Great reading

John Mauldin decided to feature a great piece by Dylan Grice (of SocGen) on his blog. It is well worth a read, for any one with passing interest in wanting their savings to go the farthest possible distance into the future. One of the sub-titles (the future is wild; our forecasts are mild) most appropriately captures our cognitive limitation.

This applies to most humans in most situations and not just in the financial community. There are many reasons for this. One of them is denial – that is, we do not like to think of/contemplate bad outcomes. Then, we fear what would happen to our assets, income and employment if we forecast bad outcomes as though our forecast has the power of making it happen!

Post hoc…

.. ergo propter hoc – on full display in financial journalism today. US Conference Board, a business association, revised its April 2010 leading index reading for China and it crashed the China stock market by 5%. H…mmm. FT goes with this logic too. What is the purpose of this lazy journalism, if not just laziness? Is it to put China on a pedestal or in a corner or to shift attention away from the source of the trouble – the faltering US economy? The weekly leading index of the Economic Cycle Research Institute is contracting at an annual rate of 7% and that spells trouble for the US economy in the second half.


I read two or three pieces today – two in FT and one in ‘Economist’ forwarded by Mr. Ram Narayan in the US. All three left me scratching my head. The real shocker is the one from ‘Economist’. It says that India’s non-proliferation record is not spotless. But, it does not offer any evidence. It begins by talking about Pakistan’s reactors from China would cause damage wider than stoking rivalry with India. It ends up with a comment on Indian hypocrisy.

So much for intellectual honesty, competence, objectivity and clarity of purpose. If the idea was to hit at India – without any argument or evidence – then it has begun with the wrong header.

I wonder what its former editor, Bill Emmott, has to say on this. He saw light after he quit ‘Economist’. But, of course.

I shall do a separate post on the two articles I read in today’s FT – European edition.

(Update: See this post too by Rohan Joshi at the ‘Filter Coffee’, fellow blogger on TNI)

Faulty framework

“We must not balance budgets on the backs of the world’s poorest people,” Ban said at a G20 dinner Saturday evening. [More here]

This is a red herring and a wrong way to frame the issue. The poor are not against balanced budgets. They are against them being used as a pretext to run fiscal deficits that provide support to the rich and the wealthy, in the name of preserving the economy’s investment and job creation potential. Nothing prevented the governments of the West from directing most of their fiscal stimulus in the last three years to the poorest of the poor in their countries while letting the economy’s natural healing process take its course. The obsession with economic growth (at all costs) in the name of the poor causes more damage to the poor in the long-run and is also misleading. Growth is desirable but it must also be sustainable. If not, it becomes undesirable and dangerous.

That is what happened between 2002 and 2007. Given that backdrop, few years low or no growth are needed to work off the imbalances while scarce government resources are spent on the most needy. Is that what really happened?

Hence, the G-20 obsession with growth reflects their fears arising out of the lessons of the 1930s that they have absorbed, particularly in the US. Premature tightening of fiscal policy in the U.S. is said to have deepened and prolonged the stagnation. The second lesson is said to be that of Japan’s in the 1990s. We do not know how the counterfactual would have played out. Even granting that the counterfactual would have been more favourable to their economies, it is hard to argue that the situations are similar.

A cookie-cutter approach to economics is more injurious to growth than premature tightening. Each country should choose what it deems appropriate to its circumstances and what it deems sustainable in the medium-term. Further, it must remain open-minded about admitting mistakes and reversing course if empirical evidence argues against the action that they have pursued. In the final analysis, all of us know that economics is all about lags and luck.

Therefore, judgements have to be tempered and qualified. Something American commentators have not learnt. See here. That is why I am not in agreement with Simon Johnson’s recommendation that the economist Paul Krugman be appointed the new director of the Office of the Budget Management in the US Government to replace Peter Orszag who resigned recently. TGS has not had many occasions to disagree with Simon Johnson. This is one of the rare occasions.

