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Did the FeD bet the bank on betting money?

August 15, 2011 Leave a comment

Why is the FeD unable to kickstart the US economy despite pumping in Trillion of dollars into it?  Have Keynesian techniques of stimulating slack demand failed? As the world wades into the swamp of another recession, the question takes on urgency.

 

Banking crisises are not new in history. Some suggest they follow a 50 year Kondratieff cycle. A Credit crisis is caused by a fractional reserves banking system that allows credit expansion far in excess of what is required to support the real economy. Excesses create loans that cannot be repaid by known income streams.  This eventually causes new credit creation to stop and a downward spiral of credit contraction results. The crash of 2008 was essentially a credit crisis brought on by excessive debt.

 

If credit crisises are that well known then so must be the solutions. Unfortunately that doesn’t appear to be true. To see why, we must briefly examine the changing nature of debt created by banks over time.

 

Good old debt isn’t what it used to be. Time was when debt was a loan you took to create an income creating asset. Over time, the income was sufficient to pay down the loan and leave a surplus. Hence debt was economically productive and helped spur growth by giving innovators access to capital with which to exploit new opportunities. Excesses were possible due to a herd chasing the same idea creating an oversupply.  But it was easy to stop the process, recalibrate valuations to reality, take the losses and start over again in a relatively straightforward way. Capitalism worked by weeding out the inefficient and making room for the efficient.

 

When you add consumer credit to the mix of debt that banks create, the nature of the banking crisis changes.  Consumer debt is basically preponed consumption against existing streams of income. If you are young, and being rapidly promoted, increasing income may justify a permanent hike in living standard.  But in most cases, when you take on a consumption loan, the repayment has to come, not from income growth, but from reduction in future consumption. This is true in terms of housing loans as well. You may be justified in buying a house with a loan paid out of future savings. But the essential difference with a productive loan remains. You are looking to future savings to pay off your loans; the loan is not self-liquidating from income generated by it. Sadly, in recessions that follow credit crisises, incomes shrink.  So it is that much more difficult to stimulate your way out of a credit crisis caused by excessive consumption. It takes more time to train and move a labor force to a higher level of productivity.

 

Even that would be manageable but for a new and strange kind of debt that began to creep into the system in 90s. For want of a better name, we shall call it derivative debt. Consider writing a call option. To do so, one would [1] buy the underlying asset laying out money, owned or borrowed, [2] Buy a put from a put seller to hedge against the possibility that the price might fall exposing one to a loss, and then [3] sell the call, valid for say 30 days, to the call buyer. At expiry, the value of the call if any would be paid out to the buyer by selling the asset at the market price and repaying the money to self or to whoever it was borrowed from. If the call has any value the put expires worthless. So derivative debt is self-unwinding so long as the options written have an expiry date and the whole chain of transaction is unwound in an orderly fashion at expiry. But for the duration of the call, or put, credit to buy or short-sell the underlying asset is created, usually by banks, and remains outstanding. For the duration, this credit creation is real, not imaginary.

 

Starting early 90s, banks were not only writing long term options, swaps etc over the counter but also warehousing these internally. Long term options don’t self-liquidate like the 30 day call we examined above. The credit they create persists in the system. Worse, such credit gets “delinked” from the underlying written options as credit by itself is traded as a commodity. In short, we neither have a measure of the “orphaned” derivative credit so created by the banks nor do we have established “clearing houses” in which to settle these OTC options in a transparent fashion.  When you don’t know, you can’t regulate. As events after 2008 showed, these transactions, and the derivative credit associated with them, had overwhelmed the normal asset backed loan making function of the banks many times over.

 

How is “derivative credit” repaid or unwound? Imagine some people placing bets on the outcome of a match. The bets are placed with a bookie who collects all the money before the match. Let us assume the bookie doesn’t bet himself. When the match is over, the bookie pays out all the bets and should be left with zero in his kitty barring his commission. Only if the bookie miscalculated the odds, or took a position himself, would there be a deficit or surplus. Betting is a zero sum game no matter how many players play and what the nature of odds.  The same is true of the whole game of trading derivatives. There is utility to the trades beyond the game in terms of risk mitigation for some. In the immediate context of such trades, somebody’s loss is an others gain. So the big question is: if the banks and institutions were simply running agency accounts in derivatives trading, how did credit losses come about?  Were banks lending for speculation?  Or were they speculating for their own account? We still do not know the true extent of such transaction though we know they were humongous.

