates for agriculture and industry appear to be realistic. However, the projection for services is aggressive at 10% as the services sector may not grow at such a high rate when the sectors that it supports, i.e., agriculture and industry, are growing slowly. Intuitively, it may be seen that any slippage here will get reflected quite sharply in the GDP number.
The other interesting projection made is that the investment rate is to increase, albeit marginally, from 36.4% to 36.7% in FY12. This is significant because in a rising interest rate environment, one would have expected investment to take a knock. The resilience of investment to interest rates is a major take away. Further, it also means that the higher interest rate policy followed by RBI is expected to affect consumption more than investment. Therefore, growth of consumer goods including automobiles backed by finance would be affected more by higher interest rates than investment, which, in a way, is comforting as future growth prospects are addressed.
The external sector is to be the flag bearer at a time when the global economy is in a state of flux. Exports are to grow by 32%, which will be awesome as it will come over a high base year number while the deficit will widen. Given that the current account deficit is going to rise only marginally, to 2.7%, there is quite a bit of elbow room here. But the high point will be foreign investment where capital flows through FDI (gross of $35 billion and net of $18 billion), FIIs (muted at $14 billion) and borrowings ($35 billion). This is not bad news except for the higher external commercial borrowings, which will exert pressure on the external debt situation.
So, what are we to make of these numbers? Growth will be subdued and could take a dip if the assumptions made are violated. The interest rate hikes and their impact appear to be factored though the optimism on investment is still significant. The external sector will provide strength, which, prima facie, appears feasible. India will remain a fast growing economy in depressed global world, though periodic review of the fiscal picture will be essential to gauge the progress.
Let us see how we should read between the numbers presented by the PMEAC. Bringing down the GDP growth rate to 8.2% from 9% assumed in the Budget is realistic, but what is important is as to how this number would affect other variables. In particular, the fiscal numbers deserve scrutiny at a time when the fiscal deficit ratio has been increased marginally from 4.6% to 4.7% of GDP. Is this possible? There are two parts to this ratio, the numerator and denominator. The denominator has been assumed to remain unchanged with growth of 14% in nominal terms for GDP at market prices, which can be broken up into 8.2% real GDP growth and 5.8% inflation. But, by the government’s own admission, the inflation rate will remain at 9% till October and come down to 6.5% by March 2012. If this is so, then the average for the year has to be higher at around 8%, which will mean growth of around 16% in nominal GDP.
The slippage in fiscal deficit has been assumed to be just 0.1%, which amounts to around R9,000 crore; this is difficult because of three reasons. The first is that the government has given away around R50,000 crore in taxes on oil products. Second, lower GDP growth will mean lower production too. In particular, industry is to grow by 7.2% now, which will lower excise and corporate tax collections. Third, the Budget talks of R40,000 crore of disinvestment, which may not happen as the market so far has been at best stagnant. Therefore, the fiscal deficit ratio has to be higher than 4.7% if ceteris paribus conditions prevail.
The only way to meet this mark is for further expenditure cuts, which cannot be ruled out as this was also done in FY11. If this happens, then we can see infrastructure growth taking a back seat, as this is normally the area where allocations are reduced to meet fiscal targets. But, based on the GDP sectoral projections made by the PMEAC, the sector, community and personal services, is to actually grow at a higher rate of 8.5%. Therefore, we have the curious case of one part of the trinity—fiscal deficit, government expenditure or GDP (nominal) actually moving out of the loop as internal consistency is difficult.
The growth rates for agriculture and industry appear to be realistic. However, the projection for services is aggressive at 10% as the services sector may not grow at such a high rate when the sectors that it supports, i.e., agriculture and industry, are growing slowly. Intuitively, it may be seen that any slippage here will get reflected quite sharply in the GDP number.
The other interesting projection made is that the investment rate is to increase, albeit marginally, from 36.4% to 36.7% in FY12. This is significant because in a rising interest rate environment, one would have expected investment to take a knock. The resilience of investment to interest rates is a major take away. Further, it also means that the higher interest rate policy followed by RBI is expected to affect consumption more than investment. Therefore, growth of consumer goods including automobiles backed by finance would be affected more by higher interest rates than investment, which, in a way, is comforting as future growth prospects are addressed.
The external sector is to be the flag bearer at a time when the global economy is in a state of flux. Exports are to grow by 32%, which will be awesome as it will come over a high base year number while the deficit will widen. Given that the current account deficit is going to rise only marginally, to 2.7%, there is quite a bit of elbow room here. But the high point will be foreign investment where capital flows through FDI (gross of $35 billion and net of $18 billion), FIIs (muted at $14 billion) and borrowings ($35 billion). This is not bad news except for the higher external commercial borrowings, which will exert pressure on the external debt situation.
So, what are we to make of these numbers? Growth will be subdued and could take a dip if the assumptions made are violated. The interest rate hikes and their impact appear to be factored though the optimism on investment is still significant. The external sector will provide strength, which, prima facie, appears feasible. India will remain a fast growing economy in depressed global world, though periodic review of the fiscal picture will be essential to gauge the progress.
