Exchange Rate appreciation

The Reserve Bank of India (RBI) announced the monetary policy on tuesday 28th. In one of the innocuous statements RBI mentioned it will allow appreciation of Rupee if there is higher capital inflow than can be managed through intervention. Not many commentators weighed in on this at the time. But that represents the most important signal.

Felix Salmon explains the dilemma of the asian central bankers in more details. RBI has sensibly tackled the financial crisis as of now and this indicates RBI is one of the intelligent central banks around. China faces this dilemma more critically as it wants an undervalued Yuan. To top its list of worries the GDP is rising really fast. If there is one way to attract big money then this is it.

There is a good chance central bankers will soon resort to good old capital restriction. This will be the first blow in the test of globalisation. This threatens to raise the friction between countries. We are witnessing increase in friction over anti-dumpting duty imposed by EU on Chinese.

Such regulatory threats have the potential to create more cycles in markets. So this is definitely going to be painful - we will have to hold our nerves. Fortunately or otherwise, we cannot, will not be able to reverse the globalisation.

Why no one saw the crisis coming?- An explaination for Queen Elizabeth II

The question reminds me of King Charles II who invited members of the Royal Society to explain why a dead fish weighs more than same fish alive. After the Royal society provided various explanations it was brought to everyone’s notice that they actually weigh the same! It is the same with current economic crisis.

The group of eminent economists could not foresee the current crisis due to “failure of collective imagination of many bright people”. In my humble view, your highness, this is incorrect. Nobody actually bothered to make the real‑world observations. How could one not notice unemployed people buying multiple homes? Or, how could they not notice people with mortgage repayments more than their incomes?

Such ignorance on the part of trusted few will cost the world dearly. The developed world, including Great Britain, is on throes of worst economic decline spurred by international debt. We are facing a decline in standard of living that will undo decades of development. In such times of calamity, the elites are busy retrofitting explanations to history. The “group of eminent economists” has been deeply inbred and so have all other eminent groups who run the financial system. These are groups formed between likeminded fellows, those conforming to specified views. These groups have shown clan-like behaviour ridiculing alternate points of view. One only needs to look at ridicule heaped on likes of Peter Schiff, Nicholas Nassim Taleb, Nouriel Roubini and others. These groups lack diversity of opinion to understand multiple facets of financial, economic innovation.

I further disagree with the economists’ gracious claim that everyone was doing their job to the best of their abilities. If guarding the door “to the best of our abilities” when thieves attack through the window, you are not much of a guard, are you? Sadly, even the press has abandoned its duties of fourth estate. Our journalists no longer reflect on social implications and problems but often report from their own ivory towers. We haven't seen any pointed intelligent debate between press and policy makers even as policy response aggravates the crisis further.

To ensure such crises never occur again, we need more respectful cross-disciplinary debates involving social understanding and moral values. We need philosophers and cross disciplinary thinkers more than ever. Usually, such is the responsibility of the House of Lords. Are there, if I may humbly ask, real knights amongst your ranks, your majesty?

Note: This is a response to Guardian Story about Economists explaining how the crisis happened to the Queen.

Future of Financial innovation

There has been a lot of talk about financial innovation being bad for general populace. Economist blogs about it Financial innovation in the rearview mirror quoting Tyler Cowen and Felix Salmon. This pulls up a paralled to pharma industry in my mind.

Just like we have drug testing labs for pharma companies, we need labs and regulation for finance innovations too. In a sense, sub-prime was a drug being directly tested on population. The result is predictably disastrous. The Consumer Financial Protection Agency (CFPA) could take up such a role. Then, if pharma is any indication, we will have lot more innovation in the near future.

Pharma industry also created higher cost structure to foster innovation. The regulatory burden along with pseudo-barriers in the name of intellectual property created unaffordable costs. The opportunity before the CFPA is to set the benchmark for simplied, easy to athere but difficult to cheat, low cost regulatory structure. CFPA, all eyes are on you!

