To be or not in the B-Index

It is difficult to keep up with Andy Mukherjee. At the rate at which he is writing, he might give Amol Agrawal of ‘Mostly Economics’ a complex with his prolificity of writing. In the last twenty-four hours alone, I have counted three Andy pieces – joining the Bond index, on the lone SELL rating on ICICI Bank and on Uber selling out to GRAB in SE Asia.

We shall focus on the column on China joining the Barclays-Bloomberg Bond index with India an onlooker. Andy thinks that India should be less fussy about foreigners holding its sovereign debt issued in Indian rupees. After all, the country runs a current account deficit and it can do with some foreign savings. Once you are in the index, index tracking funds will be invested, no matter what the fundamentals are. Of course, they can go underweight but they won’t sell and scoot fully. That is the sum and substance of his argument, if I understood them correctly.

I do not disagree with the logic. There is something to be said in its favour. Andy’s points are well made. But, on balance, I think India is not ready for it and I am not sure it will be ready in the very near future. India lacks the governance and discipline required for sustained macroeconomic stability. China can and will brazen it out. It is ‘Too big to fail’. India is not.

Whether most investors stay invested or not because of index tracking requirements, what matters to asset prices is the behaviour of the marginal investor.

Whether the debt held by foreigners is denominated in local currency or in foreign currency matters little in the end. If investors whose reference currency is not INR decide that they wish to get rid of INR risk, then the foreign exchange risk comes into play fully, regardless of the currency of denomination of the Indian debt.

India frequently gets into situations in which foreigners would want out. Despite its savings rate at a low 30%  (given its growth ambitions), India has not given up the ambition to become a high growth nation.  Governments feeling shaky politically – that may be a reality after 2019 elections – might want to go for high growth and do so via fiscal populism something that India did, not so long ago (2009 to 2011) and that is recipe for disaster for debt and for the currency because with a savings rate of 30% and low capital and labour productivity, high growth can come only via a ramp-up of aggregate demand and that would blow out the current account deficit.

The bond market – rational as they are with respect to emerging markets (only) – would administer tough love. Sometimes, it is too tough.

Bond markets are far more sanguine with respect to fiscal profligacy and debt accumulation by advanced nations. Indeed, over the last thirty five years, bond investors have rewarded advanced nations’ public debt accumulation with ever-lower interest rates. So much for market discipline!

Therefore, all told, if one is not sure of self-control and discipline and would likely binge, it is better not to look at the plate of delicious sweets.

So, India is better off not regretting missing out on the bond index membership.

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The Thiruvadanthai trilemma

Although my friend Srinivas Thiruvadanthai did not mean to pose the question as such, I thought I would credit him with a ‘Trilemma’ that, I hope, will remain for posterity! His blog post triggered the following thoughts:

Another thoughtful and thought-provoking post as usual, Srini. The last paragraph of the post has been the rallying cry of BIS economists from White to Borio (including Cecchetti or not?).

I found the paragraph on the ‘ex-post criticism’ of the Fed not being easy enough in mid-2008 to be particularly insightful. Hindsight is a gift for critics that is denied to policymakers in real time!

The blog post can be considered a formulation of ‘Thiruvadanthai Trilemma’ between free-market finance, financial stability and economic stability. You can have two of the three but not all of them.

Notice that I have taken interest rates out of this trilemma. That is deliberate. In other words, the problem that there is no one single interest rate that stabilises the financial economy and the real economy at the same time disappears if (a) we remove the paradigm that ‘markets know best’ particularly for the financial sector and for financial markets (in a sense, I believe, the comments by Ms. Carolyn Sissoko reflect that) and if (b) the relevant horizon to evaluate the correctness of the monetary plolicy setting was long enough.

Let me take up my point (a) above. The question is whether regulating finance alone is both necessary and sufficient to enjoy both financial and economic stability at the same time. Yes, some would say.

That is what Ms. Caroline Sissoko has said in her coments on his post. But, is that really the case? We will never know because two things were at work in the post-Great Depression period and, in particular, in the post-WW II period. Economic growth was a low-hanging fruit. Therefore, it is possible that, regardless of how the financial sector or financial markets behaved, sustained high growth would have washed away all sins – with or without tight regulation. We will never know.

Therefore, it logically follows that in the era of slower growth that we face now, the case for financial sector and financial market regulation becomes stronger and not weaker.

Critics would object that this would further jeopardise the already lower growth. Well, the IMF has the answer. In a paper that is now a book, ‘Too much Finance’, the authors argue that financial development in advanced nations has already crossed the theshold at which it is beneficial for economic growth.

So, financial sector/financial market regulation will take care of the ‘Thiruvadanthai Trilemma’.