What's wrong with our statistics? Business Standard JUly 25, 2011
Irony by definition is laced with dark humour, but it would be more like black humour when one views data systems in India. Less than a week after the Reserve Bank of India (RBI) expressed concern over the quality of data, the Central Statistics Office drastically reduced the Index of Industrial Production (IIP) growth number for capital goods for April to 7.3 per cent from 14.5 per cent when it was initially announced. Such revisions are quite bizarre and have a deeper implication because such high-frequency data is used for high-frequency monetary policy stances. The RBI’s frustration is palpable because the April number would have provided the justification for increasing interest rates based on robust investment growth. But, now it turns out that capital goods production was, at best, stable.
One may recollect that for a long time we had spoken about our base years being anachronistic at 1993-94, and bringing forward the base year to 2004-05 was pragmatic. For some reason, the GDP, IIP and Wholesale Price Index (WPI) indices were changed sequentially. A statement often made was that there was high volatility in the growth numbers that would be addressed by the new series. Though having a new series is necessary, the larger issue is whether it addresses the question of volatility. Volatility in the jargon of financial markets economics means the standard deviation of the growth rates. Now, the annualised volatility for the IIP old series was 16.4 per cent and it has increased to 22.6 per cent in the new series. For the WPI series, the annualised volatility was 11.5 per cent and 10.2 per cent respectively. So there has been improvement in the WPI, but not the IIP. Curiously, when the same volatility is reckoned on annual data, then the IIP volatility changes from 2.96 per cent to 4.76 per cent and 1.67 per cent to 2.42 per cent for WPI, meaning that the older series fares better!
Three conclusions can be drawn here. First, the volatility argument does not hold. Second, the fluctuations in growth rates will vary based on seasonal trends as well as base year effects. Third, the problem is with our data collections systems and processes.
What are the problems with our data? There are basically two areas that need to be addressed. The first concerns farm prices. Today prices come from the mandis, where both transactions and prices are opaque. Agricultural Marketing Research & Information Network (AGMARKNET), the official source of data shows prices within a rather wide range that is not helpful. Further, the single numbers that are displayed vary significantly from what commodity exchanges like NCDEX collect from the ground level. In fact, the volatility of prices is much higher for exchange prices compared with the WPI because the latter are based on modal values that do not vary very often. Further, since farm products are seasonal, they do not enter the mandis every month but are traded widely all the same, which moderates the WPI numbers because they are dependent on the quotes received from mandis. The solution is to have electronic mandis where all transactions are recorded so that we have actual prices that can be weighted by the trades that take place.
The other pertains to manufactured goods. If one looks at metals, our WPI shows that prices are increasing when globally prices are falling based on World Bank data. India is a price taker in all metals except iron and steel. Therefore, there should not be such differences in price changes. The problem in manufacturing is exacerbated by the fact that one-third of total manufacturing comes from the unorganised sector where it is difficult to get timely information. Even for the organised sector, the WPI index for a particular product often does not change for weeks because of non-availability of data after which there is a sudden spike in prices. One way out is to make it mandatory for all firms to record every transaction at the factory gate. By linking this to tax filing, firms will be compelled to report accurately the true picture. Admittedly, this is a challenge considering that even unaudited results of firms are not always filed on time.
This being the case, what should be our approach? First, we need to move away from providing high-frequency data if we are unable to vouch for its sanctity. While revisions happen everywhere, changing growth rates by 50 per cent is dangerous for policymakers.
Second, we need to electronically connect all the mandis and have a database in which all firms registered with the Registrar of Companies have to mandatorily enter their production and price numbers.
Third, we need to look at other leading indicators when taking policy decisions based on monetary data that is generally more accurate because it comes from a smaller universe of commercial banks.
Fourth, whenever we interpret data, we should never look at single month data points to eschew the trap of base year and seasonal influences. It would be better to look at cumulative numbers, especially for the real sector. When we look at annual IIP growth rates, we do not look at March over March, but the average of 12 months over the same of the previous year. This automatically factors in the so-called volatility due to inaccuracies or seasons.
Finally, the RBI should seriously think of going back to two policies with need-based Keynesian intervention. While adopting global practices like the Federal Reserve is progressive, other authorities do not have distorted images in the form of inaccurate data like we do. We will have to wait some more time to reach these levels.
One may recollect that for a long time we had spoken about our base years being anachronistic at 1993-94, and bringing forward the base year to 2004-05 was pragmatic. For some reason, the GDP, IIP and Wholesale Price Index (WPI) indices were changed sequentially. A statement often made was that there was high volatility in the growth numbers that would be addressed by the new series. Though having a new series is necessary, the larger issue is whether it addresses the question of volatility. Volatility in the jargon of financial markets economics means the standard deviation of the growth rates. Now, the annualised volatility for the IIP old series was 16.4 per cent and it has increased to 22.6 per cent in the new series. For the WPI series, the annualised volatility was 11.5 per cent and 10.2 per cent respectively. So there has been improvement in the WPI, but not the IIP. Curiously, when the same volatility is reckoned on annual data, then the IIP volatility changes from 2.96 per cent to 4.76 per cent and 1.67 per cent to 2.42 per cent for WPI, meaning that the older series fares better!