Chris Anderson explains Free / Freenium

A lot of people get confused with Chris Anderson's book free. Particularly because his book is free. Here he explains the concept in details. A fantastic read about changes in business models.
Charlie Rose - A conversation with Chris Anderson of Wired Magazine

A re-polarization in Risk Structure of Investors

Tadas Viskanta notes how hedge funds have survived the current crisis in his post The curious incident of hedge funds during the financial crisis Abnormal Returns. This refreshes an old idea I had earlier about polarisation of investor companies based on risks.

Capital providing institutions were divided into two based on this. Banks (low risk) and Equity investors (higher risk). But now we have finer risk classifications. The resultant business models were, in a crude way, spread across the risk spectrum. The downside was the risk demarcation became a little (a lot?) fuzzy. Large banks too moved towards higher risk assets (CDO etc) and were burnt. Equity investors came with low-risk schemes that have mostly lost money. The money-making strategies in current market situations align better with clear risk demarcation. That's why possibly hedge fund survive.

The investment rules getting too tight is basically a risk reduction strategy. It will be wiser, possibly, to remove constraints on fund managers. Money managers who manage their own book may be better off with the flexibility (provided their reading of markets is correct of course).

China led recovery?

The largest consumers, US, EU and Japan are spent. US has domestic and corporate indebtedness. Japan still languishes from the lost decade. EU members sit across the spectrum between US style indebtedness to that of 1980s Japan. Only country who has the right cards is China. It is significantly big and fast enough to turn the course of the history. So then will China play its hand right?

Well, it is not inspiring any confidence to say the least. Micheal Pettis points to Notes on a real estate trip in China where we realize that Chinese policy of investment driven demand is banging against the wrong wall. China is looking for the final buyer that we discussed earlier.

Meanwhile, I notice market feedback, logic structures and arguments are regaining 2007 flavour. This definitely does not auger well for any of us. It is as if markets have noted Roubini near term possibilities but are still ignoring Taleb's long term solutions. (Taleb has attacked the root causes VAR, (ill-applied) probability theory, portfolio theory and algorithm trading framed on these.)

Where is the Greenspan Model?

I remember that there is a Greenspan model that Alan Greenspan used to determine if markets were fairly valued. It pointed to over-valuation in 1998 and again in 2004. Where is that model now and what is it indicating given the current earnings scenario?

Fail safe regulation!

Obama's financial sector regulation is under scrutiny. In one word will it prevent crisis - no. Will if prevent this crisis from occurring again - possibly. Why? Is it so ineffective? Well no, the terms are well intentioned. What we need is Fail-Safe regulation.

Fail Safe - engineering definition v/s common definition

There are two definitions of fail safe. Generally, fail safe means does not fail. Whereas in engineering fail safe means - when it fails it does not cause harm. It is impossible that regulation will never fail. So financial regulation needs to apply engineering definition.

Using Engineering fail safe regulation...
Now we need not regulate hedge funds, or investment banks or increase their capital adequacy beyond certain limit. We simply need to ensure that when banks fail they do not take the world with them. Hence I proposed the new banking system.

In the new structure, we should see polarization of financial institutions along the risk axis. The high risk FIs, like hedge funds and private equity, will never be bailed out. Investors into these asset classes should sign a government disclosure that they know they can potentially loose their money - just like hedge fund investors. We will see more groups joining hedge funds and private equity in this pole.

In any case regulation has to take responsibility for low-risk financial infrastructure part of the system, leaving other pole to dynamics of capitalism.

In Sum...
The current regulations are good intentions with potentially poor outcome. I hope Obama advisors are able to get around to the engineering fail-safe regulations.

Market turmoil and picking Survivors

Global markets showed weakness again today. Over the past few days global markets have weakened about 2% per day. There are theories that point to a three week correction before a pick up in prices.

Picking survivors
A popular anecdote highlights importance of holding stocks for long term. So people often tell me - so what if price is too high - just "sit on it" for XX years and you will be fine. Unfortunately that is a wrong strategy. Current situation is more about picking winners.

Winners change and lot of companies fall by the way-side during times such as these. In a smaller crisis, bigger companies are typically better off. But not so for structural crisis such as we are seeing now. A long term investment strategy is more about picking survivors. Survivors will loose less value when market falls and will rise higher when it gains.

