Rate cut dissent

If Andy Mukherjee is right that India’s financial stress is spreading, then why should one be surprised that RBI cut rates? Shouldn’t one be surprised about the dissent in the meeting? Credit Suisse research says that financial system stress is slowing the economy.

Viral Acharya’s reply at the press conference does not mirror any of the frantic distress signals that Andy is writing about:

I think this issue has come up quite a bit over the last six months I would say starting with the default of IL&FS. We have looked quite carefully at the data and our assessment is that since the peak of the stress in the short-term commercial paper markets in September and October, things have eased quite comfortably, they have eased especially for the better quality NBFCs and HFCs. So I think what is happening is that the liquidity conditions that had been extremely in surplus mode post-demonetisation have finally reached some normal level so that mutual funds and others who are providing capital to these entities are finally doing quality sorting themselves. I think that needs to be allowed to happen but nevertheless we remain watchful and if we think that there are extremely healthy borrowers who are also struggling with the funding, then we would consider that. [Link]

India should not let Finance become a Frankenstein monster

On January 20th, I read in THE HINDU that Indian stockbrokers wanted the Securities and Exchange Board of India to roll back its new risk management norms for derivatives. I was both amused and not amused. Along with Praveen Chakravarty and Ajit Ranade, I had written about the need for tightening risk management norms for derivatives exposure in Indian stock markets. Prior to these op.-eds., in our co-authored book, ‘Economics of Derivatives’, Dr. T.V. Somanathan and I had highlighted that derivatives were almost wholly used for speculation (=gambling) rather than for hedging.

That does not mean they needed to be banned but the losses from such speculative activity should be borne wholly by the participants who engage in them and that they should not have systemic consequences.

Based on the news-story, one does not get the impression that the brokers have provided any solid arguments or evidence that the proposed margining requirements would do zilch to reduce risk. In fact, their very protest is solid indication that it would. If it resulted in a lower volume or transactions in the derivatives markets, it is good for systemic stability.

This is a classic example of the case of socially useless finance. India, at this stage of development, does not need to go out of its way to facilitate such financial market activities. Instead, it should do what SEBI is trying to do now.

My co-author Gulzar Natarajan and I have finished our manuscript, ‘The Rise of Finance: causes, consequences and cures’ and we have received the first proof from the publisher. We hvae a special chapter on India. India needs to avoid repeating the mistakes that the West made with respect to Finance. The West allowed Finance to become a Frankenstein Monster and India does not have to repeat that mistake.

The myth that secondary market trading facilitates efficient capital allocation in primary markets has been persisted with, for too long, without being subject to the burden of proof. Shrinking investment horizons alone should have let that theory be put to rest permanently. It has not.

Buttonwood, in its penultimate column in ‘The Economist’ last year had written on the ‘Flaws in Finance’. There was a link to his earlier article published in May 2015. Both the short piece from May 2018 and the long essay he had written from May 2015 are thoughtful and make for good reading. But, his conclusions are vague. Here are two samples:

For all their criticism of mainstream economists, the challenge for the behavioural school is to come up with a coherent model that can produce testable predictions about the overall economy. [Link]

Here is the second one:

For too long economists ignored the role that debt and asset bubbles play in exacerbating economic booms and busts; it needs to be much more closely studied. Even if the market is efficient most of the time, we need to worry about the times when it is not. Academics and economists need to deal with the world as it is, not the world that is easily modelled. [Link]

In contrast, witness the most practical suggestion from Cliff Asness:

Making people understand that there is a risk (and a separate issue, making them bear that risk) is far more important, and indeed far more possible than making a riskless world. And if I may go further, trying to create and worse, giving the impression you have created, a riskless world makes things much more dangerous. [Link]

Honestly, the call for new models, etc., are either diversionary or distracting. They are not needed. One does not have to have new behavioural models that incorporate human irrationality. In fact, all that is needed is for policymakers to be reasonable.

(1) You may believe that markets are mostly or, for the most part, efficient. I do not. But, you can accept that humans can and do make mistakes. That is reasonable assumption.

(2) That one does not ignore empirical evidence is a reasonable thing to ask of policymakers

(3) That one requires policymakers to be able to see through the self-interested demands of the financial sector is not such a onerous demand either.