 

Betting losses have to squared off, settled or cancelled. Investment banks in the US were betting shops not lending shops. Some like AIG, though an insurance company ran huge betting shops in the name of credit assurance basically writing puts on toxic assets that went wrong. They also speculated on their own accounts. When the music stopped, most were left high and dry by defaulting counter parties and own losses. FeD stepped in, not to force their liquidation, but to bail them out. Hundreds of billions of dollars were paid to add cash to the betting pool that should never have been in deficit. Furthermore, FeD purchased trillions of dollars of assets far in excess of their market value in order to shore up bank balance sheets indirectly adding billions of more dollars to betting pool. Which future stream of income does the FeD have to recover these payouts?

 

FeD effectively assumed the betting losses of the banking system. Fine. But to pay for them the US Government can raise taxes, resort to negative real interest rates or debase currency. Or resort to a combination of all three. Spending in recession is used to stimulate demand. Instead FeD is using it mend holes in the banking system that neither creates additional demand nor jobs. In the process the weak haven’t been weeded out and continue to bleed profits from the efficient. FeD has negated the basic creative-destructive force of capitalism.

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Does India live in its villages?

August 8, 2011 4 comments

The Indian economy appears to be running out of steam as fractious politics and unprecedented corruption combine with policy paralysis to take their toll on growth. Suddenly capital is predatory, industrialists and politicians are crony capitalists if not robber barons, the rich are getting richer and the poor getting poorer. Fossilised minds are busy churning out regurgitated wisdom that never quite left our elites. Predatory capitalism is to blame. Punditry is trotted out that it is perhaps time to turn to ‘inclusive growth’. Never mind that the ‘inclusive growth’ chariot is drawn by a couple of Trojan horses that conceal the old state controls designed to smother enterprise, energies and dreams of a billion plus people. Once again the cry is not to let a thousand flowers bloom but to prove that flowering is a wholly wasteful activity unbecoming of our ideals and culture. Now, as before, such stunted visions hide the self-serving motives of those who are already aboard the gravy train to dissuade the ones not so lucky to stay where they are. Think agriculture.
India lives in its villages, said Mahatma Gandhi. Has anybody asked the villagers if they want to live there? Had we not been keen on keeping the hoi polloi away from our own habitats, we would have noticed a singular disinclination on the part of the villagers to confine their aspirations to the villages. Even when there was no cable TV, villagers sacrificed all to give their progeny an education to escape from the clutches of rural poverty. This shows the aspirations that animate the dreams of our peasants for a brighter future. It is time we treated them as equals and paid attention to them in terms of what they really are rather than in terms of what we wish to believe of them. The simple life of idyllic villages is just a myth that blinds us to reality.
Why must an Indian farmer pay the going international price for steel but receive only one-third the international price of the vegetables he produces? This is not an isolated statistic. It is true of most things across the board whereby we underpay our farmers for their produce but charge them full for products and services they use. We do offer them stupidly designed subsidies on things like water, power and fertiliser. But these together constitute no more than 15 percent of the cost of production to farmers and the subsidy element in them at 33 percent would still amount to no more than 5 percent of the total cost. However, for this 5 percent subsidy, we underpay them 66 percent in terms of the price of vegetables! The old socialistic system we designed after independence is still at work. Working through a system of exchange controls, denial of export markets for agriculture, and direct and indirect price restrictions, it ensured transfer of wealth from the farmers to industry. The model impoverished our villages while we surreptitiously transferred their wealth to industry to fatten our middle class at the expense of farmers. Twenty years into liberalisation, we have barely touched agricultural reforms.