Airline example - British Airways and Singapore Airlines
Airline operators were part of massive industry slowdown after 9/11. These two companies used this opportunity to replace their fleet with young more fuel efficient planes at reduced prices thus building tactical advantage for years to follow.

Stockpiling Commodities - What is China doing?

China stock-piling commodities or buying US assets seems useless to me. If US dollar were to loose value and commodities / dollar assets were to retain value – then technically Chinese Yuan should also retain same value. US dollar starts loosing value means commodity prices start shooting up. Meaning, in technical terms, US will then export its inflation to the rest of the world. There are few responses to this –

• the world keeps global exchange rates constant
• The world let dollar go down alone
• Some allow exchange rate changes some (like china) dont

If everyone keeps exchange rates same – we will have another recession and commodity prices will come down. And whatever you do this cycle will repeat itself till world is sick of the pain. The fundamentally sound parts of world can recover if they let currencies appreciate.

Holding commodity assets signals the Chinese intent to keep the Yuan (RMB) hard pegged to the dollar. This is clear signal of pushing towards "status quo". The stockpile will help China reduce the inflationary impact on its economy while US recovers. But ideally this should require inventories equal to the expected duration of such inflationary scenario.

The only other reason could be - China expects disruption is supply chain. Such disruptions occur in crisis - so China might be preparing for crisis possibly even a war.

China's domestic demand and other notes

Brad Setser starts a wonderful discussion on "How can we explain growth of China while all other export oriented economies continue to slide?" Thereafter follows a range of serve and volley explanations that are delicious treat for thought! Here are my views:

Walmart sales increased when other retailers went bankrupt because Walmart was lower cost than most. Same logic, I believe, explains partly why Chinese exports did not slowdown as much as others.

China’s monetary expansion will have two components – domestic stimulus and US treasury demand. It will be interesting to understand which will be bigger and will there be any crowding out effects.

If you push large liquidity through the system fast – high value, long-term assets (houses, stocks, etc) tend to inflate. This keeps overall inflation low (since these do not form part of consumption basket) giving an impression that everything is fine. This corners the excess liquidity to one end of the pool. Eventually the system breaks but till that time we have fantastic illusions.


Problems of Europe
Europe is about 13 billion giant (excluding Russia). Problems of Europe will impact world recovery to the same / slightly more than problems of US. We have somehow left Europe out of discussion.


Domestic demand / Market
Creating domestic markets is not easy and does not simply happen by throwing capital. Domestic tastes and preferences, as we see in India, are lot different than we anticipated. Same logic should hold for China.It is easier to customize goods (like restaurant services) are easy to manage – but inflexible goods (capital goods e.g.) take long time. The changes cascade from consumer side till they reach the top end. Examples:

1. A large part of textile industry may be geared to service cotton clothes – whereas Chinese might prefer silk. (OK I simplified it a bit too much)
2. You take milk, some producers added some hormones to aid milk production. Resulting milk was not safe for children. Now we need institutions, legal, regulatory etc that create a feedback system to discover and curb such practices. These complex frameworks anchors in democratic setup – leading us to political minefield.

If someone clarified the entrepreneurial scene – we may actually get better clues about domestic demand. Large entrepreneurial pool backed by venture funds experimenting with products and distribution is the best way to create (and an indicator for thriving or potentially thriving) domestic market.

The easiest part of domestic demand stimulus is to allow top brands to enter the domestic market and give them some price leeway through currency appreciation. Louis vitton bags, Chanel perfumes etc will kick start domestic consumption faster.


Psychology of excess
This is one of the problems facing China. In its quest to stimulate – it might create excesses that can haunt it later. Large ammunition is mega problem if it explodes in you own backyard.


China is our hope
Our global recovery hopes are pinning on China. The question is does China know and will it take the responsibility?

A New Banking System

The current crisis made us realize how financial sector in general and banks in particular can hold the economy hostage. The crisis was precipitated by a credit freeze triggered by fall of Lehman Brothers. As a response Fed kept pushing money into the bank but none of it reached the deserving households or small enterprises. So we know we need a new Financial system. Mike has a nice post about The financial sector we want.

