Friday, March 29, 2013

Cyprus solution is band-aid, not cure

Another crisis, another half-solution, another sigh of relief. When will the Eurozone stop rattling financial markets? Not in the near future, I guess.

In Cyprus, those concerned- the EU, the ECB, the IMF and the government of Cyprus- had the sense to rework a badly flawed proposal and come up with something that seemed to pass muster. But this does not mean the Eurozone problems have gone away. Indeed, the approach in Cyprus raises serious questions about what would happen if problems in Spain, Italy or Portugal reared their head again.

The total cost of the bail-out is € 17 bn. The absolute amount is so small that the EU could easily have underwritten all of this. But voters in Germany won't stand for it- they want to see citizens in the distressed economies suffer for their past sins. So, Cyprus had to bear some of the pain. The issue was what form it should take.

Mercifully, the insane proposal to penalise insured depositors- which mean a straight flouting of the EU-wide guarantee- was given up. Instead, Cyprus agreed that their share of the burden-
€ 5.8 bn- would fall on large deposits (those over € 100,000). In return, the EU would hand Cyprus 
€ 10bn. 

What are the implications? First, Cyprus has imposed capital controls, which goes against the principle of an economic union.  These controls are supposed to be "temporary" but we all know what that means. Secondly, and more importantly, the principle of bailing in creditors has been carried farther than in the case of Greece. In Greece, bond-holders suffered a hair-cut; here, uninsured depositors have been included. 

You might say this is fair: creditors should suffer in any bankruptcy (after shareholders), not tax payers. Not accepting this principle gives rise to moral hazard, which has been the bane of banking. But there are costs to this approach. First, Cyprus' banking system will shrink. Make no mistake, this means that GDP will shrink. What happens to the debt to GDP ratio then? How does the Cyprus solution solve the basic problem of sovereign indebtedness?

Secondly, how would depositors in other troubled economies, such as Italy and Spain, respond? Can we expect a flight of deposits to safer economies? What does this mean for recovery in Italy and Spain? Lastly, in the case of Greece, bond-holders were told that the losses they had to take were an exceptional case. It now turns out that this is to be the norm. What does this mean for the cost of raising subordinated debt for banks in Europe? Debt is going to become more expensive and this will translate into higher costs for borrowers. Also, at the first hint of trouble, bondholders will flee. Again, growth will be a casualty.

Granted, all stakeholders in banks will have to suffer the burden of adjustment in what is fundamentally a banking crisis. But the burden has to be distributed not just among bank shareholders, creditors, taxpayers and the citizens of distressed economies. Taxpayers elsewhere in Europe - and indeed the rest of the world- have to chip in if stability and recovery in the Eurozone are to be facilitated. Banks in Europe have to be recapitalised and the costs of recapitalisation must be universally shared, albeit in differing degrees. 

FT has a good article on the balance to be struck between moral hazard and systemic risk and resolving banks.  

Sunday, March 17, 2013

Monetary policy: the case for an interest rate cut

Industry as well some members of the fraternity of economists are clamouring for a rate cut on the ground that it will stimulate growth. Those oppose to it say the RBI can't afford a rate cut when consumer inflation is in the double digits (and has risen lately) and the current account deficit is alarming. I think there is a case for a rate cut but not because it will stimulate growth. The case I would make is a different one.

Let me address the reasons given for not having a rate cut. Inflation is now driven by food inflation and demand management can't do much about that. As for the impact of a rate cut on the CAD, the RBI governor addressed the issue in his recent I G Patel memorial lecture at Oxford:

The risk of the CAD widening further because of the stimulus offered by the rate cut is much less than apprehended for a host of reasons. First, when growth is sluggish as is the case now, the rate cut is unlikely to translate into import demand. Second, the rate cut was a response to softening inflation. Lower inflation will improve the competitiveness of our exports. Third, the rate cut was effected during a phase of easing commodity prices - particularly of oil - which will reduce the pressure on the CAD. Finally, empirical evidence shows that in emerging economies such as India, import demand is less a function of lower interest rate than of increased income. In other words, the marginal propensity to import by borrowing money is small.
However, the case for a rate cut is not that it will stimulate growth by boosting investment. Real interest rates today are way below the real interest rate of 7.8% in the 2004-08 boom period, so high interest rates are not why growth is being held back. The villains are policy and regulatory uncertainty and a weak global environment. There is not a damned thing fiscal policy can do to stimulate growth because if the fiscal deficit is not brought down as promised, the rating agencies will downgrade us.