(4) Policymakers simply have to stop writing CALLS and PUTs for the financial sector. That is what Cliff Asness is saying in the quote above. Central banks do not have to remove risk from the lexicon for the financial sector and, in the process, encourage them to take excessive risks that put the economy and their goals for the economy in peril.

The fear of surprise, volatility and the realisation that policy will not be beholden to the financial sector even if there is short-term pain need to be inculcated in the financial sector.

What India’s brokers ask of SEBI is what the American financial sector has been asking of the Federal Reserve in the last thirty years and been getting, up to yesterday.

India does not have to walk the American way in this matter.

Minding the banana skins and not the manholes

On Tuesday, I had written my MINT column on the Powell PUT now reinforcing the trend of Greenspan, Bernanke and Yellen PUTs. I knew that the Fed Meeting was due to conclude on Wednesday. The Federal Reserve Open Market Committee (FOMC) did vindicate me. It is a huge letdown. This FT article calls the FOMC U-turn ‘momentous’. It, indeed, is. But, for the wrong reasons. The article cites somone from Barclays calling it a Powell PUT. Powell says NO. But, it is difficult to give him the benefit of doubt.

Narayan Kocherlakota is outdoing himself calling for a Fed rate cut now. The notion that there is a financial economy which will only be helped such mindless monetary easing, resulting in excessive risk-taking seems to escape him totally. Such excessive risk-taking, in turn, will result in a collapse or crash somewhere causing economic activity to slump and remain slumped for long, defeating the very purpose of monetary easing that he is calling for, now. Just recently, what is happening in Australian property market is an example. Stubbornness in the face of evidence to the contrary is not conviction. It is stupidity. Mr. Kocherlakota is keen on and proud to avoid the banana skins and never mind the manholes of finance!

The header of this post is a take-off from the short and sensible article in ‘The Economist’ on the overextension of finance in Australia. That is what I had mentioned in my MINT column too – a long cycle or an economy running well above capacity will spawn excesses.

Mike Mackenzie in FT cites an analyst/economist from Brown Brothers Harriman:

“We believe the Fed gave in too quickly and too completely to market demands that it pay more attention to market tantrums. By doing so, the Fed changed its message by a whopping 180 degrees from the December meeting. This goes back to our complaints about the extreme swings in Fed messaging over the last few months. Markets would have been happy with ‘patience’ and ‘flexibility’ but instead, the Fed went ahead and gave away the family silver.” [Link]

In the same spirit, John Authers wrote:

This begins to look like an example of the market leading a new Fed chairman by the nose. [Link]

Read this comment on the monetary policy stance of the European Central Bank:

Draghi had warned that the euro zone would slow this year, but things looks worse than predicted. This raises questions about the wisdom of stopping quantitative easing. He committed to this step in June last year, but a little more patience might have avoided the potential embarrassment of this turning into a policy mistake. [Link]

Comments such as this betray lack of elementary commonsense. If, after several years of unprecedented asset purchases, zero and/or negative interest rates, one withdrew the policy tentatively and the economy slowed down considerably, then what does one make of the efficacy, the durability or the desirability of such a policy medicine? Isn’t it normal to ask if that was the right policy at all? It is hard to believe that journalists cannot get themselves to ask such an elementary question.

The world lacks leaders with the right sort of convictions and spine to see them through. If not, they should even have the courage to resign and use their resignation as a bully pulpit.

Feel sad and let down.

[No, not because, as you might think, I have short positions on the equity market. I don’t.]

Finance and Federal Reserve

In my first column for MINT for 2019, I dealt with the issue of the Federal Reserve backtracking on its rate hike trajectory. Methinks it is sustained pressures from ‘financial market types’ that led the Fed chairman to cave in. I don’t buy the argument that he is tightening on two fronts: federal funds rate and quantitative tightening. So what? One acts through the banking channel (from the overnight lending rate to bank loan rates) and one acts through the capital markets channel – through the yield curve. All the rates, across the yield cuve, were depressed extraordinarily – in magnitude and for an inordinately long time. So what if all points in the yield cuve were rising? Financial conditions still remained accommodative.