Rethinking banking - Banking as water management system
We can think of banking as water management network. We have water reservoir, the piping and usage meters, then we have used water drainage, used-water treatment and back to other reservoir. The used-water is savings that feed into the reservoir - bank deposits. The worst part of banking crisis was the looming disappearance of the the piping and drainage network.

Now, the network needs to be as big as possible, bigger the better. A larger network means accessibility across the country / world, it means freedom for the consumer. It means the network will be operated like a utility company, with very small fee and highly regulated operation.

The reservoir however, needs to be small enough to be manageable. And more the merrier. Here replacing one by other will ease the strain on the economy. In radical times, Fed can directly be the money reservoir and plug itself into the system.

Tomorrow's Banks = Today's banks - Banking infrastructure "system"
So we are looking at splitting banking into three parts - financial infrastructure system, deposit taking institutions and loan making institutions. While, the last two can be same, they cannot ever be infrastructure. Glass-Steagall Act achieved this in smaller degree. I think, looking at recent experience, it makes sense for the financial infrastructure to be government owned. At least, it needs to be heavily regulated large utility like power transmission company or water supply company. Alternatively, it can be a well-designed Internet based system as well - then no need for any company.

What is financial infrastructure system?
The role of financial infrastructure company will be that of a conduit. Citizens will have an online account, with a free (zero fee+ zero charge) debit card. It will allow the citizen to login and allocate his/her savings to deposit-taking-institution of choice that can manage it with promise of interest income. The system will collect a fee from deposit-taking-institution as an insurance against insolvency of the institution. The amount of fee retained will depend on rating of the institution.

Further, lender (including credit card providers) can lend to citizen based on report generated by system. These reports will protect privacy as per legal guidelines and give information enough for processing creditworthiness test. It may also generate a FICO-like score for the borrower. Lender, once satisfied, can be plugged into citizen's account. The system will schedule and process payments or at least set alerts to prevent defaults.

Privacy and prudence
The suggestion also raises privacy and government intrusion concerns. I am not sure I understand all the problems that may arise in such scenario. However, it is definitely an idea worth exploring.

An increased (though very small) probability for War

Probability of war seems to have increased. It is still small but definitely increased. Though it is unlikely that India will be involved in one (we never invaded any country in 5000 years - so we dont have the mindset) But, look how different war-indicating trends are catching up.

1. China has more males in its population - typically when the pop ratio gets skewed the chances of war increases. Further, income polarization is very high in China.
2. Recession will make more people (mainly youth) unemployed and in financially distressed situation - implying combative etc
3. US-china have classical debtor-creditor problem any strong arm by China will not be taken lightly by US. China believes it may be wronged by the US. If US dollar devalues then you can be sure things wont be easy on this front.
4. War is by far the biggest domestic stimulus one can give - creates domestic jobs and stuff hence politicians are ok with war in such times.
5. The typical flash points are visible - Afghanistan Pakistan is now a flash-point. If Us forces are attacked or get in some trouble then we could see drastic actions. Earlier North Korea, Malaysian protests, Demonstrations in Greece were some flash points ( though none as big as Af-Pak)
6. Religious alignments are getting more stricter - talibanization of SWAT valley in Pakistan is an indicator. To certain degree, Obama election has reduced any polarization along religious lines that we saw earlier in US.
7. US policies and other global stimuli are going to result in more income polarization. As global inflation strikes the differences will become more evident - I can foresee Mary Antoinette - "if you don't have bread eat cake" statements.
8. Usually such conditions are off-set by economic growth (that promotes peace) - but that has near about halted in past few months. Now if things do not improve we could be in for much tougher times.

Since last year I have been advising small businesses (even if uncalled for many times - and often at risk of being sounding intrusive) to preserve cash and lower debts. This is time to tighten the seat belts and check the gun in glove compartment for bullets just in case.

So I say it again - better prepared than sorry!

Global Slowdown Solution VI: Going Green and Blue!

Given that real stimulus will take a form of modified Keynesian approach- we need to know what are the "highways" of today. During the last depression, the building of highway and rail infrastructure got the US out of trouble. This time, to my mind, it has to be Green and Blue infrastructure.