Three conclusions can be drawn here. First, the volatility argument does not hold. Second, the fluctuations in growth rates will vary based on seasonal trends as well as base year effects. Third, the problem is with our data collections systems and processes.
What are the problems with our data? There are basically two areas that need to be addressed. The first concerns farm prices. Today prices come from the mandis, where both transactions and prices are opaque. Agricultural Marketing Research & Information Network (AGMARKNET), the official source of data shows prices within a rather wide range that is not helpful. Further, the single numbers that are displayed vary significantly from what commodity exchanges like NCDEX collect from the ground level. In fact, the volatility of prices is much higher for exchange prices compared with the WPI because the latter are based on modal values that do not vary very often. Further, since farm products are seasonal, they do not enter the mandis every month but are traded widely all the same, which moderates the WPI numbers because they are dependent on the quotes received from mandis. The solution is to have electronic mandis where all transactions are recorded so that we have actual prices that can be weighted by the trades that take place.
The other pertains to manufactured goods. If one looks at metals, our WPI shows that prices are increasing when globally prices are falling based on World Bank data. India is a price taker in all metals except iron and steel. Therefore, there should not be such differences in price changes. The problem in manufacturing is exacerbated by the fact that one-third of total manufacturing comes from the unorganised sector where it is difficult to get timely information. Even for the organised sector, the WPI index for a particular product often does not change for weeks because of non-availability of data after which there is a sudden spike in prices. One way out is to make it mandatory for all firms to record every transaction at the factory gate. By linking this to tax filing, firms will be compelled to report accurately the true picture. Admittedly, this is a challenge considering that even unaudited results of firms are not always filed on time.
This being the case, what should be our approach? First, we need to move away from providing high-frequency data if we are unable to vouch for its sanctity. While revisions happen everywhere, changing growth rates by 50 per cent is dangerous for policymakers.
Second, we need to electronically connect all the mandis and have a database in which all firms registered with the Registrar of Companies have to mandatorily enter their production and price numbers.
Third, we need to look at other leading indicators when taking policy decisions based on monetary data that is generally more accurate because it comes from a smaller universe of commercial banks.
Fourth, whenever we interpret data, we should never look at single month data points to eschew the trap of base year and seasonal influences. It would be better to look at cumulative numbers, especially for the real sector. When we look at annual IIP growth rates, we do not look at March over March, but the average of 12 months over the same of the previous year. This automatically factors in the so-called volatility due to inaccuracies or seasons.
Finally, the RBI should seriously think of going back to two policies with need-based Keynesian intervention. While adopting global practices like the Federal Reserve is progressive, other authorities do not have distorted images in the form of inaccurate data like we do. We will have to wait some more time to reach these levels.
Saturday, July 30, 2011
Their debt, our woes: 30th July Financial Express
The Greek tragedy, which turned out to be quite a farce, is not an isolated instance of distortion in the financial markets. Uncle Sam appears to be the imminent threat today with President Obama striving to have the debt limit of $14.3 trillion enhanced. A payment of $29 billion in interest is due in August. Given the size of the US debt problem, the PIGS story appears to be merely a short tale in an epic of indebtedness. Now, whether or not the limit is enhanced will be more of a political issue with the President having the right to bypass Congress as a last resort. But, more importantly, the fact that the US government can default highlights the fact that the global financial system is not really stronger even after emerging from the crisis of 2008. Lehman and Bear Stearns were institutions that shook the financial markets, but a US government default will damage the credibility of the sole superpower and anchor currency.
A US government default will mean that all holders will have to reconsider their options. The outside world holds around $4.5 trillion of the total debt, which is a little over 30% of the total. Clearly, they would get jittery at this prospect and the country likely to be affected the most would be China, which holds $1.16 trillion. China and the US are now symbiotically bound. If the US defaults then China’s holdings get affected. However, the US cannot afford to default because it will then find it difficult to find buyers for its debt in the future, for which China is a major customer. A fall in the value of these reserves will mean losses to be written off that can be quite substantial. A lower value of reserves will compress money supply, which, in turn, will mean pressure on interest rates. Higher rates impact investment and growth.
The second constituent of the market that would be affected will be the pension funds, provident funds and insurance companies that have to perforce invest in triple-A-rated paper. Any erosion in value would mean a withdrawal, which, in turn, will mean large-scale selling of treasuries that will spur up interest yields in the market. Lastly, this panic will affect around $4 trillion of treasuries that are held as collateral in the futures market—repo, OTC derivative, etc. A default will induce a haircut on these values, leading to a tailspin the market.
The issue may be seen as being more of a political dilemma where the Republicans want an expenditure cut as against Obama who would like to see taxes increased. This impasse has meant that the financial markets remain on the edge. Various packages are being spoken of in terms of expenditure cuts and the rating agencies are intransigent about anything less than $4 trillion in debt to retain the triple-A status.
What does this mean for the world? Even in case a default is eschewed, there will be a certain loss of credibility in the dollar and the global system will have to look for alternatives. Currently, with the dollar being the anchor currency, the US has the prerogative to follow the policy of benign neglect to supply dollars to the world where there is belief that the currency is strong. However, now with doubts being raised, we have to look at another currency. The euro was to be the alternative but given the entanglements with the debt crisis and the existence of a common currency has inextricably put the better performing nations in a compromising position. The euro tangle is one where no one can let the rogue nations sink as it would affect every bank’s and hence nation’s balance sheet.