I was reminded of what I read in Dr. Atul Gawande’s website recently. The website features the review of Malcolm Gladwell on Dr. Gawande’s latest book, ‘The Checklist Manifesto’ published in December 2009. I have not read the book yet though I had bought it, on coming to know of it through my visit to his site. Nonetheless, these remarks of Malcolm Gladwell must be remembered by all ‘experts’:

Gawande thinks that the modern world requires us to revisit what we mean by expertise: that experts need help, and that progress depends on experts having the humility to concede that they need help. [More here]

Innovation in India – a guest post

In response to the announcement in Hindustan Times that the newspaper proposes to show case innovations in India, Dr. Vidyasagar responds as below. Dr. Vidyasagar is Cecil and Ida Green Professor at University of Texas at Dallas. He is the head of the department of bio-engineering. All views below are his.
Innovation in India

(Dr. Mathukumalli Vidyasagar)

The URL contained the same introduction but not the 14-page special section. So I do not know what was in the article. In any case, it is good to see HT take up this topic; but I wanted to add a few observations, based on my having spent the past 20 years in India working in R&D, first in Defence Research Development Organisation (DRDO – under former President Kalam) and later in Tata Consulting Services (TCS). Before proceeding to my main points, I would just like to add one caution: We should not interpret “innovation” very narrowly as “something that gets noticed by the West”. That would be just a post-colonial hangover.

1. Indians have been at the cutting of edge of innovation for decades; but they have not reaped the benefits of it, and have allowed others to retain the IP and attendant benefits.

2. There are no true angel investors in India, only early stage investors.

Let me elaborate each of these points.

I. Indians have been innovating for years!
Contrary to what many in the English media believe, Indian IT companies have been providing cutting-edge solutions for years now. Way back in 1986, the world’s first workstation based on the Intel 80386 microprocessor was built by Wipro! More recently, when the iPod was launched, the chipset had to be designed and tested in an extremely tight time schedule. The only way in which this could have been done was to split the work between San Jose and Hyderabad. Thus one could say quite rightly that the first version of the iPod was at least half designed in Hyderabad. TCS’ project for Ferrari to allow them to analyze and fine-tune engine performance in near real-time is another example. So it is not exactly news to us insiders that Indian IT companies have been providing state of the art solutions in a variety of domains.

The main shortcoming has been that, for the most part, Indian companies have NOT BENEFITED from these contributions. In almost all such instances, the work was done on a strictly contractual basis, meaning that the customer retained 100% of the IP, and the Indian company did not benefit from the upside when the product proved a hit. This was due not only to the customers’ insistence, but also to the reluctance on the part of the Indian IT companies to envisage any model besides MSAs (Master Service Agreements), hours billed, head counts, etc. For instance, in one case which I am not allowed to mention due to confidentiality, I could actually browbeat our account manager to retain the IP with TCS for a very high-profile project (after he swore up and down that the client would never agree — but they did!). But AFTER that, there was zero interest in packaging and commercially exploiting the IP — WITHIN TCS! “Work once, earn once” is the only model that everyone at the top of the Indian IT companies understands, and they simply don’t “get” the model of “work once, earn over and over again”.

Of course merely owning IP does not by itself lead to revenue. One has to invest in packaging, marketing, sales, customer support, upgrading, etc. With its remarkable success in its current business and revenue model, Indian IT has grown complacent to the point of hubris, and simply does not feel the need to do any of this. They are not investing in R&D even when they are making 20+% profit margins, because they are more interested in squeezing an extra “point” (that is, 0.01%) of profit margin, than in investing for the future. Imagine that not a single Indian IT company is investing more than 1% on R&D, and other than Infosys, no other company is investing more than 0.25% on R&D! This is truly a scandalous situation. No business model lasts forever, and one day our IT companies will also be knocked off their perch. When that happens, they will have nothing to fall back on.

II. There are no angel investors in India, only early stage investors
It is often repeated (usually by people who know nothing about such matters) that the reason why India does not have so many start-ups is that Indian society places a stigma on failure, which is not there in the USA. This kind of psycho-sociological babble is very popular with certain types of people. The truth of the matter is that the VC community in the US is basically a highly incestuous community (the politically correct term is “networked”) that looks after its own and mans all barricades against the rest.