This was the burden of my column. I was not impressed with the arguments of Stanley Druckenmiller and Kevin Warsh nor was I impressed with the arguments of John Mauldin. My friend Gulzar Natarajan had urged me to read his ‘Thoughts from the Frontline’. I read the last four of them last evening. You can read two of them – pertaining to the discussion of Fed monetary policy – here and here.

Nor did Gavyn Davies impress me with his arguments. So what if the Federal Reserve were triggering an economic recession? Recessions must be welcomed after excesses have built up in so many areas – from corporate debt to leveraged loans to market concentration in tech firms

‘Wrath of the financial markets’ that Viral Acharya (RBI Deputy Governor) invoked in a speech in October is felt more by central bankers than governments and that too not in public interest but in self-interest of the financial community.

Dean Baker has a list of ‘facts’ or resolutions to improve debates on economic policy in 2019. Item no. 6 is about finance. His list is about the ‘facts’ that are often obscured in economic policy debates:

6) A large financial sector is a drain on the economy
The financial sector plays an important role in a modern economy. It allocates capital from savers to those who wish to borrow. A poorly functioning financial sector is a drag on growth. The same is true of a bloated financial sector.

The financial industry is an intermediate sector, like trucking. This means that it does not directly provide benefits to households, like a housing, health care, or education. For this reason, we should want a financial sector that is as small as possible for carrying through its function, just as we would want the trucking sector to be as small as possible to deliver the goods in a timely manner.

Over the last four decades the narrow financial sector (securities and commodity trading and investment banking) has more than quadrupled as a share of the economy. It would be difficult to argue that capital is being better allocated or that savings are more secure today than 40 years ago.

This means we have little to show for this enormous expansion of the financial sector. It would be comparable to seeing the size of the trucking sector quadruple with nothing to show in the form of faster deliveries or reduced wastage. Finance is of course also the source of many of the highest incomes in the economy.

These facts make for a strong case for measures that reduce the size of the sector, like financial transactions taxes, reduced opportunities for tax gaming, and increased openness in pension fund and endowment contracts. In any case, it is important to recognize that a big financial sector (as in Wall Street) is bad for the economy, not the sort of thing that we should be proud of.

Reducing the size of the financial sector will also mean that its influence on monetary policy will come down. About time.

Independence and interdependence

What follows are verbatim extracts from a speech delivered by Dr. Y.V. Reddy at a conference held in Patna nearly a month ago on public finance:

In brief, the three policies like all other policies have an over-arching objective of welfare with each policy having its own defined set of objectives and appropriate operating instruments to achieve the specified objectives.  It is believed that one of the contributing factors to Global Financial Crisis (GFC) is underestimating the inter-dependence of these policies, and over-emphasising their independence. 

[The three policies he is referring to are fiscal, monetary and regulatory]

Exclusive focus of monetary policy on price stability had its pitfalls.  It has become clear that financial stability considerations, in particular, the asset prices, cannot be ignored.  The possibility of excess liquidity provided by the monetary authorities for a prolonged period impacting the excesses in finance is noted. 

The assumption that financial markets correct themselves and have a benign influence on growth is questioned.  The incentive mechanisms in the financial institutions and the possibility of excessive financialisation in the financial markets are recognised. 

[In the paragraphs above, he is pointing to the lessons learnt from the crisis of 2008. I guess, they are lessons that ought to have been learnt but not quite learnt]

As regards monetary policy, RBI rejected inflation targetting and single objective, unequivocally.  It did not share the enthusiasm for capital account convertibility and decided to manage impossible trinity.

[That is a nice summary of the policy framework of RBI under his leadership]

While concerted action was possible for strengthening the private sector banking system, the regulatory actions of a prudential and counter-cyclical nature by the RBI were undertaken despite some resistance from government and financial markets. 

[He is rather understated here, on the tensions that existed between RBI and the Government of India in 2006-08 on the regulation of the financial sector]

The objectives of monetary policy in India continued to be price stability or credit for productive activities, depending on the context.  Inflation targeting was not adopted in India. Dominance of banking, in particular, public sector continued though presence of private sector increased.  There was a cautious deregulation of the banking sector.  Counter-cyclical prudential policies were followed, and capital account was managed.