The recent restructuring of Greek debt turned quite farcical. In the new package, Greece borrows 35 billion euros and buys 30-year bonds, which will be worth 100 billion euros on maturity, which is used to repay the investor. WSJ has estimated that the total loss for EU banks can be around 14 billion euros. This comes shortly after the stress tests were carried out by the European Banking Authority that found only eight banks to be deficient in capital (maintaining core tier-1 capital of 5%) out of a set of 90 banks, but surprisingly did not take into account the most vital stress test of Greek default.
The situation is hence quite fluid for the financial markets. While credibility is the main factor, the implications for global growth are compelling. An overall slowdown in global growth as well as trade cannot be ruled out, as the onus will be more on the emerging nations to provide an impetus. Countries like India and China, which have been the bastions of growth in the past, are trying hard to fight inflation and deflate their economies. In such a situation, growth prospects appear to be muted.
But, on the positive side, we can see this entire process being part of a cleansing process where nations will put their fiscal balances in order. Keynesian pump priming, which worked in 2008 and 2009, has to be reviewed now as it also means building debt, which can shake the edifice of credibility as well as future growth. These episodes should be lessons to be imbibed as we work on modifying, if not creating, a new global financial order against the background of the financial crisis that started with Bear Stearns in 2008 and culminated with Uncle Sam’s sorrows.
A US government default will mean that all holders will have to reconsider their options. The outside world holds around $4.5 trillion of the total debt, which is a little over 30% of the total. Clearly, they would get jittery at this prospect and the country likely to be affected the most would be China, which holds $1.16 trillion. China and the US are now symbiotically bound. If the US defaults then China’s holdings get affected. However, the US cannot afford to default because it will then find it difficult to find buyers for its debt in the future, for which China is a major customer. A fall in the value of these reserves will mean losses to be written off that can be quite substantial. A lower value of reserves will compress money supply, which, in turn, will mean pressure on interest rates. Higher rates impact investment and growth.
The second constituent of the market that would be affected will be the pension funds, provident funds and insurance companies that have to perforce invest in triple-A-rated paper. Any erosion in value would mean a withdrawal, which, in turn, will mean large-scale selling of treasuries that will spur up interest yields in the market. Lastly, this panic will affect around $4 trillion of treasuries that are held as collateral in the futures market—repo, OTC derivative, etc. A default will induce a haircut on these values, leading to a tailspin the market.
The issue may be seen as being more of a political dilemma where the Republicans want an expenditure cut as against Obama who would like to see taxes increased. This impasse has meant that the financial markets remain on the edge. Various packages are being spoken of in terms of expenditure cuts and the rating agencies are intransigent about anything less than $4 trillion in debt to retain the triple-A status.
What does this mean for the world? Even in case a default is eschewed, there will be a certain loss of credibility in the dollar and the global system will have to look for alternatives. Currently, with the dollar being the anchor currency, the US has the prerogative to follow the policy of benign neglect to supply dollars to the world where there is belief that the currency is strong. However, now with doubts being raised, we have to look at another currency. The euro was to be the alternative but given the entanglements with the debt crisis and the existence of a common currency has inextricably put the better performing nations in a compromising position. The euro tangle is one where no one can let the rogue nations sink as it would affect every bank’s and hence nation’s balance sheet.
The recent restructuring of Greek debt turned quite farcical. In the new package, Greece borrows 35 billion euros and buys 30-year bonds, which will be worth 100 billion euros on maturity, which is used to repay the investor. WSJ has estimated that the total loss for EU banks can be around 14 billion euros. This comes shortly after the stress tests were carried out by the European Banking Authority that found only eight banks to be deficient in capital (maintaining core tier-1 capital of 5%) out of a set of 90 banks, but surprisingly did not take into account the most vital stress test of Greek default.
The situation is hence quite fluid for the financial markets. While credibility is the main factor, the implications for global growth are compelling. An overall slowdown in global growth as well as trade cannot be ruled out, as the onus will be more on the emerging nations to provide an impetus. Countries like India and China, which have been the bastions of growth in the past, are trying hard to fight inflation and deflate their economies. In such a situation, growth prospects appear to be muted.
But, on the positive side, we can see this entire process being part of a cleansing process where nations will put their fiscal balances in order. Keynesian pump priming, which worked in 2008 and 2009, has to be reviewed now as it also means building debt, which can shake the edifice of credibility as well as future growth. These episodes should be lessons to be imbibed as we work on modifying, if not creating, a new global financial order against the background of the financial crisis that started with Bear Stearns in 2008 and culminated with Uncle Sam’s sorrows.
Thursday, July 14, 2011
Challenging the poverty dimension of inflation: Economic Times 13th July 2011
A perverse, yet novel reason put forward to explain high inflation is that the poor are eating more as they are becoming less poor. The Mahatma Gandhi National Rural Employment Guarantee Scheme (MGNREGS) has been extolled for being responsible for higher consumption, which in a way is a vindication of high inflation. The extended logic used here is that if the poor are eating more and we are paying high prices, then there is nothing amiss.