The finance minister has said his principal worry is the CAD. His budget was driven by his concern that any fiscal deterioration would cause a downgrade and result in a flight of FII flows. We need, as he said, $75 bn to finance our CAD. An interest rate cut  would improve corporate profits and valuations and hence keep FII interest in India alive. It would also help banks access capital needed to meet Basel 3 norms and ease credit constraints in growth which seem to have emerged. (Proof: SLR holdings are 30% instead of the mandatory 23%). A cut in interest rate, as the RBI governor points out in his lecture, might cause FII flows into debt to slow down but it would still have a positive effect on equities. Monetary policy would thus reinforce fiscal policy in sustaining the financing the our large CAD.

More in ET column, Will Mint Street and Dalal Street unit to sustain FII flows?


Friday, March 08, 2013

Infosys surge: another miss for analysts

Infosys surged past Rs 3000 yesterday and has fallen back a bit today. I have no expertise on the IT sector. However, having been in investment banking, I do note with interest- though not with surprise- that analysts completely missed the turnaround in the stock's fortunes.

The big shocker to the analyst community was the favourable revenue guidance given by the company during the last quarter results. That caused analysts, who were predicting a stock price of around Rs 2200 or below in the months ahead, to revise the stock price target upwards. Even then, the higher targets were only around Rs 2850. Some analysts insisted they would wait for another quarter to see if the improvement was sustainable. Then, there was a whole tribe of analysts and media commentators who were telling us that the problem lay with the wrong choice of CEO to succeed Kris Gopalakrishnan, that the exit of most of the founders had changed the company culture completely, etc. So, the stock surging past Rs 3000 is quite a miss for the analyst community.

Of course, in these situations, hindsight is always available. ET, quoting various experts, gives reasons for the stock's improved performance. But the question is worth asking: if analysts can't get it right with a company so visible and so closely tracked as Infosys, what are they there for?

Narendra Modi's bid for prime ministership

Speculation about Narendra Modi emerging as a contender for the PM's job has been rising and has reached fever pitch. Most of the analyses tend to be partisan. Those against say the nation will never allow it, given what happened in Godhra. Those for Modi say that the time has come for a leader in the mould of Indira Gandhi. Sheela Bhat provides a more insightful and detailed analysis in Rediff.

The key point she makes is that the BJP is unlikely to get more than 150-170 seats. How does Modi become PM in that situation? She argues that the regional parties will probably strike a suitable deal with Modi. The author is clear about one thing: the BJP cadres are all for Modi and there is support amongst voters not given to watching the talk shows on the English TV channels. She believes Modi's campaign will rest on the dynasty, corruption and inflation. But what if Chidambaram delivers and the economy turns around by 2014?

Wednesday, March 06, 2013

Management lessons from a spy

This might sound tiresome but it appears, from a book written by a spy (a lady), that there might be a lesson or two in management that spies -of all people- have to offer. Or so Lucy Kellaway suggests in her review in the FT. And, no, the lesson is not that you gun down bad guys using a silencer.

What can spy teach us? One thing seems obvious: observe people carefully. They have to do this for a living (and sometimes to save their own lives); most of us couldn't care less.

Ok, what else? Here a couple of points that Kellaway highlights that might be useful:

Less obvious but no less valuable is her tip for job candidates: get the interviewer to do most of the talking and then hang on their every word. As hard­ly anyone can resist talking about themselves to a rapt audience, a job offer is almost bound to follow.

To the public speaker and the salesman, Carleson has further good advice: never rely on a script and never learn what you are going to say off by heart. When you do this you use a different tone of voice, go on to autopilot and all trust is lost in an instant. Carleson is right. I have done this, but never again.

But the main lesson is the one mentioned at the outset, namely, watch people carefully to catch their weaknesses:
....and for this there are some common denominators: “ . . . ego, money, ego, ego . . . ego, ego, ego.”

Tuesday, March 05, 2013

UK's 'cash for access' affair

I had to pinch myself in disbelief when I read this. UK's fund managers pay brokers for getting access to the latter's CEO clients. The payment rate is as much as $20,000 an hour and total spending on this account in the sector runs into millions, FT reports.

