Explaining the Indian stock market's fall

Business Standard carries a report on how margin requirements contributed to the steep fall in the Indian stock market earlier this week:

According to stock brokers, the real pain in markets started with the over-zealousness on the part of stock exchanges in collecting margin money after the 700 points fall on January 18 and another 14,00 points fall on January 21.

The trading terminals of nearly 90 per cent stock brokers were shut on Tuesday when the markets hit the lower circuit of 10 per cent within a few minutes of opening bell, as the National Stock Exchange doubled the margin money overnight.

"The exchanges wanted stock brokers to pay additional margin money immediately. How can we do this when our clients' cheques take at least two days to clear?" asked a Bombay-based broker who deposited an overdue margin of about Rs 1,000 crore (Rs 10 billion) with the exchanges on Wednesday.

A payment crisis was already looming in the aftermath of the Reliance [Get Quote] Power IPO.

The call for more margin money, from stock exchanges, had a domino effect on the markets.

How far is this explanation valid? Well, increased margin requirements for brokers at a time of falling markets are always a reason for the sharpness of market declines. But, it is not as if the problem will go away if the cheque settlement system is improved.

That's because many of the investors who get into payment difficulties are those who have borrowed in order to speculate in the market. They borrow for day-trading, for IPOs and for any other investment in the stock market. They will have to sell their shares any way in order to meet margin calls. Whether the shares are sold by the brokers on whom margin demands are made or by the investors makes no difference- there will be huge sales and there will be overshooting in the market.

Theoretically, banks can provide finance to investors but they will be wary of lending when markets are in a state of free wall. As the BS report mentions elsewhere, there has to be some proportionality between margin payments made by investors and their brokers- the less stringent the margin requirement, the greater are the chances of a decline in the stock market escalating into a crash.

US crisis does not spell crisis for world economy

I have been saying this for a while now and am glad to have the formidable backing of financier George Soros, writing in the FT:

Although a recession in the developed world is now more or less inevitable, China, India and some of the oil-producing countries are in a very strong countertrend. So, the current financial crisis is less likely to cause a global recession than a radical realignment of the global economy, with a relative decline of the US and the rise of China and other countries in the developing world.

The danger is that the resulting political tensions, including US protectionism, may disrupt the global economy and plunge the world into recession or worse.

If you accept this, then it follows that what we are seeing in the Indian stock market is an over-reaction and the market should bounce back.

World Bank on brain drain

The World Bank's latest Global Economic Prospects (2008) has a section of emigration of highly skilled professionals from developing countries and its impact. Page 124 in this section has two graphs. One shows the percentage of Ph D students from various countries still living in the US after graduation. China tops with over 90%, followed by India (over 80%). Iran and Argentina also have a share of more than 50%. But a number of other countries including Brazil, Chile, Indonesia and South Korea have a share of under 50%- their doctorates prefer to return home.

Another graph alongside shows that the higher the percentage of Phds returning home, the higher is the per capita national income. But correlation, we know, does mean causality. We cannot conclude that because more Phds come back, a country will be more prosperous. It could well be that when a country become prosperous, its nationals would like to return home after studies.

I say this because the growing brain drain in recent years has gone hand in hand with an accleration in economic growth in both India and China (just as it has gone hand in hand with the decline in the quality of economists in government!). The loss of highly skilled professionals may be notional because the home country is not in a position to utilise talent of a certain order.

Moreover, once highly skilled professionals succeed abroad, they may be in a position to contribute to their parent country- remittances are an obvious way but the creation of knowledge networks and initiation of investments from MNCs abroad are other ways in which non-residents can contribute. In other words, brain drain may less of a loss than is commonly supposed.

Anil poised to overtake Mukesh Ambani

Anil Ambani is poised to overtake Mukesh Ambani as well as Lakshmi Mittal as the richest Indian, FT reports:

Anil Ambani, the controlling shareholder in Reliance Power, is set to leapfrog his brother Mukesh Ambani, as well as steel tycoon Lakshmi Mittal to become the richest Indian on the back of record investor demand for shares in his company.

.....Mr Mittal and Mukesh Ambani topped a list of richest Indians published by Forbes in November, with fortunes worth respectively $51bn and $49bn. But the value of their companies has not risen since, while Anil Ambani is creating billions of dollars of paper wealth overnight.

Reliance Power is listing just over 10 per cent of its shares at Rs450 each on the Indian stock market next month to raise $3bn. The flotation will value the company at about $30bn. Mr Ambani’s interests will be valued at about $13.5bn. He indirectly controls about 45 per cent of the company.