There are two thoughts here. The first is that higher demand per se, especially of food items, has to be met by augmenting supplies; and this holds for any good or service. If people want more mobile handsets, industry produces more of them, which leads to lower prices.
Therefore, ideally if people are less poor and demand more food, then we should produce more food at a lower cost. This is the duty of any economy that works and hence we cannot sit back and take pride in such a development as it is a reflection of the failure of the system to deliver if there are persistent supply imbalances. However, for the sake of argument, let us suppose that this theory has a basis and prima facie makes sense.
This leads to the second issue. Do the numbers really add up? The MGNREGS allots around .`40,000 crore on an annual basis, and while the code speaks of an allocation of 60:40 for wages: materials, it has turned out to be 70% for wages. Therefore, there is an additional income of .`28,000 crore. Let us suppose that all this money is actually spent and nothing is saved as the people are poor and think only of the present. Here one cannot be sure whether or not this income will lead to additional spending or will merely substitute other sources of funding.
This is so because on an average, the MGNREGS in reality provides 37 days of employment to households when they are entitled to 100 days, which means that this becomes an income supplement when they are between two harvest seasons. In the extreme case, it will fully substitute other sources of income or else they will spend the money progressively on non-food items.
Now, the consumption pattern in the country points towards around 36% of expenditure going into food items and another 7% or so into clothes, which would be the areas the farmers would be looking at. This means that around 85% of their incomes would go into food as an approximation (36 divided by 43). Total consumption expenditure on food was estimated to be .`16.20 lakh crore for the country by the CSO in FY10 while the MGNREGS money of .`24,000 crore (i.e., 85% of .`28,000 crore) will be the maximum that can be spent on food items.
Now, this amount works out to 1.5% of total food consumption (or 1.7% in case the entire .`28,000 cr is spent on food products), and considering that farm output has increased by 6.6% in FY11, one cannot really see a mismatch between demand and supply for food items in general.
At the next stage we can get down to the micro level and examine whether this theory can still hold. Out of the.`28,000 crore being spent on food products, CSO data shows that around 25% is spent on cereals and pulses, where prices showed a decline or marginal increase.
Besides, they would be covered under the public distribution system where prices have remained unchanged. Fruits and vegetables account for another 26.5% and the problem is not higher demand but high losses on account of absence of storage facilities. The Union Budget admitted that around 40% of the crop is wasted due to the absence of logistics support.
Another 21% is spent on milk products, where the higher price is due to higher cost of production (i.e., animal feed such as oilcakes and fodder) while another 12% is on meat/poultry products where prices have increased due to higher cost of animal feed. There is hence reason to believe that this higher purchasing power would not have significantly affected the demand picture, given that the problem is still on supply and cost factors.
Therefore, either way the theory that inflation in FY11 has been caused by the poor becoming less poor does not hold. The problem is on the supply side as also our inability to manage surpluses. India is traditionally in surplus when it comes to cereals, horticulture, sugar and deficient in pulses and oilseeds. The curious case here is that when production of pulses and oilseeds increase, prices move downwards and we also simultaneously lower our imports as we do not store them for the rainy day.
On the other hand, when production declines, we import more. Given that we import around 15-20% of our pulses requirement and 55% of edible oils, international prices are also influenced by this demand. Hence, inflation gets imported into our system. The wastage in horticulture is now quite well known and the country struggles to create the storage facilities to harness the production levels. Therefore, to use diminishing poverty as a factor causing inflation is neither an explanation nor an excuse.
There are two thoughts here. The first is that higher demand per se, especially of food items, has to be met by augmenting supplies; and this holds for any good or service. If people want more mobile handsets, industry produces more of them, which leads to lower prices.
Therefore, ideally if people are less poor and demand more food, then we should produce more food at a lower cost. This is the duty of any economy that works and hence we cannot sit back and take pride in such a development as it is a reflection of the failure of the system to deliver if there are persistent supply imbalances. However, for the sake of argument, let us suppose that this theory has a basis and prima facie makes sense.
This leads to the second issue. Do the numbers really add up? The MGNREGS allots around .`40,000 crore on an annual basis, and while the code speaks of an allocation of 60:40 for wages: materials, it has turned out to be 70% for wages. Therefore, there is an additional income of .`28,000 crore. Let us suppose that all this money is actually spent and nothing is saved as the people are poor and think only of the present. Here one cannot be sure whether or not this income will lead to additional spending or will merely substitute other sources of funding.
This is so because on an average, the MGNREGS in reality provides 37 days of employment to households when they are entitled to 100 days, which means that this becomes an income supplement when they are between two harvest seasons. In the extreme case, it will fully substitute other sources of income or else they will spend the money progressively on non-food items.
Now, the consumption pattern in the country points towards around 36% of expenditure going into food items and another 7% or so into clothes, which would be the areas the farmers would be looking at. This means that around 85% of their incomes would go into food as an approximation (36 divided by 43). Total consumption expenditure on food was estimated to be .`16.20 lakh crore for the country by the CSO in FY10 while the MGNREGS money of .`24,000 crore (i.e., 85% of .`28,000 crore) will be the maximum that can be spent on food items.