Living as I do in Dallas, which as everyone knows is home to a lot of billionaires but not a lot of VCs, I often say jokingly that it is far easier to generate an endowment in Dallas than an angel investment!

In India, by and large people with money are far too cautious in making angel investments and counting on the law of averages to work in their favour. Instead they make what are in reality early stage investments, once the idea has already been proven. This cultural difference limits our Indian start-ups to very “cheap” ventures (by this I mean ONLY that failure is inexpensive, and nothing more!).

I have often been amazed as to why our successful businessmen, who have many hundreds if not thousands of crores, do not simply invest up to 50 lakhs in a wide range of start-ups. If only a few of them would find the courage, I think our Indian scene would be transformed.

I saw it LIVE

… Well on TV. But, what the hell? I am happy (understatement is the best in these circumstances) that I saw it. When I began seeing the 1st round match (in the All England championship at Wimbledon in 2010) between John Lisner (USA) vs. Nicholaus Maut (France) on Tuesday evening, something was impressive about the quality of tennis that both men played. BBC 2 stopped the live telecast on Tuesday night when the match had gone into the fourth set. So, the first thing I asked my wife on Wed. morning was to check the final result of that match. She found out, after some effort, that the match was suspended at 2 sets apiece. I returned to our serviced apartment on Wed. evening from work only at 6:45 PM (CET) and immediately switched on the T.V set or rather took over it from my son, much to his disappointment. They were showing the Lisner vs. Maut match, to my surprise. I had to look twice to believe the score-line – about 32 games apiece or thereabouts in the fifth set.

The rest, as they say, is history. What would one say of the mental make-up of some one serving to save the match point at 58-59 down in the fifth set (yes, the total no. of games played was 117 in the fifth set alone) after some nearly 10 hours of tennis? Worse than a jelly? Looks like the stuff that Mahut’s brain and heart  are made of, ought to be studied by scientists and psychologists. That might hold the clue to solving clinical depression. He produced an ace and went on to tie the match again at 59 games all in the fifth set. The match continues into the third day tomorrow! You can get a feel for it here.

Speaking on BBC 2 Sports coverage, John McEnroe said that there should be a tie-breaker in the fifth set, after worrying genuinely about the physical well-being of the two players. But, I do not agree. These are really once-in-a-lifetime or once-in-many-lifetimes events and we should let nature have its way and not constrain it. There would not be another moment to cherish like this, if everything were truncated – limited by us, our abilities, our imagination, our brains! But, two individuals showed that they could defy it all. Even if it was only two individuals and even if only once in decades or even centuries. But, that is the beauty of it. Why seal it? Cap it?

Well, between World Cup Football and Wimbledon Tennis ,it is clear where my heart is.

Bond bubble

David Rosenberg gets into his stride from the word GO, in his Op-ed. piece in FT on the question of bond bubble:

I find it truly amazing to see how many pundits refer to the bond market as if it is in some sort of a bubble. How can a security whose price is constantly projected to decline by the economics community be in a bubble? How can any asset class be in a bubble where the capital is guaranteed and which pays out a coupon twice a year? It makes no sense. [More here]

On Monday, Julius Baer hosted the Asia Investors’ Day in Zürich. Dr. Marc Faber was one of the speakers. He argued, equally compellingly, the opposite case. He said that the US Federal Reserve would keep interest rates low in real terms – even negative  – not just for the foreseeable future but for the conceivable future. Fair enough. Even the Federal Reserve Bank of San Francisco note on the future trajectory of the Federal funds rate ruled out any rate increase until 2012.

Therefore, he felt that bonds with their fixed coupons would be worst hit by the inflation-fostering monetary policy, ending their 27-year long bull-run.

The question is one of timing, at the minimum, even if the scenario painted by Dr. Faber is mostly plausible. What conditions would prompt the Federal Reserve to opt for an explicitly inflationary monetary policy? Would the onset and the arrival of such conditions be not bond-positive, initially, sending yields to a record-low, lower than they were in the last months of 2008? After all, if an asset has been in a 27-year bull market, nothing prevents it from being in a bull market for another two or three years!

