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Friday, October 29, 2010

Are Trade and currency openness complementary?

The recurring discussion about US-China trade deficit and the resultant "currency war" left me wondering about a different solution. Can we link trade and currency openness?

The principle is simple, a country should be allowed as much freedom in trade as it allows freedom in pricing exchange rates. If a country has restrictive exchange rates, it should have trade restrictions as well. In a sense, this should prevent countries creating too-big-to-fail currency problems like China has.

With its asset boom, ghost cities, empty offices, China should have eased up a lot earlier. Given the artificial controls on its currency, the markets could not (or did not) adjust the balance accordingly. The question I pose, essentially a hypothesis, is, doesn't this indicate that the two freedoms, that of currency and trade, be complementary?

My book "Subverting Capitalism & Democracy" is available on Amazon

Thursday, October 28, 2010

Why some imbalances are more important than others?

I am linking to Scott Sumner again. He has a post that identifies the current account imbalances between countries. And he is right, in terms of imbalances, nordic countries have highest per capita surplus than others. However, surplus of some countries hurts us more than others. 

As I mention in my book, the net impact of surplus or deficit depends on the skill profile of the nation as a whole. If the skill profile of two nation matches then the current account surpluses have detrimental impact on the one with deficits. The problem with large nations is that even if the profile of nation as whole is not alike the amount of overlap is significant.

It is because of this mismatch that US is losing jobs. Further, US has not invested in the "next big thing" whatever that is, to create alternative employment for those who lose jobs. 


Monday, October 25, 2010

Comeptitive devaluations - Krugman, Sumner and Yglesias

Scott Sumner remarks on Paul Krugman's post "Worst economist in the world". Krugman is not impressed with the logic, neither is Sumner. Sumner also points to Matt Yglesias who dissects the argument. But the journalist's argument has merit. It is slightly different but I would give it a benefit of doubt. Let me explain:

In normal circumstances, "competitive devaluation"results in inflation. Inflation is OK if income distribution mechanisms are working. So if employment is robust, economic engines are operating, then the transmission of higher oil prices into higher incomes creates a balancing effect by creating higher ability to spend. 

Currently, those mechanisms are not working. So "other things being equal" does not apply today. Thus, higher oil prices will impair the household balance sheets further. At the same time, the increase in input costs will either weigh in on corporate performance or get transmitted to households again. Thus, the rise in oil prices is ominous for households.

However, they have no bearing on international trade. It cancels out.

Meanwhile, there is an argument about commodities being store of value. We need to understand the argument carefully. Store of value has to be independent. Commodities are co-dependent on the economy. Commodities carry value because of the demand. At higher prices, elasticities tend to affect demand and hence the value. The commodity prices may reach higher but will have to come back to demand-supply equilibrium. 

Thus, commodity prices contain two intersecting variables. A measure of value and price as indicated by demand supply balance. Since these two variables are finely mixed up we cannot separate one from other. Thus it is inappropriate to draw conclusions from the prices of commodities.


Wednesday, October 20, 2010

Forecasting equity prices in turbulent times

The markets have been very volatile over the past few years. Investing in these times has been fraught with risks. In such a market, it is very difficult to make investment decisions based on valuation models. Almost always these models indicate that stocks are over priced. Equity fund houses are adding to the confusion with their near-random buy-sell ratings. There seems to be little logic behind these recommendations.

However, there is a method wherein we can logically explain the variations in valuations. We can look at equity prices as composed of two components, a value component and an asset inflation component.

Value component can be expressed as a price band based on fundamental assumptions. The output of most models is usually a price band. These assumption are dependent on the company and economic situation. As we tweak these assumptions for a base case, bull case and bear case we end up with a price band. The price or value is based on various valuation models such as sum-of-parts, residual income, etc. Normally, prices should vary within these bands and the inflation component should be bare minimum. However, in recent years the prices have moved out of the valuation range.

The movement is because of asset inflation because of the high liquidity being pumped into the market. Those are not the only reasons and each market has a different variables that influence the asset inflation for that market. The role of equity analyst, therefore, also includes forecasting the expected asset inflation. From a first principles, in a market influenced by foreign capital flows, average daily volume should be a good indicator. For example, in India, the asset inflation component for large cap stocks with high volumes could be to the tune of 35-40%. For mid-caps or firms out of favour the range may be 20-30% while small caps may have inflation factor of 10%. As the global picture changes, the macro analyst can thereafter adjust the asset inflation component at the country level. I believe this is a better way to present equity research prices.