Now, this amount works out to 1.5% of total food consumption (or 1.7% in case the entire .`28,000 cr is spent on food products), and considering that farm output has increased by 6.6% in FY11, one cannot really see a mismatch between demand and supply for food items in general.
At the next stage we can get down to the micro level and examine whether this theory can still hold. Out of the.`28,000 crore being spent on food products, CSO data shows that around 25% is spent on cereals and pulses, where prices showed a decline or marginal increase.
Besides, they would be covered under the public distribution system where prices have remained unchanged. Fruits and vegetables account for another 26.5% and the problem is not higher demand but high losses on account of absence of storage facilities. The Union Budget admitted that around 40% of the crop is wasted due to the absence of logistics support.
Another 21% is spent on milk products, where the higher price is due to higher cost of production (i.e., animal feed such as oilcakes and fodder) while another 12% is on meat/poultry products where prices have increased due to higher cost of animal feed. There is hence reason to believe that this higher purchasing power would not have significantly affected the demand picture, given that the problem is still on supply and cost factors.
Therefore, either way the theory that inflation in FY11 has been caused by the poor becoming less poor does not hold. The problem is on the supply side as also our inability to manage surpluses. India is traditionally in surplus when it comes to cereals, horticulture, sugar and deficient in pulses and oilseeds. The curious case here is that when production of pulses and oilseeds increase, prices move downwards and we also simultaneously lower our imports as we do not store them for the rainy day.
On the other hand, when production declines, we import more. Given that we import around 15-20% of our pulses requirement and 55% of edible oils, international prices are also influenced by this demand. Hence, inflation gets imported into our system. The wastage in horticulture is now quite well known and the country struggles to create the storage facilities to harness the production levels. Therefore, to use diminishing poverty as a factor causing inflation is neither an explanation nor an excuse.
Are T-bill futures a good idea? Financial Express 11th July 2011
Futures on 91-days’ T-bill is an interesting development, considering that there is scepticism attached to money market derivatives, given the lacklustre response to the IRFs twice over. But, this one can be different because it does address, to a large extent, the concerns that thwarted the growth of the IRF market.
If we look at the structure of the market, the primary market has issues every week of, say, R8,000-10,000 crore depending on the RBI’s calendar. The buyers are banks, mutual funds, corporates and other institutions and some state governments. The secondary market does not inspire too much of trading and at best registers around R2,000 crore a day, which obviously has to change. This may be contrasted with, say, trading of around R20,000 crore a day in the cash segment of the stock market. Overall outstanding on such paper would be around R80,000-90,000 crore, though there is considerable churning of such bills as they expire every 91 days, which, in turn, are replaced by fresh issuances. This makes it an interesting underlying product as there is a virtual rollover of paper on a regular basis. How then will the derivative product on this underlying work?
For any market to work for a derivative product, we need to have large number of players—hedgers and speculators besides the arbitragers. The actual holders would be interested in such an instrument as hedgers. In FY12 so far there has been a movement of a little over 100 bps in the primary yield on 91-days T-bills, which means that the prices of these bills have been coming down. Intuitively, in such an environment of rising interest rates, this is a big risk that is being carried in the books of the holder and there is need to hedge it. This is where the investors or speculators could come in and take an opposing view on movement in interest rates. Hence, holders of such instruments would be shorting their futures, so as to buy back at a lower rate and provide cover for their loss on portfolio. At times, when the volatility in interest rate has been high and uncertain, given that one is still not too sure of RBI’s view on interest rates, this is a very useful option for interest rate hedging. As a corollary, it makes a sensible investment option.
T-bill futures have the potential to actually set benchmarks for short-term instruments such as commercial paper, certificates of deposits and other treasury bills. 91-days T-bills futures will hence help enable them to take positions based on their holdings of pother instruments. Corporates who are dealing with floating rate bonds would find this attractive as they are able to benchmark and hedge or trade based on interest rate perceptions. In fact, even within the T-bills market there have been major shifts in yields on other maturities which are above 50 bps for 14-days and around 75 bps for 182- and 362-days bills in the last three months. A major improvement over the IRFs is that there is no delivery and all transactions are cash settled, meaning thereby that one does not have to go running around for the right security to deliver. The absence of securities transactions tax will also help in further lowering costs along with lower margins, which provide greater leverage to investors.
In fact, this instrument should also attract attention from the retail end as one can actually take advantage of interest rate movements, especially in an era of rising interest rates. Deposit holders normally get into the instrument and have their interest rate locked for a fixed tenure. In an increasing rate environment, one can actually start playing on T-bill futures to derive the benefit of hedging or making a profit. The advantage for this derivative segment is that one can directly trade on the NSE platform just like one does for, say, shares.