Ed Harley, head of asset management supervision at the FSA, raised the prospect of multimillion-pound fines for fund managers found to be in breach of its rules......Mr Harley said analysis by the FSA of the use of client commissions by 15 asset managers found large payments that were “hard to justify”. The bulk of them covered payments for corporate access, alongside smaller sums for access to market data.
Why would fund managers pay for access to CEOs? Presumably, they glean information that is not otherwise available? There is public disclosure of information and CEOs take conference calls from analysts and fund managers after results are disclosed. So, what exactly is to be gained by meeting the CEOs in person? And if there is something to be gained, does not that not qualify as insider information?

Incidentally, ending cash payments for access may not solve the problem. There are so many other ways in which fund managers can take care of cooperative brokers and CEOs. 

Sunday, March 03, 2013

IT sector: a case of successful government intervention

It's fashionable to say that India's IT sector has been a terrific success precisely because it doesn't need support from government- it was never subject to the licensing regime, for instance. We know this is not true because the sector has been supported through tax concessions and because it was state-subsidised education that made possible the initial supply of trained personnel.

In a thought-provoking article in EPW, Jyoti Saraswati elaborates on the theme of state intervention and shows how the sector's success is, in fact, a case study in successful intervention, contrary to the nonsense that is spouted by advocates of neo-liberalism or the leading figures in the sector.

The author mentions two big forms of support in the initial period. One, the 1972 Software Export Scheme which provided 100% loans for computers meant for export use. Secondly, investment in telecom infrastructure that made possible off-shore delivery of services. The state has continued to support the sector in the post-liberalisation phase as well- the Software Technology Parks of India was one such significant initiative. Another point worth noting is that India's IT firms were able to move up the value chain by gaining experience in the domestic market which, by then, had begun to find use for their services. (eg CMC's experience in computerising the Indian railways' ticketing system helped it win the London Underground contract).

The author's  conclusion is worth quoting:
The experience of the Indian software industry over the past 20 years supports the argument that the Indian state should not be seen as pro-market but be understood as pro-business (Kohli 2010), i e, it is able and willing to intervene in support of selected sectors and industries regardless of the neo-liberal rhetoric it may espouse and the international diktats it claims to adhere to. Indeed, the state can continue to play a significant supporting role for firms, industries and sectors.
The broader point I would add is that private entrepreneurship in most countries flourishes on the back of covert or overt government support. The idea that the state should back off  and 'leave it to the market' is a myth that is perpetuated by private sector interests when it suits them. 

Kumbh Mela managerial marvel

FT joins others (including a  team from Harvard) in marvelling at the managerial capabilities that underlie the successful organisation of the Kumbh Mela festival this year.

On the sandbanks of the river Ganges at Allahabad, bureaucrats and workers from Uttar Pradesh, India's most populous state and one of its poorest, took less than three months to build a tent city for 2m residents complete with hard roads, toilets, running water, electricity, food shops, garbage collection and well-manned police stations.....

.....Devesh Chaturvedi, a senior official who is divisional commissioner of Allahabad, is proud of the “huge task” that he and perhaps 100,000 workers have completed in organising this year’s festival.
He mentions 165km of roads on the sand made of steel plates, 18 pontoon bridges, 560km of water supply lines, 670km of electricity lines, 22,500 street lights and 200,000 electricity connections, as well as 275 food shops for essential supplies such as flour, rice, milk and cooking gas.
The obvious question that is being asked is if such a feat of organisation can be accomplished for this purpose, why not elsewhere? Why can't India's villages and towns be similarly transformed. Well, motivation apparently is everything: the people involved in the project think they are actuated by a sense of mission, given the religious significance of the event. In principle, however, India should be able to replicate it in other places: neither talent nor resources is the real constraint:
First, the authorities ensure that all those working on the project are accountable for their actions and the money they spend. Second, those involved are highly motivated.
“They feel it’s a real service to all these pilgrims who have come here, the sadhus [holy men] and the seers, so it’s a sort of mission which motivates them to work extra, despite difficult working conditions.” 

Good organisation and efficient infrastructure, in short, are no more impossible in India than anywhere else. “The lesson is, it can be done,” says Bhagawati Saraswati, a Californian-born Hindu devotee camped on the river bank with other members of an ashram based on the upper Ganges.