[That is an excellent summary of the differences in the global ‘best practice’ (?) and Indian policy framework between 1993 and 2008. After 2008, the world has copied some of the above practices.]

A common thread in all these arrangements is that they were intra public sector transactions that were transparent and strengthened effectiveness of public policy.  All of them strengthened the balance sheet of RBI to enable it to serve the economy and government. 

[He is referring to the various arrangements put in place between the GoI and RBI on management of foreign exchange reserves, sterilisation costs, on the guarantees that RBI had extended on foreign exchange losses, etc. Indirectly, he is hinting that the current differences could have been handled if there was recognition that these were ‘intra public sector transactions’]

Government continues to be a privileged owner of enterprises in the financial sector – thus constraining the regulator’s effectiveness. 

He is right to reiterate his reservations on the Government ownership of the banking system inasmuch as it adversely affects RBI’s regulation of these banks. He endorses Urjit Patel’s comments in this regard.

The overall thinking in Government about reforms changed from the moment Raghuram Rajan Committee gave its recommendations in 2008; and Justice Sri Krishna Committee gave its report in 2010.  The influence of RBI on the general thinking on reforms changed and a new framework took its place.

[In the above comments, he leaves more unstated than state them. Justice Sri Krishna Committee’s recommendations were made in 2013, I think. I think Dr. Reddy is referring to the recommendations of the Financial Sector Legislative Reforms Commission. Or, it could be another Committee.]

The government by virtue of its role as a coordinator and at the same time as the owner of the regulated entities puts / makes the central bank and the regulators somewhat ineffective unless they are on the same wave length as the government. The financial intermediaries in banking, insurance and even non banking mutual funds, etc. continue to be dominated by the presence of public sector.  Hence, the regulators’ standard tools are ineffective. 

[A rather forthright comment by the former Governor. The votaries of public sector banking in the present ruling dispensation must take note of these observations.]

Under the new regime, the financial stability considerations are not explicitly taken into account. In regard to external sector also, the stability considerations are not explicitly built into the monetary policy objectives. Is there a danger that the advantages of in-built coordination available in full service central bank been foregone?  Is there an identity crisis because of the juxtaposition of the MPC in a full service central bank? 

[Dr. Y.V. Reddy has raised some very important questions here on the monetary policy framework, on the government-RBI relations, etc.]

The effectiveness of “independent” monetary policy is blunted by the criticality of government owned banks for transmission of monetary policy.

[In a sense, he is highlighting the incompatibility of independent monetary policy and government-ownership of the banking system]

The regulatory framework of banks is not neutral to ownership in the sense that governance of public sector banks continues to be determined by the government.  The fiscal authorities use the banking system to implement some of the government developmental programs and RBI as a regulator does facilitate the use of public deposits with the banks for pursuing governmental programs. 

[Dr. Reddy again reminds us of the complexity that the RBI has to deal with, given government’s ownership of the banking system and its fiscal and development imperatives.]

This speech is not yet uploaded on his website. Once uploaded, you will find it here.

Roach and I agree

I have often found myself in disagreement with Stephen Roach in his cheer-leading of China. After I read Martin Pillsbury’s ‘100-year marathon’, I am all the more convinced that, as a Sinophile, Roach got China wrong. Never mind. I hope he is right on the Federal Reserve and he is right about this too:

The subtext of normalization is that economic fundamentals, not market-friendly monetary policy, will finally determine asset values. [Link]

Similarly, I have had plenty to disagree with Martin Wolf too. On this one, especially with the header, he is right. The future might not belong to China. In fact, while I liked Martin Pillsbury’s book, I must concede that James Kynge gave us an excellent psychoanalysis of China (without really intending to do so) that accords with what Martin Pillsbury wrote some nine years later. Kynge’s ‘China shakes the world’ (published in 2006, I think) showed us clearly that we are not dealing with a normal nation.

For them, cheating, hacking, stealing technology secrets, redrawing boundaries unilaterally, accessing markets around the world but keeping theirs closed are all part of the statecraft and fair game. The only way to deal with them is to play the game ‘by their rules’.

That is why, this piece by Raghuram Rajan in FT, published nearly a month ago gets it somewhat muddled and wrong. The last paragraph begins correctly saying that America’s tough negotiating tactics brought China to the table. Then, why should America sound conciliatory now? What does it have to show for its toughness in terms of a more open China market?