A vibrant futures market in the IRF segment including T-bills has the potential to make the financial markets more buoyant. Futures typically trade a multiple times that in the physical or cash markets. In stock markets, for example, we have trades of around 6-7 times the cash segment, which, on its own, could mean comparable numbers for this segment. Commodity futures generate business volumes of around R60,000-70,000 crore a day while currency derivatives clock R30,000 crore a day. Quite clearly, the money market, which has a large underlying of GSec paper, corporate bonds, T-bills, CPs and CDs, should be able to match the same once they set acceptable benchmarks for other instruments, given that there is a large mass of GSecs which banks hold on to that always run the risk of MTM losses in a regime of rising interest rates. The IRFs were to address this issue, but the contract structures were a deterrent. Hopefully, we have gotten the product right this time as the initial trading volumes look more respectable than it were when the initial IRFs were launched.
If we look at the structure of the market, the primary market has issues every week of, say, R8,000-10,000 crore depending on the RBI’s calendar. The buyers are banks, mutual funds, corporates and other institutions and some state governments. The secondary market does not inspire too much of trading and at best registers around R2,000 crore a day, which obviously has to change. This may be contrasted with, say, trading of around R20,000 crore a day in the cash segment of the stock market. Overall outstanding on such paper would be around R80,000-90,000 crore, though there is considerable churning of such bills as they expire every 91 days, which, in turn, are replaced by fresh issuances. This makes it an interesting underlying product as there is a virtual rollover of paper on a regular basis. How then will the derivative product on this underlying work?
For any market to work for a derivative product, we need to have large number of players—hedgers and speculators besides the arbitragers. The actual holders would be interested in such an instrument as hedgers. In FY12 so far there has been a movement of a little over 100 bps in the primary yield on 91-days T-bills, which means that the prices of these bills have been coming down. Intuitively, in such an environment of rising interest rates, this is a big risk that is being carried in the books of the holder and there is need to hedge it. This is where the investors or speculators could come in and take an opposing view on movement in interest rates. Hence, holders of such instruments would be shorting their futures, so as to buy back at a lower rate and provide cover for their loss on portfolio. At times, when the volatility in interest rate has been high and uncertain, given that one is still not too sure of RBI’s view on interest rates, this is a very useful option for interest rate hedging. As a corollary, it makes a sensible investment option.
T-bill futures have the potential to actually set benchmarks for short-term instruments such as commercial paper, certificates of deposits and other treasury bills. 91-days T-bills futures will hence help enable them to take positions based on their holdings of pother instruments. Corporates who are dealing with floating rate bonds would find this attractive as they are able to benchmark and hedge or trade based on interest rate perceptions. In fact, even within the T-bills market there have been major shifts in yields on other maturities which are above 50 bps for 14-days and around 75 bps for 182- and 362-days bills in the last three months. A major improvement over the IRFs is that there is no delivery and all transactions are cash settled, meaning thereby that one does not have to go running around for the right security to deliver. The absence of securities transactions tax will also help in further lowering costs along with lower margins, which provide greater leverage to investors.
In fact, this instrument should also attract attention from the retail end as one can actually take advantage of interest rate movements, especially in an era of rising interest rates. Deposit holders normally get into the instrument and have their interest rate locked for a fixed tenure. In an increasing rate environment, one can actually start playing on T-bill futures to derive the benefit of hedging or making a profit. The advantage for this derivative segment is that one can directly trade on the NSE platform just like one does for, say, shares.
A vibrant futures market in the IRF segment including T-bills has the potential to make the financial markets more buoyant. Futures typically trade a multiple times that in the physical or cash markets. In stock markets, for example, we have trades of around 6-7 times the cash segment, which, on its own, could mean comparable numbers for this segment. Commodity futures generate business volumes of around R60,000-70,000 crore a day while currency derivatives clock R30,000 crore a day. Quite clearly, the money market, which has a large underlying of GSec paper, corporate bonds, T-bills, CPs and CDs, should be able to match the same once they set acceptable benchmarks for other instruments, given that there is a large mass of GSecs which banks hold on to that always run the risk of MTM losses in a regime of rising interest rates. The IRFs were to address this issue, but the contract structures were a deterrent. Hopefully, we have gotten the product right this time as the initial trading volumes look more respectable than it were when the initial IRFs were launched.
Yield curve not based on real market conditions: Economic Times 6th July 2011
The government debt market trades almost as much as the cash segment on NSE at around Rs 15,000 crore a day. The size of the market is large with outstanding central government paper of around Rs 25 lakh crore, with net annual addition of around Rs 3.5 lakh crore of paper. Yet, there are some interesting statistics on the topography of trade that takes place in this market. More than 80% takes place in paper with a residual maturity of 10 years and above, despite the fact that around 38% of fresh paper being issued has over 10 years maturity, with an equal share for papers with 5-10 years maturity. What does this indicate? The market is still narrow in terms of trade taking place. A curious factor is that the difference in yields on 1 year and 10 year paper is around 15-20 bps.
Contrast this with the markets overseas and the picture is startling . On an average, based on Bloomberg data, for the last month, the difference between these tenures was around 280 bps in the US, 270 bps for UK and 150-160 bps in Germany. For 5 years, this spread was 140 bps, 150 bps and 85 bps, respectively. In our case, it was slightly inverted with a spread of 20 bps. Quite clearly, the Indian picture is a manifestation of a weak market. While the US and the UK are relatively more indebted than Germany , India , too, is a high debt nation. Yet, the yield spreads indicate a different picture. One of the two conclusions that come from these numbers is that the market is immature and the yield curve is not actually based on real market conditions.