Saturday, March 02, 2013

Capping bankers' bonuses

The European parliament has grasped the nettle when it comes to bankers' bonuses. They have passed a law that mandates a 1:1 limit on the salary to bonus ratio. This can be go up to 2:1 with shareholder approval. The move has raised a storm in London where bankers and politicians believe that the proposal will undermine the City's importance as a financial centre, perhaps by causing banks to move key personnel to locations where the caps would not apply. FT has a primer on the new regulations.

One obvious response on the part of banks would be to increase base pay so that the overall compensation is not affected. But this has its own problems: it raises a banks' fixed cost and leaves it vulnerable in times when revenues and profits shrink. The EU banks fear that the proposal would confer American banks, operating in the US, with an advantage. (Presumably, the rules would apply to American banks' subsidiaries in the EU). Andrew Hill has a critique in the FT, but I am not convinced by his arguments.

The cap on bonuses follows regulations that require banks to defer the vesting of stock options over a longish period. Increasing the requirement of bank capital, which will reduce returns to equity in banking, should also help address the issue of systemic risk posed by large bank bonuses.

Incidentally, we are seeing the first major attempt at clawing back bonuses. Barclays is clawing back 300 million pounds paid to its bankers. The claw back follows huge fines the bank has incurred for Libor rigging and mis-selling various products.

Where does all this leave banking? The outcome, one imagines, would be to reduce incentives for taking excessive risk. Will it curb innovation? Perhaps, but, then, there is the perception that much of the innovation we have seen in recent years is of dubious value. A certain imbalance has crept in between the financial sector and the real economy. There is such a thing as excessive 'f'inancialisation' of the economy. Tackling compensation in banking is one element in addressing the larger problem of systemic risk in banking.

Friday, March 01, 2013

At the mercy of the rating agencies

The FM has kept his pledge. He has contained the fiscal deficit for 2012-13 at 5.2%. All of us know that this is at the cost of a cut in Plan Expenditure of nearly Rs 90,000 crore. He pegs the deficit for the 2013-14 at 4.8%. Since he sees no choice but to appease the rating agencies, chances are he will stick to this target as well. The question is: how?

Many analysts have pointed out that the revenue estimates are optimistic even if we grant that growth revives to 6%- the figures non-tax revenues, including divestment proceeds, certainly are ambitious. Subsidies in the coming year are to decline by Rs 25,000 crore, which means fuel subsidies will be axed even further, which would be a tall order as elections approach. It is more likely that the FM will meet the fiscal deficit target the same way he did this year- by pruning Plan expenditure and capital expenditure. The increase in 29% in Plan expenditure is clearly iffy.

Growth has sagged in the current year because of an investment famine and cuts in government capital expenditure have clearly contributed. If the government resorts to the same in 2013-14, that is bound to tell on growth. The betting is that private investment will somehow revive strongly, helped by lower interest rates. As fuel subsidies are pruned, inflation will stay in the region of 7%, so there is little the RBI can do to help. More importantly, it is not at all clear that high interest rates are the deterrent to private investment- real interest rates today are way below they were doing the boom period of 2004-08.

Private investment will revive if investors see demand looking up. Either export demand must pick up with an improvement in the global situation. Or domestic demand must revive- and, in the present situation, this requires a strong push from the government. Think of the what the highways project did during the NDA regime. But, if the government is fixated on a fiscal deficit number, there is no way this can happen.

For me, the big puzzle is why rating agencies are so obsessed with the fiscal deficit number. India's total debt to GDP ratio of less than 70% looks good in the present environment; India is among the few countries to have seen the ratio declining post-crisis. States have got their acts together on the fiscal front. External borrowings are low. If only the rating agencies would allow elbow room in respect of the fiscal deficit, it will be easier to get into a virtuous cycle of higher growth, higher revenues, and lower fiscal deficit. Historical experience shows that nations grow their way out of a high debt situation. The G-20 is veering towards reducing austerity. But here the rating agencies won't allow it. And we can't annoy the agencies thanks to our yawning current deficit.

Just hope and pray that gold prices collapse. Then, the current account deficit will narrow. That will give us greater freedom in respect of fiscal policy. Also, pray that the global environment improves. t's hard to see how the present fiscal approach can lead to any early revival in growth.

Some related thoughts in my ET column, Budget must cheer the markets.