Going Green

US has been victim of development invention. Most of the infrastructure / engineering of the country is based on older technology thats not green. Few years ago when the green revolution was knocking at the doorstep, it was difficult to see how US and developed world can re-engineer the entire setup to go green in a meaningful way. Luckily the current situation presents us with an opportunity to do just that. In doing so, US will lay the foundation for competitiveness for the coming decade or more while adding to comfort on global warming.

Going Blue

While green is important, blue is even more so. By blue I mean developing potable water resources. Greening, apart from using lower emission fuels, also means creating tree cover and rebuilding green-ecosystems. Initiating this will require potable water sources. Further water is the most essential commodity for sustaining life. Investing in rain water collection ponds and lakes, water seepage assistance to rebuild ground water resources etc will have to take precedence. India has got an initiative off-ground through India water portal.

Implications for cities and homesteads

If at homestead level we can create sustainable water and green infrastructure, we will have a much better self-sustaining planet. That imlies our city-oriented development models will have to be modified to make it more sustainable.

Implications for current economic slowdown

The ability of these initiatives to create jobs is under-rated. If properly deployed these initiatives may create more jobs and more self-satisfaction than most optimistic forecast. These initiatives have unique character. They need huge manpower up front and then possibly the overall manpower requirement for sustaining this effort will be about 3% of original. This means they can create enough jobs to reduce unemployment rates by some perrcentage points in initial years. And the man-power can be freed in few years as economic activity resumes full steam.

In Sum

Green and Blue are compulsions. We either take up our share of responsibility or implications are large and life-threatening. As they say, "nature does not do bailouts". The opportunity has presented itself - lets grab it!

Elizabeth Warren on John Stewart show

Elizabeth Warren speak colloquial on John Stewart show. As he says "it feels like Financial chicken soup".

Is Recovery Just Around the Corner? | The Big Picture

Jack McHugh goes on to look for answer to famous question - Is recovery just around the corner?

Sometimes I am ashamed of how pessimistic I have become. But nothing tells me that we are closer to situations when fundamentals are sorted out. I think the bottom here is fixed - its way below from here for US markets. A slower descent implies longer time to see the bottom. Implies more pain - and slower recovery.

With current healthcare situation and age demographics as they are - I see US consumers going towards 15% saving rate as sustainable rate going forward. Under strong dollar regime it means income de-growth and therefore sustainable consumption will be a long long way below current levels. In a weak dollar regime, it would mean, higher inflation sharper fall and concentrated impact of consumption dip - with a possible under-shooting below sustainable consumption level. On a discounted basis these both will be equal impact in all likelyhood.

What this implies is that sustainable world consumption should see a 1.5 the dip seen at US (roughly). So the only way to recovery is when jobs seem safe and incomes stop falling. Note this is just the average - so we will see a dip below this to about 2X US consumption loss. So stock markets should reach corresponding levels.

Newer Orgnisation Structures

One of my pet implication of the global slowdown is changes in organization structures. I think this is one of areas where organization-citizen relationships are going to be redefined. We are going to see restoration of balance in this relationship. Currently, organizations have disproportionate leverage that is being misused. It means new value-chains, new types of organizations based on skills.

No one has noticed but Apple just did that - the application part was moved out of the organization into public domain - modifying the traditional value chain that Friedman mentions.

Further I think organization-employee relationships are going to change fundamentally. We will have new loose forms of organizations that can fail easily and not become tighly controlled - economic behemoths that can hold entire economies to ransom. The new form of organisation will most likely have Schumpeterean creative destrution switch built into their DNA making them more efficient, vibrant through fail-fast, fail-safe means.

Richard Koo on Balance Sheet Recessions

Richard Koo on Balance Sheet Recessions (from Paul Kedrosky) gives an interesting perspective on global crisis and how possibly Japanese way could actually be a best case scenario. At the fag end he goes into really interesting implications for politics, differences between current crisis and Japan that is critical.

Japanese crisis was essentially corporate balance-sheet crisis. Current crisis is US and European household balance sheets and financial institution balance sheet crisis. Japan has strong household and financial balance-sheets. So fiscal stimulus kept Japanese consumption going. In addition, export demand did not actually fall off a cliff. These two issues will make current slowdown actually more horrible.