Interesting. When the famous spat occurred between the Ambani brothers, Anil was soon as the loser since he got a smaller portion of the assets and Mukesh walked away with the flagship, Reliance Industries. But, in the stock market, asset size is not everything. Earnings growth is what matters. Communications, finance, infrastructure- the areas that Anil inherited or is moving into are hotter areas than chemicals. They are seen as high growth areas and will attract greater interest from institutional investors, that is why Anil Ambani is forging ahead.

Bottomline for businessmen: don't be obsessed with size, think earnings growth. Go for mergers and acquisitions not if you believe it will boost earnings growth, not because you will have a larger company in your stable.

Reining in bankers's incentives

Martin Wolf weighs in on the side of those believe that incentives in banking are flawed and need to be reined in:

By paying huge bonuses on the basis of short-term performance in a system in which negative bonuses are impossible, banks create gigantic incentives to disguise risk-taking as value-creation.

We would be better off with Jupiter’s 12-year “year”, since it takes about that long to know how profitable strategies have been. The point is that a year is an astronomical, not an economic, phenomenon (as it once was, when harvests were decisive). So we must ensure that a substantial part of pay is better aligned to the realities of the business: that is, is made in restricted stock redeemable over a run of years (ideally, as many as 10).

Yet individual institutions cannot change their systems of remuneration on their own, without losing talented staff to the competition. So regulators may have to step in. The idea of such official intervention is horrible, but the alternative of endlessly repeated crises is even worse.

.....all bonuses and a portion of salary for top managers should be paid in restricted stock, redeemable in instalments over, say, 10 years or, if regulators are feeling generous, five.

Yes, locking in rewards over a long period will help as will payment in stock. If rewards are to be in made in cash, only a portion of the rewards announced for a year should be paid out; the rest should be held back over the business cycle and adjusted for losses bankers' run up. When one bank poaches people from another, the vesting period of options assumed by the hiring bank should remain unchanged.

China's economy not that export-dependent!

China is not as dependent one exports for its growth as is made out to be, according to the Economist. Investment accounts for 40% of China's growth. This won't be heavily affected by a drop in exports because over half of it is domestically driven- it has to do with infrastructure and property. It cites a research report that forecasts that a downturn in the US economy will result in China's growth slowing down from 11.5% to 10%- hardly catastrophic. The US may be more export-dependent than China- exports contribute 30% to US growth.

The high share of exports to GDP- 40%- in China may be deceptive. Exports are measured as gross revenues whereas GDP is the value added. A UBS analyst has attempted to measure China's exports in value added terms and measure these as a proportion of GDP. The ratio is much lower- 10%. This, the analyst suggests, is a measure of "true" export dependency of the Chinese economy.

I guess this reinforces my position that growth in China and India will help mitigate the effects of a US downturn on the world economy.

The price of dissent in the CIA

The Iraq war under the junior President George Bush highlighted how intelligence agencies could be pressure to produce reports that satisfied their bosses. Evidence is now emerging that much the same thing happened in respect of Pakistan's pursuit of nuclear weapons under the now disgraced scientist A Q Khan.

The Economist has a review of a recent book, The Nuclear Jihadist, that details how the US disregarded reports about Pakistan's flouting non-proliferation laws in order to secure the bomb. Worse, an intelligence agent who protested about the cover-up of the growing evidence ended up paying a heavy price:

The book's most revealing passages are about America's role in the affair. The authors argue that successive American administrations knew a lot about Mr Khan's activities, but for larger strategic foreign-policy reasons, chose to do nothing about them. Mr Khan was able to flout international rules on nuclear non-proliferation because American policymakers thought that securing Pakistan's assistance in defeating the Soviet Union in Afghanistan—and, more recently, President Pervez Musharraf's help in fighting terrorism—were more important than limiting the spread of nuclear bombs.

The story of Richard Barlow, a CIA agent who once worked in its directorate of intelligence on proliferation, sums up the American attitude. Mr Barlow had protested that intelligence was being manipulated by the Pentagon to suit the policy adopted by President Bush senior's administration of turning a blind eye to Pakistan's nuclear development. He lost his job. The authors find Mr Barlow at the end of the book denied his state pension, living with two dogs in a motor home.

World Bank optimistic on growth outlook

I have placed myself unambiguously in the optimists' camp when it comes to the economic outlook for the world in 2008- I've said that we will see a sharp slowdown in the US but not a recession and a deceleration in the world economy that will still leave emerging markets in good shape.