Further, Dr. Faber cited the example of Mexico where the initial collapse in the currency and onset of inflation proved negative for equities. But, subsequently, equities were boosted by the positive nominal effects of a weaker currency. He said that the same thing could happen in the US when the Federal Reserve chooses to pursue this explicitly inflationary policy which would be followed by inflation and currency debasement. In other words, equities would do a lot better than bonds.

Now, if only two situations were similar. History may only rhyme and rarely repeats.

In Mexico, equities might have rallied after an initial sell-off because the country might have embarked on some fiscal consolidation or there might have been debt restructuring (Brady bonds?). Further, the global growth backdrop might have been benign. The US case is altogether different.

Suppose it embarks on quantitative easing with an expressed desire to stoke inflation and if the U.S dollar begins to tumble against other currencies, what would happen to the risk-premium/discount rate on U.S. assets?  How would other countries react as their currencies skyrocket against the U.S. dollar? Would it not stoke economic tensions and proxy or real battles between nations? Would equities still outperform in such an environment?

I guess it must be clear to the readers as to where my sympathies lie. For now, I am on the side of David Rosenberg even though I am in agreement with some aspects of the ‘end-game’ that Marc Faber outlines.

The battle of the fisc

It is an understatement to say that Paul Krugman is pugnacious. Robbed off his favourite adversary by the U.S. Presidential election system that limited former President George Bush’ tenure to eight years, he has now trained his guns on those calling for fiscal austerity. His latest NYT column is but an example.

Going back 15 years, I was responsible for covering Canada for UBS in the mid-90s. I tracked their budget consolidation efforts after the spread to the US Treasury soared to some 300 basis points. That consolidation worked and the bond yield came down. I doubt if growth was hurt too much. In any case, I wonder how one could have constructed a counter-factual scenario: that is, how much better would growth have been, had the stringent fiscal consolidation not taken place? There might have been a further rise in the bond yield, the currency might have weakened further and risk considerations might have taken over from economic considerations, leading to loss of business confidence and delay of investment decisions, etc. Economic growth would have been a casualty.

In some sense, I am surprised that Krugman has difficulty in seeing this positive side of fiscal austerity. If the public feels concerned by the future tax burden, they may not consume now at all, fully negating the fiscal stimulus. On the contrary, fiscal consolidation with its beneficial impact on interest rates might set off confidence and business spending through lower cost of capital.

There is also a certain sense of helplessness conveyed by the huge dependence on the government. Fiscal austerity, on the other hand, gives people a better sense of control over their destiny, by letting them showcase their ability to take pain. If markets like it too, they reward such behaviour with lower interest rates and sooner, rather than later, the whole thing turns into a virtuous circle.

So, I can buy the argument that fiscal consolidation, under certain circumstances, could be positive for countries. The question is one of credibility with markets and whether it appears do-able. In fact, what my European colleagues tell me is that, so far, it appears to be on track, credible and working, in the peripheral European countries. But, we need to keep an eye out for both reassuring signs and faltering signs in the Eurozone.

If it is the former, it is hugely positive for Eurozone in general and one that goes beyond economics. It would enhance its geopolitical standing. If it is the latter, then the risk to EURUSD downward could be substantial.

A ‘flexible’ Saturday afternoon

Until the end of the week, China was warning all and sundry to lay their hands off the Chinese currency. See here and here. This statement by Xinhua is, however, more colourful.

Not to be deterred, President Obama wrote a letter to the heads of G-20 governments urging them to do more to boost domestic demand:

I am concerned by weak private sector demand and continued heavy reliance on exports by some countries with large external surpluses.

I also want to underscore that market-determined exchange rates are essential to global economic vitality. The signals that flexible exchange rates send are necessary to support a strong and balanced global economy.

Then, on a cold (10 degrees C) and rainy Saturday afternoon here in Zurich, we heard that the People’s Bank of China had said that, henceforth, the yuan would be managed flexibly. For the last two years, the currency has remained pegged (vs. the US dollar) at around 6.82-6.83.

Reuters has the statement released by PBoC here.