Class wars are not the answers to conflict of interests such as above; creative solutions are. Recall that the cost of daal (pulses) at your kirana (retail) shop is split half-and-half between the cost of production paid to the farmer and a whole group of expenses related to warehousing, processing, interest, wastage, branding, transportation and marketing. Who provides these services to the farmers on the one hand and consumers on the other? We call them middlemen. They are the proverbial bogeymen who eat away all the profits due to farmers. They are small town merchants that buy your daal from farmers and push it to you through kirana shops with varying degrees of value addition. Is this wholesale-cum-retail chain efficient? Can reforms help in releasing hidden values to benefit both farmers and consumers? Consider.
Reforming and opening up trade that moves produce from farms to store shelves is low hanging fruit ready for picking. The existing middlemen are essentially government agencies and small merchants. The existing system provides no feedback to farmers in terms of future prices, what to grow, seeds, agronomic practices that standardise produce, and a host of other inputs needed to make farming less risky and more productive. Existing middlemen have limited warehousing capacity, their best practices are substandard, wastage is high, interest costs usurious and price risk mitigation is unknown. Lack of price hedging makes them charge huge profit margins to compensate for losses in lean years. A reasonably capitalised, professionally managed enterprise with warehousing, processing and retailing services could cut these wasteful expenses to less than half. Further economic gains would accrue to the system as farmers respond to higher and less risky incomes by more investment in their farms. Agricultural marketing firms would expand existing markets and find new ones abroad by investing in logistics to make exports feasible. We have the world’s cheapest labour in agriculture and labour accounts for something close to 40 percent of the costs of agricultural production abroad. That makes us one of the most competitive producers of food. [For a success story, look at soya bean cultivation and exports.] Where we have failed is to build the infrastructure required to capture markets abroad by not letting in the organised sector. We have restrictions in the name of protecting the common man. Common man who? Who do we protect if we rip off our farmers, gyp our consumers and punish the economy with gross waste and inefficiency?
The politics of such a move to throw open the agricultural marketing sector to domestic and foreign capital is interesting. It involves deconstructing a few myths that have been used to blind us to reality. Consider the existing chain of middlemen that move daal from farmers to consumers. When we need a bogeyman to explain inflation, we turn to the despicable middlemen. Miraculously, these very people become small traders and common people as we talk of letting in competition into their business. Over 60 years we have perfected the art of political rhetoric whereby we can be persuaded to diametrically opposite conclusions depending on which cheerleader of what persuasion is leading the discourse. The net effect of the false discourse is that it serves the collective interests of the vocal middle class at the expense of those lower down the food chain. Agricultural marketing is but one example of our intellectual blinkers. Letting in the organised sector has many economic benefits. Equally, it also has the necessary political votes. The trader class in small towns and the kirana store-wallahs are smart, suave and articulate but their numbers are minuscule compared to the farmers in the villages who would benefit the most from reform. Politicians who help bring about the change can expect a political bonanza in the rural areas. Further, there are likely to be enormous benefits to consumers in general in terms of quality and price of agricultural products. Overdue reform in agricultural marketing may help break the logjam in agricultural growth, which in turn could push us to a sustained growth above 10 percent. Imaginative reforms in agriculture can be excellent politics. Ideally, one would combine these reforms with step up in education facilities available in rural areas to provide a visible momentum for change.

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Telcom Scandal – Who decided FCFS policy should continue and why?

August 1, 2011 14 comments

Quote 1:

“The PMO noted that “it was well known at that time that there were conflicting interests between existing operators and new entrants. The Prime Minister felt that this matter required detailed examination and deliberation by the Department of Telecom in consultation with TRAI and others.”

 

Quote 2:

“The Prime Minister’s Office has clarified on a file noting dated January 15, 2008 related to the 2G. The noting by his Principal Secretary said the Prime Minister wants to be kept at arm’s length on the issue of the sale of spectrum.”