The World Bank takes much the same line, I'm heartened to note, in its latest Global Economic Prospects. The world economy slowed from 3.9% in 2006 to 3.6% in 2007; the Bank sees a further slowdown to 3.3% in 2008- in other words, a soft landing. Growth in developing countries will moderate only somewhat over the next couple of years- in 2008, the Bank expects growth of 7.1%. For India, the Bank projects growth of 8.4% and 8.5% in 2008 and 2009 respectively, down marginally from 9% in 2007.

The Bank does see the risk of a US recession and its impact on the rest of the world but does not appear to think this is the likely scenario. It thinks that the impact of the housing sector on the US economy will be mitigated by export growth; it also thinks that the financial markets crisis will be contained as risks are not likely to be concentrated in a few institutions.

Why neither the banking channel nor the consumption channel is likely to lead on to a recession in the US is an issue I address in my latest ET column, Liquidity, not solvency the issue.

Bankers' pay

I have written in an earlier post and in other posts about how the incentive system at banks and investment banks needs to be overhauled if recurring financial crises are to be avoided.

The problem I have been highlighting is the heads-I-win-tails- the- firms- loses syndrome. Bankers rake in bonuses when they do well. When they run up losses, it is for the firm to pick up the pieces. At the most, bankers may lose their jobs and a portion of stock options that have not vested. But they would still have the accumulated bonuses of the past to enjoy life.

I have argued that only a portion of bonuses due should be paid out in a given year; the rest should be credited to an account in which there will be entries for bonuses for profits and negative bonuses for losses. At the end of, say, five years, the balance would be paid out to managers.

I note with satisfaction that my view finds endorsement from Raghuram Rajan, former Chief Economist of the IMF. Writing in the FT, Rajan says:

Compensation structures that reward managers annually for profits, but do not claw these rewards back when losses materialise, encourage the creation of fake alpha. Significant portions of compensation should be held in escrow to be paid only long after the activities that generated that compensation occur.

Rajan also makes the point that excess returns- that is, returns in excess of that warranted by a given level of risk- are rarely achieved. What a manager claims as excess return is actually a level of return for which the appropriate risk has not been factored in. Very often, the risk shows up much later in the form of a loss, not in the year in which performance is being measured. That's why a big chunk of bonuses must be deferred.

Anti-business bias in European text books

High school text books in Germany and France take a dim view of business enterprise, says Stephen Theil, Newsweek's European economics correspondent in an article in a Foreign Policy article reproduced in FT. This, the writer says, must explains the profound mistrust towards the free enterprise economy in those countries- in France, only 36% of the people supported free enterprise in a 2005 poll and in Germany support for socialist ideals was running at a high of 47% in 2007.

Theil cites intances:

Economic growth imposes a hectic form of life, producing overwork, stress, nervous depression, cardiovascular disease and, according to some, even the development of cancer,” asserts Histoire du XXe siècle, a text memorised by French high-school students as they prepare for entrance exams to prestigious universities. Start-ups, the book tells students, are “audacious enterprises” with “ill-defined prospects”. Then it links entrepreneurs with the technology bubble, the Nasdaq crash and massive redundancies across the economy. Think “creative destruction” without the “creative”.

In another widely used text, a section on innovation does not mention any entrepreneur or company. Instead, students read a treatise on whether technological progress destroys jobs. Another briefly mentions an entrepreneur – a Frenchman who invented a new tool to open oysters – only to follow with an abstract discussion of whether the modern workplace is organised along post-Fordist or neo-Taylorist lines. In several texts, students are taught that globalisation leads to violence and armed resistance, requiring a new system of world governance. “Capitalism” is described as “brutal”, “savage” and “American”. French students do not learn economics so much as a highly biased discourse about economics.

German textbooks emphasise corporatist and collectivist traditions and the minutiae of employer-employee relations – a zero-sum world where one loses what the other gains. People who run companies are caricatured as idle, cigar-smoking plutocrats. They are linked to child labour, internet fraud, mobile phone addiction, alcoholism and redundancies. Germany’s rich entrepreneurial history is all but ignored.

I do not know how far the material in textbooks can influence and explain popular attitudes. After all, there is the mass media as well. Are the media too hostile to business enterprise in Germany and France? I doubt that would be the case because they would not be able to survive commercially if that were so. US text books, one would imagine, are not ill disposed, yet popular distrust of at least big business is widespread there.

I don't know that Indian text books have much to say either way but celebration of business is common today among the intelligentsia- so much say that many want government to vacate even education and health.