What the Statement means, going forward, is not clear. What it does not mean have been made clear, however:

The exchange rate floating bands will remain the same as previously announced in the inter-bank foreign exchange market.

the basis for large-scale appreciation of the RMB exchange rate does not exist.

These statements found in this Reuters news item are both interesting and significant:

The “crisis-mode” of locking the yuan to the dollar was over, but any appreciation would likely be slow and modest, said Li Daokui, an academic adviser to the monetary policy committee of the People’s Bank of China, the central bank.

In fact, the yuan could begin to move in two directions, he told Reuters.

“If the euro falls sharply against the dollar, the yuan may depreciate against the dollar as it refers to a basket of currencies. But if the euro stabilizes, the yuan could rise against the dollar,” he said.

“The message to the outside world is: don’t pressure us,” he said.

Whether the outside world, especially U.S. lawmakers who say an undervalued currency gives China an unfair trade advantage, will agree with that remains to be seen.

That is the key. If the US Congress sees this as China giving itself more flexibility to depreciate its currency in the event of further EUR depreciation against the US dollar, they are unlikely to be amused.

Reaction of Stephen Green of Standard Chartered is appropriate:

The danger is that on Monday morning everyone gets very excited and then end up being disappointed with what happens. There is very little appetite for appreciation, so in the short-term the central bank is likely to be very conservative,” said Stephen Green, an economist at Standard Chartered. “As a result, the US-China relationship could still be very tricky.” [More here]

Regardless of what China intends to do with this additional flexibility they have given themselves, there is no denying that it buys every one time.  Financial markets (risky assets) are going to like it, on Monday.

Further on UK regulatory framework

Waking up on a rain-soaked and cold June Saturday here in Zurich, I saw the email that Mr. Vijay Mahajan (Chairman of BASIX) had sent, attaching the speech by Hector Sants, Chief Executive of the FSA in England. He has waded in where regulators would be reluctant to, lest free-market ayatollahs accuse them of blatant interference in managerial decision areas. This prompted TGS to do a follow-up post to the one done yesterday.

He has talked of the role that regulators could or should have in influencing organisational culture, ethics and integrity since they impinge on the social outcomes that organisations give rise to. Clearly, in finance, it has been an important factor but equally, a woefully under-discussed factor.

Economists conduct their models and experiments inside the vacuum sealed containers that exclude politics and ethics. We have found that, even in developed societies, such an approach falls well short of explaining reality.

The speech needs to be read and reflected upon before trigger-hungry commentators compose a garbled response and hit the SEND button.

Apart from culture and ethics (or, is it part of it?), the aspect that has been conspicuously missing in the financial industry (or in the corporate world as in the sports world?) is the aspect of humility. I was reminded of it as I forayed after a long gap into Dr. Gawande’ s web site on Thursday night.

This is what Malcolm Gladwell writes in his review of Dr. Gawande’s latest book, ‘Checklist manifesto’ (I managed to buy a copy yesterday):

Gawande thinks that the modern world requires us to revisit what we mean by expertise: that experts need help, and that progress depends on experts having the humility to concede that they need help. [Full review here]

One of the more concrete implications of this for regulators and this is something for the Indian government to ponder over is the Human Resource Requirement for the regulators in this new world:

Moving into making judgements is undoubtedly more difficult.  The FSA will now ‘take a view’.  This may well be disputed by firms and require greater engagement.  In some cases we may prove to be wrong and accept that we are.  But in others we will be right, and make real improvements.

I recognise that to do this we require more and better-quality people and analysis – where we have already made real strides – as well as more sophisticated systems.   It is only by doing this and being more proactive that we will achieve society’s goal of minimising failure.

Delivering this operating model has required a significant increase in the quantity and quality of the FSA’s personnel and technology platform.   In particular, the people mix has moved from one primarily of career regulators, to a blend of career regulators and market practitioners, with a helpful sprinkling of academics and others who can provide the required challenge to the risk of ‘group think’ and regulatory capture.

As to how far (far, far) we (Indian politics and business) are from having a culture with any remote semblance of accountability and ethics, all it would take is to read the stuff here, here and here.