 

Up there in those two paragraphs you have the heart of the Telcom Scandal. There was a clash of interests between existing operators, [read Bharti group] and new entrants, [read Tatas, Essar, Rcom] and Government was required to find a via media between the conflicting interests of the two groups. The existing players had been the ones who got their licenses dirt cheap in the first round of liberalization. They had been in business for almost 10 years and were running a highly profitable operation.  They were naturally keen to protect their turf and franchise. The new entrants on the other hand, were keen to enter the business having belatedly realized just how profitable the business could be. They wanted to enter the business as cheaply as possible. The existing players were keen to see that the Government charged them a high entry fee for their licenses.  That was the corporate war being waged behind the scenes. The PMO clarifications now establishes facts for the first time and confirms the clash of commercial interests for us as well.

 

Let us examine step by step how GoI went about resolving the commercial conflict of interest between the two warring groups forgetting its own vital interests in the process.  But first a word on the First-Come-First-Serve policy that GoI had adopted at the time of liberalization when the first bunch of Telcom licenses were given out in 2001.

 

FCFS policy has a rationale when [a] the Government is not able to properly price a service or a license and hence does not know what to charge, [b] the fee itself doesn’t matter in the overall public good and [c] the Government needs to be fair to all those who apply for the license or service. All three conditions obtained when the licenses were first given out to private players.  At that time, through stupor or whatever, Tatas, Rcom, Essar et al missed the bus because they never applied in time. They therefore have nobody to blame but themselves. The sole purpose of FCFS is to attract participation in a new venture being privatized for the first time because the potential is unknown. It is a one-time exception to the rule not a policy for all times to come.

 

By 2008, the Government had 10 years of data on private players in the Telcom field and was thus in a position to determine precisely the value of the licenses it was to give out.  Secondly, given the huge profitability of the existing players, the intrinsic value of the spectrum was known to be humongous.  Giving it away free should have been properly weighed against all options available to the Government including that of auction. There is absolutely nothing to show that somebody in Government carried out such an valuation exercise. Lastly, fairness demanded that existing and new players be treated differentially rather than on the same basis because existing players had taken on far more risk than the new entrants and thus were entitled to preserve their first mover advantage.  Hence, on all three considerations, there was no case for continuing with the FCFS policy in 2008.  That it was continued is itself highly irregular and the reasons that weighed for it to continue expose the real dimensions of policy errors that the Government made or was induced to make.

 

By the PMO’s own admission, the new entrants were actually fighting to get into the Telcom business by hook or by crook. If FCFS is meant to attract participation from potential players the very fact that they were fighting to get in shows there was absolutely no justification for FCFS from a public policy perspective.  Nobody was in any doubt as to Telcom’s profitability and attractiveness after 10 years of operating data from existing private and public operators.  The continuation of FCFS ipso fact is the single biggest contributing factor in the whole Telcom muddle.  Why did it happen?  This question has been neatly ducked by GoI spokesmen including Sibal as if the need for a level playing field among operators justified the continuation. That is logically incorrect. A level playing field in fact demanded the opposite!

 

An examination of the “level playing field” hypothesis trotted out by Sibal exposes a deeper contradiction in the way GoI went about resolving the corporate war between existing operators and new entrants.  As we saw, the existing players were within their rights to seek to preserve their first mover advantage in the form of a lower operating cost structure.  But let us put that aside and look at the matter purely from a Government’s policy perspective.  Government did not need to attract new players. They were fighting to get in and common sense shows they would have paid a fair price for the privilege of entry. Why not charge everybody, existing and new players, by auctioning the spectrum to be made available?  That would mean existing players would pay the same higher price for additional spectrum as the new players but also preserve the advantage on existing spectrum already with them.  So a level playing field for all.  But more importantly, GoI would earn a huge fee for the spectrum so auctioned.  As we know, this revenue could have run into a lac of crores or more. Not a small amount. So GoI gives up about 15% of its total annual tax intake just to ensure that new players are given the same benefits that existing players had with retrospective effect going back 10 years!  Does that make sense?

 

The question is who decided FCFS should continue?  On what considerations?  Was the alternative of auction considered?  Was the cabinet informed of the revenue loss implied? Who recorded the justification for continuation of a onetime exception to policy that the FCFS is.  Please note the subtle way in which the whole discourse around the Telcom scandal has been shaped to deflect people away from the core question of why FCFS was continued into side issues.  The main revenue loss to GoI and the consequent bonanza conferred on new entrants was occasioned not by Raja’s side show of out-of-turn shenanigans but by continuation of FCFS.  And corporate interest now forbid bringing that issue into central focus. But to get at the truth that is where we must focus, not Raja.