Finally, I understand that Jeff Bezos and Bill Gates do dishes in their homes. As long as I lived in America and in Europe, I did them too. But, I did not become a billionnaire. Looks like doing dishes is neither a necessary nor a sufficient condition for becoming a billionnaire. H..mmm. What to do? I tried.

Retreat of liberal economics

My topic for the MINT column coming Tuesday was partly inspired/provoked by this piece by Vivek Dehejia in the Nikkei Asia Review. He laments the retreat of liberal economics. He should not. Western economies did not become prosperous by following liberal trade or with independent central banks or by encouraging free capital flows. 

Even if one were to vote for free trade, it has to come with caveats on compensating losers. That never happened in many countries in the world. Winners – capitalists – became richer. Losers faced job insecurity and diminished incomes. But, to lump capital flows with trade flows is flawed and dangerous:

The acolytes of Indic economics espouse an end to free trade and free movement of capital.

Dehejia’s mentor – Jagadish Bhagwati – distinguished between trade liberalisation and capital account liberalisation. 

Dehejia has harsh words to say on demonetisation:

His best-known achievement so far has been to oversee demonetization — the botched 2016 cancellation of high-value currency notes in a futile bid to fight corruption, that Prime Minister Narendra Modi insisted was necessary even though most economists said in advance it would be a disaster.

‘His’ in the first line in the above quote refers to Shaktikanta Das.

and this one:

The protectionist swing follows the earlier demonetization fiasco and the mismanaged introduction of a new national sales tax. Ironically, it was Das, the newly appointed central bank chief, who supervised not only demonetization but also the tax reform.

You must read the earlier pieces of Vivek Dehijia on demonetisation. You can find them here, here and here. The tone and the tune are very different now. I doubt if any new evidence has emerged since the last link above (September 2017) that justifies the about-face on demonetisation.

If anything, recent data from the Central Board of Direct Taxes vindicate the header of the last linked article that it was too soon to assess the success or failure of demonetisation. 

Clearly, the Goods and Services Tax (GST), in theory, could have been done better. The peak rate need not have been set at 28%, for example. Exempted goods could have been included. But, this is a continental size economy. Only Singapore has a single GST rate. Other countries have multiple rates. In short, India has not done too badly with the GST introduction and the subsequent course corrections. For another perspective, readers should read the book, ‘Of Counsel’ by Arvind Subramanian.

For some of the newspapers and columnists, Mr. Gurumurthy has become a lightning rod. My views do not correspond with his on all matters and he has acknowledged that we differ, in one of his tweets. That said, I find it hard to accept the argument that he has precipitated the departure of Mr. Urjit Patel from RBI.  Just to be clear, Patel is the fifth RBI Governor to resign.

Further, RBI has made many mistakes in recent years. It was late to wake up to the problem of non-performing assets. It ordered Asset Quality Review of banks only in 2015. It has not undertaken an honest review of its own shortcomings and failures in banking regulation.  The fraud in Punjab National Bank was going on for seven years. IL&FS was regulated by the Reserve Bank of India. On monetary policy, it had stuck to a version of doctrinaire monetarism.  The Government has not interfered with monetary policymaking, even if it has not been happy about it.

The accusation that India is returning to failed autarkic policies of the past appears too extreme. At best, it is a risk that needs watching. But, before that, the world has to avoid returning to the failed liberal economic policies of the last four decades.  For that to happen, so-called ‘liberal economists’ have to admit first that many tenets of ‘liberal economics’ were flawed and they were the fountainhead of many insurmountable problems that the world faces today.

In this regard, the rating agency Moody’s threat that any threat to RBI independence could be construed as needless interference. As I wrote in my earlier post, the Reserve Bank of India is not an independent body, created under the Constitution. It was created by an Act of Parliament. The Ministry of Finance is accountable to the Parliament for the functioning and performance of the Reserve Bank of India. RBI is now independent for the conduct of monetary policy. That has not been jeopardised and it has actually not covered itself with glory on that, with its excessive monetarism.  See Sanjaya Baru’s piece here for a different perspective.