Fortifying that will be a monetary policy setting that chooses its relevant horizon more carefully than what central bankers have done in the last three+ decades. It should be longer than the business cycle so that it encompasses the financial cycle. I am merely paraphrasing the arguments made regularly by BIS economists. That is my point (b) above.

In a long enough time horizon, the dilemma, of fixing a high enough rate that handles financial market exuberance without hurting real economic activity or a low enough rate that allows financial intermediation to repair or to resume while the economy is overheating, solves itself.

In recent times, I beleive that the former dilemma has imposed much bigger long-run costs on the economy and on the society than the latter dilemma, in the above paragraph.

If unelected and technocratic policymakers optimise their decision over a reasonably long time frame, then the need for (or, the impossibility of) multiple policy rates is avoided or obviated.

If they cannot do that in practice that easily, then another approach is to have the domestic economy counterpart of ‘unremunerated reserve requirements’ that is applied to regulate capital flows. There can be a counter-cyclical credit surcharge (or discount) that the central bank, in its capacity as a banking regulator, prescribe for credit allocation, on the top of the policy rate. There can be times when this surcharge (negative or positive) can be zero. In that case, the policy rate works both for the financial economy and for the real economy. This can be on top of (and not in lieu of) countercyclical capital buffers that regulators now want to impose on banks.

Gross confusion here

At least, as reported by Reuters, Bill Gross appears to be all over the place. If global economies are leveraged to the hilt and if that means that intrest rates cannot go up without causing big dislocation/disruption/pain, then it risks adding to the pile of debt. This is a Catch-22 situation that Jerome Powell’s predecessors had landed him in. For the future of his country and for the future of the rest of the world too, some beginning has to be made somewhere.

If Powell is to be counselled against raising rates as indicated by him and his fellow FOMC members – 6 to 8 rate hikes of 25 basis points each in 2018 and in 2019 – then it is a counsel to allow more debt creation and a bigger eventual and inevitable pain.

This is what he had written, from which Reuters has written its report:

I write this – not in support of low interest rates and financial repression – indeed I have argued for the necessity of an eventual normal rebalancing if small savers and financial institutions such as pension funds and insurance companies are to continue to perform their critical capitalistic role. But I believe, as does Fed Governor Neel Kashkari, that our financial systems’ excesses cannot be expunged quickly by “liquidating assets” à la Andrew Mellon in the 1930’s, but by a mild and gradual re-entry back to privately influenced, as opposed to central bank suppressed, interest rates. 2% Fed Funds in a 2% inflationary world is the current limit in my opinion. [Link]

I am not sure I buy it fully. But, that does not mean that his point of view is any less valid than mine.

Leveraged loan volumes

From John Plender in FT on March 6, 2018:

Credit protections such as restrictions on the borrowers’ rights to dispose of assets, degrees of leverage and dividend payments are sacrificed in the manic search for yield. The biggest uses for such loans are the refinancing of existing debt together with funding for mergers and acquisitions.

Evidence suggesting an escalation of risk-taking in this area comes from the Institute of International Finance, a global financial services industry representative body.

It points out that issuance of US leveraged loans rose nearly 50 per cent in 2017 to more than $1.3tn, which is well above the pre-crisis peak of $710bn in 2007. The numbers in more bank-dependent Europe are smaller at more than $290bn in 2017, rather below the level of $330bn in 2007.

The share of covenant-lite loans in these totals has soared to nearly 50 per cent in the US and 60 per cent in Europe, much higher than before the crisis. [Link]

‘Leveraged loans’ are loans extended by one or more banks to entities that already have a good proportion of debt in their books.

One quibble with the article:

Against that background the transition from Janet Yellen to Jay Powell at the head of the Federal Reserve is potentially momentous because the scope for policy error over the next 18 months is considerable. On Capitol Hill last week, Mr Powell made it clear that the risk of an overheating economy may now become the focus of monetary policy.

The juxtaposition of the two sentences is problematic making it sound look as though policy tightening would be a mistake. Quite the contrary. It is never too late to stop such risks from becoming bigger and wider.

Adults in the room

That is part (or full) of the title of the book by Yanis Varoufakis, former Greek Finance Minister. I would like to get hold of it.  I have read his ‘Global Minotaur’. I liked it. The review of his book by Prof. J.W. Mason (a Marxist-economist, I am told) is quite well written. Makes one want to buy and read the book. J.W. Mason is Assistant Professor of Economics at John Jay College – CUNY.

The private memo sent by the European Central Bank to Italy, the advice that the Italian Prime Minister got from the German Finance Minister Wolfgang Schäuble to end collective bargaining and then the question that Christine Lagarde posed on Pharma sale de-regulation to Yanis Varoufakis are rather revealing. Notwithstanding all the tall talk of having learnt their lessons from the global crisis, of heightened sensitivity for the marginalised local population, the real agenda is laid bare in these situations.