Let us take an example.  Let us say that the value component for stock like Bharti Airtel comes to INR 300 per share. Now telecom as a sector is a little out of favour and the inflation factor for Bharti Airtel would be lower than usual 35-40% for large-cap stocks. Let us say it is 20-25%. Therefore, the expected price range for Bharti Airtel will be INR 360-375.

Long Bharti

Tuesday, October 19, 2010

The Foreclosure Mess and justice

In the blog "The big picture", David Kotok has a very interesting article on the foreclosure mess. In the context of that article I would like to make a few comments. 

Before the comments, I must state that the issue, like all other in this crisis, straddles the political, legal, social and financial sectors. As a preamble, we must look out for the interest of individual as that is the primary responsibility of the courts and the governance mechanism. We must, like I say in my book, differentiate between real living citizens and firms that have acquired citizenship. It is time for the congress, government and legal apparatus to stand behind the interest of individual. Here are my comments:

First, both the defaulting lender (genuine defaults) and the institutions that misplaced the promisory note are at fault. However, the court has to evaluate the gravity of the situation and that depends on the relative bargaining power of the two parties. The question of relative bargaining power is very important as I discuss in my book Subverting Capitalism and Democracy. The bargaining power equations are clearly favoring the institute. The responsibility of the court is, therefore, to protect the interest of the weak i.e. the individual. Even if it means, in some cases, rewarding the mistakes of individual. Further, the individual will obviously pay for the mistake through higher taxes and loss of jobs. In all fairness, she will pay no matter what the outcome of the foreclosure.

Second, if the chain of title is broken, the person who can defend the title should have the right to initiate foreclosure. However, the person must show unequivocal demonstration of the title. In all probability, an institution within the chain of title cannot establish this without dispute for those downstream will challenge their claim either as fraud or will stake their claim to title. In the light of this claim, it is unreasonable to ask the individual to make a payment.

Third, if it was a matter of making payments, courts could have ordered payments into an escrow account to be allotted to those who can establish rightful ownership. The interest rate or size of payments should be in accordance with the agreement, or if the agreement fails to establish clear rate of interest, it should be at the interest rate set by the Fed. Similarly, courts can initiate a suo-moto foreclosure in cases where it is clear that borrower willfully defaulted and recover the money through auction of the property. The recovered money can then be transferred to escrow account waiting to be claimed by rightful owner.

Fourth, in all fairness, courts must set out limitation date for the title to be clarified. Without a limitation, the process can drag along for years. It is unjust to the individual.

Finally, in all the situations the outcome for banks, mortgage brokers and investors in mortgages are grim. Either way, we have a problem on our hand. It clearly means that banks and other intermediaries will need a bigger capital buffer than what they are currently carrying. Further, approximate estimates peg the capital requirement to be much higher than during 2008 Lehman episode.

It appears that the financial institutions may have realized this and initiated a global pull-back of capital. It is possible the recent correction in global equity markets are a result of this problem.


Thursday, October 14, 2010

Why foreign funds are preferring EM banks?

I was wondering why banks are the first object of desire for foreign funds in the emerging markets. Given the view on the currencies, I expected foreign funds to go after relatively(in currency adjusted terms) cheap EM- hard assets. I did not think banks would be such overwhelming favorites. However, the preference for banks seems to have some logic.

Banks in emerging markets have lower cost of funds as EMs have higher savings. The stress on bank incomes is lower as economy is growing and banks have first claim on the corporate income. Third, despite inflation pressures, FII flows and US FED's near zero interest rates are keeping the interest cost low. This has reduced the probability of defaults for large borrowers. No wonder this is most viable entry point for foreign funds.

Long SBI

Wednesday, October 13, 2010

Fighting the Currency War

There is a lot of debate about how to fight the impending currency war. The problems are more from the US point of view rather than elsewhere. Let me explain.