 

The revenue loss occasioned by FCFS has been justified on two counts by Sibal in debates.  Firstly, FCFS was a policy issue and GoI was well within its rights to continue an existing policy of the Government.  We have seen that to be specious and grossly incorrect because continuation of a onetime exception 8-10 years after it was made is ludicrous.  Secondly, Sibal has justified the revenue loss saying it translated into reduced tariffs.  That claim merits careful consideration.

 

We will never know how much of the revenue loss was indeed passed on to consumers by Telcom operators in the form of lower tariffs.  In Sibal’s favor one must concede that Telcom tariffs in India are among the lowest in the world. But was all of the bonanza conferred on the operators passed on to consumers?  That is unlikely to have been the case.  But Sibsl’s defense is bogus for a far more subtle and deeper reason of public policy.  Remember, the revenue lost from spectrum sale belongs to the General Budget as a capital receipt from where it could have been used to construct schools, hospitals, build roads or whatever.  Who is to decide if passing on lower tariffs to Telcom consumers is a more desirable policy goal for GoI rather than building schools or hospitals?  That decision cannot be an un-scrutinized decision of the DoT or the PMO.  Both have no business making such decisions. The proper course for GoI was to charge a fair fee for the spectrum and to make those funds available for allocation from the central budget.  Why should Telcom consumers be favored over say school children or rail and road users?  Hence Sibal’s attempt at explaining away the revenue loss is not only designed to mislead but is also deeply flawed conceptually.  Pity that Sibal’s obfuscation has not been subjected to due scrutiny.

 

The inescapable conclusion is that FCFS was continued in 2008 to favor the new entrants.  This favor went far beyond the contours of just a corporate squabble between new and existing players as it conferred a bonanza on both the groups far in excess of their dreams of avarice running into a lac of crores and more.  Why was this done?  The need for a level playing field is a red herring designed take focus away from the real policy error, induced or innocent one cannot say at this stage.  Furthermore, the people who should be scrutinized afresh are those who made the decision to continue FCFS and that means many more people than Raja alone. Only then will the full scale of policy manipulation come to light.  Raja may have had his own little scam on the side in terms of out-of-turn favors to other operators which the CBI is looking into.  But that wrong doing pales into insignificance compared to the loss occasioned to the exchequer by FCFS. Who decided FCFS must continue and why?  Was the revenue implication of such a policy examined?  If not why not?  If it was examined what was the estimated loss to the exchequer?  Who then decided it was well worth forgoing this revenue in order to create a level playing field for new entrants?  How was such hugely important revenue sacrifice justified?  Surely any responsible Government would have papers on record covering these questions?  Where are they?  Can they be laid on the table of the Lok Sabha to dispel any doubts that we have re bonafides of these decisions?

 

 

 

 

 