I was also looking for a blog post that my friend Gulzar Natarajan had written on how many of these social enterprise investment funds incorporate in tax havens. Very simple. Consistency between practice and precepts or between words and deeds is missing. Credibility eroded. Backlash occurs and non-establishment candidates win. No point in blaming them. Elites bring this upon themselves and the public. Elites will survive. The public has it tough under both regimes.

At another level, this is also about the sovereign right to choose its economic agenda, the sequence and timing of implementation. Reminded of the paper, ‘Refocusing the IMF’ by Martin Feldstein published in ‘Foreign Affairs’ (March/April 1998). He said that IMF had no business dictating economic policy agenda to sovereigns.

(Postscript: I could not understand Professor J.W. Mason’s interview on the stock market. I do not quite fully understand why Marxist-economists believe that the Federal Reserve is helping the working class by not raising interest rates. To a degree, I can understand that. By raising rates just as wage growth gets going, the Federal Reserve snuffs at the nascent trend of higher income share going to workers. But, the failure lies not in that but in not raising rates early enough. The damage the Federal Reserve causes to the incomes of the working class with its monetary policy framework that underpins asset prices far exceeds the damage that it causes them with its belated tightening).

Problem disguised as solution!

A very ‘clever’ piece of writing by Ajay Shah on the Punjab National Bank scandal and the need for strengthening capabilities of the regulator, the Reserve Bank of India. Nothing wrong with the principle. But, really the devil is in the details.

In a country that does not know how to regulate banks, we should systematically reduce the size of banking relative to GDP. We should foster non-bank financing, and block the nominal growth of banking until we get to a minimum level of capabilities at the RBI.

That is the ‘clever’ bit, kept for the last.

What is the logic behind the assumption that non-banking sources of finance – i.e., capital markets – are exempt from scams, scandals and frauds? What about the capital market regulator, SEBI? Has India done enough to strengthen it with capabilities? Has India’s stock market been free of scandals and scams? Three, what about mis-selling of capital market products to retail investors if capital market financing becomes the route for Indian businesses? Yes, the Indian Financial Code (IFC) might have consumer protection clauses. But, they too require a regulator to implement. What is the guarantee that they will be born with those capabilities straightaway, in the Indian context? Four, reliance on capital markets means that savings are not pre-empted by a large State through the banking system. That is not the case in India, yet.

If we do not grow the banking system, will the public save more through small savings schemes? That carries a much higher interest burden and with tax exemptions, the effective cost to the borrower (the State) is even higher. The government will rely on it even more for covering its spending, if the banking system is ‘not allowed to grow’ until the regulator is strengthened, as the author says.

That will effectively raise the government’s interest burden and hence the deficit. Higher benchmark bond yields will follow and higher cost of capital for corporate borrowers. They will not want to tap capital markets and if, in the meantime, banks are not allowed to grow, what happens to capital formation in the economy?

If more domestic savings are either pre-empted by the government or is directed towards small savings, then for capital market, it means greater reliance on foreign savings for non-bank sources of financing to become more dominant. Is that desirable? Will that not have other consequences? Or, is there any basis to believe that foreign sources of savings are untainted and exempt from bad behaviour?

It does not make much sense to propose solutions that open a new can of worms and which, arguably or potentially, could be more destabilising.

Same ol’, same ol’

I was neither amused nor pained nor disappointed with the stories that an insider/whistle-blower has claimed that VIX has been manipulated. There is a resigned sense of apathy, indifference and cynicism – not very different from the attitudes of Indian voters to political scandals, corruption, etc.  See stories here and here.

My friend and co-author, Gulzar Natarajan, shared this link. This too must be unsurprising.  The only thing I would object to in that article, is this sentence:

Common to all the papers is the recognition that the public markets are, as conspiracy theorists have long argued, not truly public at all. [Link]

That was nothing conspiratorial at all about it. Just based on observing market trends. Even now, notice how stock indices are rising in the last one hour of trading.

Second, the article fails to connect these with the work of Cieslak
and Vissing-Jorgensen on the Federal Reserve monetary policy, governance and stock markets. May be, the papers do.

On reading these stories, I was reminded of the scene from the Tamil movie, ‘Indian’ featuring Kamal Hasan and ‘Nizhalgal’ Ravi. Ravi plays the role of a doctor who refused to treat Kamal’s daughter with burn injuries, in the movie. She dies. He expected to be bribed to do so. ‘Indian’ proceeds to execute him LIVE on TV.  Ravi offers to bribe him now, to be allowed to live! ‘Indian’ says that these guys never really repent or change and proceeds to execute him.

I suppose there is a lesson here.

This is also an opportunity to remind ourselves that the history of derivatives induced instability is too recent to be forgotten.