US households bear weight of global production. US financial bear weight of global capital supply. Both are in a mess. The stimulus required to pull-off a Japan-style escape will be of global proportion - and definitely out of league of Fed. Even by Japanese experience - global deficit would be roughly 8% of GDP. Disproportionate amount of it will come from US which implies ~ 18-20% of current US GDP. This weakens the dollar (that is good) and probably kindle some hope for US economy.

Implications

• Despite everything US and European GDP will have to fall structurally.
• We are looking at structural global GDP contraction - but unevenly spread.
• Solve household balance sheet problem - solve the crisis.
• Global realignment of production and consumption center is evident.
• Unstable political storms are coming - watching Af-Pak closely.
• Increasingly worried about China - hoping sense prevails.
• Increasingly confident of two-engine approach to economy. Wealth creation engine (entrepreneurship) and wealth distribution engine ( domestic consumption & resulting jobs)
• India looks strangely best positioned - thanks to the fact that its government's hands are tied!

Auto Bankruptcy will worsen the slowdown

Obama has been decisive in Auto bankruptcy case. While the intent is commendable, letting Auto companies go bankrupt will damage the US economy more.

Auto Companies represent a really big and powerful wealth distribution engine. At this point, wealth distribution engine health determines how much bailout actually reaches the common person who is at the heart of bailout.

Obama saved banks to ensure credit lifelines to the common person survive. But if auto companies go bankrupt, they take pensions, incomes and multipliers with them. It will be like preventing heart blockage but stabbing the patient! 

I hope Obama gets his team to explain these things to him before he signs off on anything! Just pray!

Global Slowdown Solutions V: Global Crisis - first principles

Global crisis is a result of three elements freezing together - an overleveraged buyer unable to buy more, a seller without access to credit to create supply and non-existant market where no one trusts anyone.

We cannot fix all three together as all three elements are vastly globalised and hence too big to fix all at once. So it makes sense to get back to basics. The entire economic system was created with demand at the center. When demand existed - supply emerged and market appeared to match producer and consumer. So we need to fix demand first, help supplier get started and things will start taking care of itself. But!

First lets get demand straightened out. Demand in recent past was excessive - it will never be that high any time soon. But however small - we need it. Demand comes from wages and employment certainity. This is the basic of Keynesian stimulus - create jobs system will fix itself. So this would have solved our problem this time as well - had it not been for credit starved supplier.

The supplier, earlier, was driven by equity and debt was but a cash-flow smoothening mechanism. Then we realised the power of leverage to amplify returns, create surplus wealth thereby creating a separate investor class specialising in just providing capital unleashing entrepreneurial energy. This class made the entrepreneurs leverage themselves to the maximum possible limit. This culminates today into credit being necessary mana for the suppliers to produce goods. Without supplier there is no market!

The market essentially is an infrastructure provided to suppliers to help them address demand - through exchange of goods and services. Market works on marginal cost of exchange. Markets usually take care of themselves so long as demand and supply exists. The maximum fixing markets needs is through ensuring rule of law - enforcement of contracts, protection of aggreived, ensuring people don't cheat or muscle out others etc. Markets are even oblivious of fairness of law - so long as law exists and they get implemented markets will get created.

Hence the crisis will be resolved if we solve the demand (consumers') problem first. Then we need to fix suppliers' access to credit. It is ok to have latent unsatisfied demand - that often gets channeled into savings. But excess supply translates into inventories and they have costs and lead to supplier anemia. Ensuring law and order will help markets get back in shape soon enough.

US Solution has been antithetical to first principles

The solution so far has exactly moved in opposite manner. We tried to make market functional by rough-shodding over contracts and ensuring cheater get away with it. We tried to ensure liquidity to help with supplier credit. All this while - the consumer is facing increasing credit card debts, lower job prospects and total loss of confidence in possible return to reality. We haven't really done anything to prevent creditors making predatory moves on consumers.

The solution to the crisis is essentially a modified Keynes' approach. We need to create jobs while fixing the system in coordinated precision. The kind that won Nadia Comaneci her perfect 10. And the stakes are higher there is not saffety net - no silver medal!