The Indian electorate has been either indifferent or negatively disposed towards a big chunk of economic reforms even though most of the media is pro-reform. People cannot be brainwashed through school text books, certainly not beyond a point. They can think for themselves. It is somewhat facile to ascribe popular attitudes in France and Germany to biases in school text books.

Priorities for the next US president

Strobe Talbott, Deputy Secretary of state in the time of Bill Clinton, spells out the priorities for the next US president in FT. It's reassuring to see that sane voices are not absent from US political discourse. But I have serious doubts as to whether the agenda that Talbott outlines has any chance of being implemented in full- the Conservative strangehold on policy-making is far too strong to permit it.

the next president should, shortly after coming into office, affirm full adherence to the Geneva and UN torture conventions, restore the right of habeas corpus for US-held detainees, and “re-sign” the treaty establishing the International Criminal Court, which the Bush administration “un-signed” in 2002..

To make up for lost time, the next administration should undertake an array of initiatives, starting with one directed to Moscow. Drastic reductions in the American and Russian nuclear stockpiles are important as an example to other countries....The US should also resume negotiations with Russia on anti-missile missiles.

....The US should work with all the current nuclear-weapon states to impose a moratorium on the production of fissile material, pending a formal, verifiable, universal and permanent ban. To attain that goal, America should join its principal allies and partners in direct, sustained negotiations with Iran and North Korea to bring them back into the NPT as fully compliant non-nuclear weapons states.

...Kyoto will expire in 2012. That means the next US president will have fewer than four years to play a decisive role in the design of an effective successor to the treaty. The US must do this through diplomacy and by example. Only if it passes legislation imposing stringent limits on itself, while offering other countries – especially developing ones – substantial incentives to be part of a global effort, will Kyoto be replaced by an accord mandating universal reductions.

Exaggerating sub-prime losses

Many expect sub-prime related losses to rise sharply. But some of the estimates appear to be on the wilder side- the figure of $400 bn, which is the upper end of present estimates, for instance.

Bloomberg columnist Jonh Barry explains why:

There are two reasons why the losses aren't likely to be so large.

First, the mortgages are backed by collateral, a house or condominium, and in a foreclosure a home typically retains significant value. When it is sold, the lender often will get 50 percent to 60 percent or more of the loan amount after foreclosure expenses.

Second, most subprime borrowers aren't going to default. Suppose even one in four does and lenders recover somewhat more than half the mortgage amount. A fourth of $1.3 trillion in subprime mortgages is $325 billion, and a 55 percent recovery would mean a loss of about $145 billion.

To reach a $300 billion loss would require foreclosures on about half of all subprime mortgages with a 55 percent recovery upon sale of the property. And a $400 billion loss would take about a 60 percent foreclosure rate with recovery of about half the value from the sale.

Credit crisis- a managerial failure?

The sub-prime crisis in the US and its impact on financial markets are seen as a failure of regulation to keep pace with innovation. Securitisation is good but we need to ensure that the risks inherent in it are properly understood and priced. Rating agencies are seen as contributing to the failure.

This is now common wisdom but it's interesting to look at the issue in managerial terms. I wrote in my previous blog about how a clever manager can emulate Mao Zedong's methods to achieve rewards not commensurate with his success. In many ways, the financial sector provides fertile ground for such managers. That's because banks are hugely leveraged. This creates huge incentives for managers to take high risks- if they succeed, there are large bonuses; if they fail, the shareholders get wiped out. Managers may lose out on stock options not cashed in but, by the time failure reflects in financial results, they will have made their pile.

John Kay has an interesting point on this in an article in FT. Managers typically go unsung and, perhaps, unrewarded when they take premptive action to avoid disaster. It is those who take calculated risks and win who get all the laurels.

Al Dunlap of Scott Paper declared his admiration for Rambo: “Here’s a guy who has zero chance of success and always wins.” But Mr Dunlap’s company was acquired by Kimberly-Clark, whose chief executive for 20 years, Darwin Smith, avoided the storm by taking the company out of the competitive coated paper businesses and into high-value-added consumer products. Mr Dunlap was a celebrity but Mr Smith is little known.

We prefer to read about Lee Iacocca and Lou Gerstner, who held the helm in the storm, or Jack Welch, ho managed the ship through turbulence largely of his own creation.

How do we deal with this syndrome? We need to encourage risk-taking, of course. But incentives for top management must be more carefully designed, as I have argued earlier, to take care of possible losses down the road than they are today. Secondly, the degree of leverage in financial firms must come down- I think this will happen in banks with the implementation of Basel II. Thirdly, the media must celebrate the triumphs of the quiet leader as often as they do those of the flamboyant variety.