Trading is at the higher end of the spectrum and even the 10 year paper cannot be accurately benchmarked. In the absence of this curve, developing a corporate yield curve becomes difficult as this involves a risk premium over the non-existent G-Sec yield. The second is that the government is getting funds at 8-8 .30% discount, at the worst of times for long tenures. With repo rate at 7.25%, which is a single day rate, the spread of just 100 bps or so for 10 years is good money, especially in a rising interest rate regime where corporate spreads for top-rated firms are 125-200 bps higher. Both these anomalies need to be corrected.
First, we need to have a well-defined yield curve in the G-Sec space. While the government is definitely spreading across its issues, the secondary market is trending to the higher maturities . To get the curve, interest has to be created among the participants. At the institutional level, can we actually think of making banks hold differing maturity of securities linked to the tenure of their deposits? Alternatively , banks may be incentivised in terms of the valuation of securities based on short term and long term. This would be an unconventional way of creating liquidity. The other is to bring in retail interest .
Individuals that go in for savings in fixed deposits or small savings do look at time horizons of up to 5-6 years, which can go up to 10 years. By providing them with access in smaller denominations and perhaps tax benefits, this process can be hastened. To facilitate such trading, it would also be necessary to provide a trading platform that can be done on the online stock exchanges, which provide access to equities and mutual funds. Third, the government should earmark borrowing maturities with its usage. Borrowing for infra projects can have higher maturity, while the same for meeting revenue expenditure or short-term projects should be of lower maturity. In this manner, the government can help in creating short-term paper.
Fourth, another unconventional way of creating a market is for RBI to periodically declare which are the securities that can be traded. This could be contrived to create liquidity in a tenure . Variants can be of directing specific securities for the purpose of repo so that other securities also get traded in the secondary market. Alternatively , there can be debt funds which invest only in bonds with maturities of 1-9 years. The existence of market makers could spur activity here. A well developed G-Sec market will help set benchmarks needed for the corporate debt market to grow. Globally , corporate debt markets provide funds with banks investing in the same. Migration to this mode would be possible only if there are exit options .
At present, attention is given to getting institutional players and providing more efficient trading and settlement platforms. Evidently, we have to move to the next level of generating liquidity, which should set the tone of our agenda for the next 2-3 years.
Contrast this with the markets overseas and the picture is startling . On an average, based on Bloomberg data, for the last month, the difference between these tenures was around 280 bps in the US, 270 bps for UK and 150-160 bps in Germany. For 5 years, this spread was 140 bps, 150 bps and 85 bps, respectively. In our case, it was slightly inverted with a spread of 20 bps. Quite clearly, the Indian picture is a manifestation of a weak market. While the US and the UK are relatively more indebted than Germany , India , too, is a high debt nation. Yet, the yield spreads indicate a different picture. One of the two conclusions that come from these numbers is that the market is immature and the yield curve is not actually based on real market conditions.
Trading is at the higher end of the spectrum and even the 10 year paper cannot be accurately benchmarked. In the absence of this curve, developing a corporate yield curve becomes difficult as this involves a risk premium over the non-existent G-Sec yield. The second is that the government is getting funds at 8-8 .30% discount, at the worst of times for long tenures. With repo rate at 7.25%, which is a single day rate, the spread of just 100 bps or so for 10 years is good money, especially in a rising interest rate regime where corporate spreads for top-rated firms are 125-200 bps higher. Both these anomalies need to be corrected.
First, we need to have a well-defined yield curve in the G-Sec space. While the government is definitely spreading across its issues, the secondary market is trending to the higher maturities . To get the curve, interest has to be created among the participants. At the institutional level, can we actually think of making banks hold differing maturity of securities linked to the tenure of their deposits? Alternatively , banks may be incentivised in terms of the valuation of securities based on short term and long term. This would be an unconventional way of creating liquidity. The other is to bring in retail interest .
Individuals that go in for savings in fixed deposits or small savings do look at time horizons of up to 5-6 years, which can go up to 10 years. By providing them with access in smaller denominations and perhaps tax benefits, this process can be hastened. To facilitate such trading, it would also be necessary to provide a trading platform that can be done on the online stock exchanges, which provide access to equities and mutual funds. Third, the government should earmark borrowing maturities with its usage. Borrowing for infra projects can have higher maturity, while the same for meeting revenue expenditure or short-term projects should be of lower maturity. In this manner, the government can help in creating short-term paper.
Fourth, another unconventional way of creating a market is for RBI to periodically declare which are the securities that can be traded. This could be contrived to create liquidity in a tenure . Variants can be of directing specific securities for the purpose of repo so that other securities also get traded in the secondary market. Alternatively , there can be debt funds which invest only in bonds with maturities of 1-9 years. The existence of market makers could spur activity here. A well developed G-Sec market will help set benchmarks needed for the corporate debt market to grow. Globally , corporate debt markets provide funds with banks investing in the same. Migration to this mode would be possible only if there are exit options .
At present, attention is given to getting institutional players and providing more efficient trading and settlement platforms. Evidently, we have to move to the next level of generating liquidity, which should set the tone of our agenda for the next 2-3 years.
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