US cannot unilaterally set its exchange rate. 
There are two ways of modifying exchange rate.  One ways is to clearly set the exchange rate and defend it using central bank intervention. This tool is available to smaller economies who peg their exchange rates to the dollar. But it is not available to the US as the economies of other countries depend on the US consumer. Its only way out is to convince other countries, those whose domestic jobs and economies depend on US consumer, to ease the exchange rate. US tried to convince China with the same intent. However, it is not China alone that poses a problem. The entire set of countries that use this export-dependent strategy should revalue their currencies simultaneously. Since these countries are adamantly defending the relative exchange rates, US seems to be in a state of crisis.

The other more fundamental way is to indicate to the world that the stock of money has gone up disproportionately as compared to GDP.  US has tried to print money. But it has not caused any effect. The printed money simply flows out of US into global equities, commodities and other asset classes. Further, if I get more US Dollars I can park them with other economies and wait for exchange rate reset to give me substantial gains. The more exchange rates are suppressed, the more I have to gain.

This conundrum, obscene as it is, is due to the fact that USD is also an international currency. To have a credible effect, the volume of printing must be in relation to global GDP and not simply US GDP. At USD 15 trillion, US GDP is about a third of global GDP. So you need three times more printing. Further, if US currency devalues erratically then the entire burden of currency will fall on US domestic economy. Herein lies the dilemma. It is a lose-lose proposition.

But there may be another way 
I think US may be better served by front-ending its borrowing program. The US can initiate a borrowing program equivalent of 10 years of borrowing. This program should be completed within a year. Only a part of this program will be successful. However, it will pull the global liquidity towards US while money printing is pushing liquidity out of US. It will force other banks to print and buy US bonds or let their exchange rates appreciate. Usually, governments are wary of failed bond auctions. In the case of US, this is not an option for the other countries. They need the US consumer more than US needs them. US can also set trade limits based on amount of USD reserves held. In other words, let other countries put a price on each job they are defending.

However, US needs to have a credible plan to invest this high liquidity that will flow into the country. Using this liquidity, US should get out of the recession.

Then, we must consider unintended consequences. A front-ending of borrowing may upset lenders like China. How China will react to such a policy is unclear. But it is reasonable to assume it won't be pleasant. In effect we will face a lot of unpleasantness. But then it is a war, isn't it?


Friday, October 01, 2010

Tax reforms - Ezra Klein makes a valid suggestion

Ezra Klein comes around to the idea that I have been talking about for years. He argues that we should get a receipt for our taxes.

A tax utilization break-up
While the general budget does give a broad outline, person specific contributions should be a right of the citizenry. Ezra draws similarity with food ingredients and calorie break up. To take the analogy further, government budget is equivalent of stating national food ingredient and calorie consumption. It makes little sense to the individual. We should get a break up for how our taxes are allocated.

Individual tax allocation choice
I often think about giving the choice of allocating tax dollars to the individual. I believe, in a sense, it will be a pragmatic manifestation of democracy. Embedded within this idea are two critical ideas.

First relates to relation between democracy and empowerment. A first principles analysis suggests that democracy is about empowerment of the masses. Our recent iteration of democracy is masses empowering the government. There is a substantial difference in these two points of view. 

The idea refers to the differences between masses and government. Our iteration of democracy views masses (or citizenry) and government as two separate agents. The result of this differences is evident in intellectual differences in opinion of masses and those of government.

Further more, government is now a seat of power and thus no different from the monarchs and nobles of yore. The first principles seat the power at the hands of the people. It creates government as an agent to exercise this power. Government does not acquire but borrows the power from the people to enable people to exercise their mind and opinion.

The second idea relates to the (wrongful) importance of keeping tax policies away from citizens. Governments, like monarchs and nobles before, believe people do not want to pay taxes. They have no qualms in believing that these same people will understand credit card statements easily. I do not agree with this point of view. I believe, if we trust the citizens to allocate taxes we may get a fairer spending that may actually benefit the citizens.

I believe, by taking away the ability to direct taxes from the citizens, government is limiting democratic rights. Years ago, before the advent of computers, it was not possible to allow citizens to take this responsibility. However, current technology that allows these same citizens to vote in American idol based on performance, can be used to allow citizens to make these important choices.

In sum
Sometimes, by giving responsibility to citizens, we may make them responsible. We can also foresee a possible disaggregation of governments into policy designers and bureaucracy. We do not need to career politician as a policy designer.


I discuss governments and taxes in my book "Subverting Capitalism & Democracy" is available on Amazon