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Pakistan’s Liberals

August 1, 2011 3 comments

What are we talking about when we say there are no liberals in Pakistan with whom we Indians can make common cause to further an agenda of peace and cooperation between the two countries? It is a point that needs some answering from us Indians since it was made by one of us in response to an article by Marvi Sirmed (‘We, the “delusional” liberals!’, Daily Times, July 25, 2011).
The answer depends on what we Indians think needs to be done in Pakistan to end its hostility towards India. (The converse is also true.) Broadly, these are two areas. First, end the 4G war that Pakistan has waged against us since the days of Punjab militancy. (Note Pakistan’s use of proxies and 4G warfare began with Punjab, not Kashmir. Further, Assam shows it need not end with Kashmir should Pakistan wish to bleed us.) Second, restore trade, commerce and exchanges between the two rivals to a level commensurate with the complementarities of the two economies. What we cannot, and must not, expect is that Pakistan will cease to compete with us in economics or diplomacy. Or that it will not use its leverage with China and/or the US to obtain the best possible bargain from us. That rivalry comes with the terrain. Lastly, there will always be a plurality of opinion within Pakistan. We cannot ever expect an across the board support for peace with India. A history of hostility, competing narratives, including an argument over the role of religion in politics, will never be resolved in a generation or two. So we must look for limited, specific goals where a commonality of interests might be found.
On the first issue of ending the 4G warfare, we must begin by noting that the liberals have come a long way from outright ‘stout denial’ of the war itself in Punjab to a grudging admission that the army has indeed used jihadis as proxies to bleed India, and that they continue to be used to further foreign policy objectives in Kashmir and elsewhere. That war has backfired. It needs to be rethought if not ended. The army’s double game in Afghanistan or Kashmir is unsustainable. This dynamic in the liberal narrative is internally driven. The objective is not so much peace with India but to contain domestic radicalisation and preserve personal freedoms. The idea is not to berate the army but to make it alter its policy. At the periphery, the narrative seeks to assert a realistic degree of civilian control over the army commensurate with institutional capabilities. There is also the recognition that India is not an existential threat but a self-created bogey. Can Indians support this narrative and add to it? That is the key question. The answer is yes but it also means being hands-off. The process must not only be internally driven but also seen to be internally driven.
The second broader issue for the liberal agenda is de-radicalisation of society. Putting religion back into the personal domain, ending covert and overt state backing of fundamentalists, modulating the ISI’s role in domestic politics, putting the army back into the barracks, unwinding the security state rhetoric are some of the issues on the liberal agenda. Again these are largely domestic issues. They are not intended to end the role of religion in public affairs, embrace secularism Indian-style or in any way diminish the idea of a separate homeland for Muslims. Nor should we expect it to be so. They are intrinsically reforms of the existing system, in many ways a reversal of the policy from the Zia years. They do not constitute a change in national strategy in terms of power projection, economics or diplomacy. They are intended to forestall a pariah status for Pakistan internationally.
Where is the pay-off from the overall national strategy that the Pakistan Army has pursued since the Zia years? How does Pakistan’s army see the scenario unfolding? What is the endgame as it sees things? Pakistan’s pay-off from the strategy has been predicated on: (a) acting as a trade corridor between India and Central Asia in terms of oil, etc, but a corridor that it fully controls; (b) playing off China and the US vs India to extract a bargain from all sides, and (c) hiring out its guns to whosoever can pay in the region. Is that about to change? No. So long as there is money in it, that game will continue, regardless of whether the military or civilians are in charge. The methods, process and intensity might change. The basic strategy is intrinsic to the dynamic and cannot change.
However, Pakistan’s liberals have staked out a case for change even in the basic strategy. The liberal narrative is that the trade corridor role is best played by normalisation of relations with India. And that the normalisation process must begin now. The argument between liberals and the army is more a case of what comes first — chicken or egg. It may be essentially limited in scope but it shows that possibilities for a better narrative exist.
Overall, we in India can support liberal efforts in reformulation of Pakistan’s domestic policy. These changes make normalisation of relations easier. Some in India question even the desirability of such normalisation. That is unfortunate. It is in our interest to restore a degree of flexibility in our dealings with Pakistan in the context of China’s efforts to ring us in. We are seeing the dynamic play out in Nepal, Sri Lanka, Bangladesh, etc. Time we, too, made our moves. However, we must guard against expecting too much.
How, then, does one place the taunts, insults, and yes hatred, that goes with any effort at interaction between Pakistanis and Indians? These are part and parcel of our historical baggage. We must minimise them even as we recognise that they colour the relationship. Overreacting to them is just so much wasteful friction that generates heat but no light.
Liberals in Pakistan denote its endless possibilities. They are a poignant reminder of the subcontinent’s promise. They are not what is but what can, and indeed, must be. Their sincerity, integrity, love of their country and commitment to what they believe in is not in question. Their numbers may be minuscule but they keep the torch burning. And they have demonstrated a capacity to compel response from the Pakistani deep state that was simply unthinkable even a few years ago. Friendship with them is not an imperative but it would be churlish to deny them the respect they have earned for their forthright stand on issues in their domestic context. If they bring moderation to Pakistan, why not? More power to them. Let us cheer them on!

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