MONEY THE
MANAGER AN IIM-A, IIM-B,IIM-C INITIATIVE JANUARY 2011
MONTEK SINGH AHLUWALIA SANJAY NAYAR SHYAMALA GOPINATH BRUCE TUCKMAN JAHANGIR AZIZ AMAR BHIDE ARVIND SUBRAMANIAN VIRAL ACHARYA RITESH DUTTA HAROLD KIM RANODEB ROY SWAMINATHAN ANKLESARIA AIYAR STEVE YOUNG
THE NEW WORLD ORDER
THE NEW WORLD ORDER the aftermaththe of theaftermath financial crisisof the financial crisis
© UBS 2010. A
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Money Manager / January 2011
From the Coordinator’s Desk —
2010-11 has been a phenomenal academic year for Beta – The Finance and Investments Club of IIMA. The team secured its highest ever corporate partnership with UBS emerging as a strong and patient patron for finance-related activities within IIMA. On behalf of the IIMA community, I would like to thank UBS for its unflinching support. Beta successfully kick-started the year with Finomena – a 3-day finance workshop and then followed it up with a massively successful flagship national event called Exchequer. In an event which was slickly designed and organized with the smartest future investors, traders and bankers locking horns, ISB Hyderabad was the eventual victors in the event which lasted a grueling two months. Apart from that, Beta strongly continued to support the cause of promoting finance internally in IIMA through remedial sessions, mentor programs and guest lectures and the fruits of its activities continue to bear fruit in the way a number of bulgebracket banks and investment firms continue to repose their faith in hiring talent from IIMA. One of the major successes for Beta has been its publication platform this year. Be it the Beta Budget series, Beta Daily – our daily newsletter, Beta Pedia – our daily finance glossary digest or Beta Times – a weekly finance newsletter, Beta continued to deliver on its promise to emerge as thought leaders within the student community. Further, this year Beta established a new one-stop online shop (http://beta-iima.com/) for its activities which we hope will emerge in coming years as a dominant forum for discussing and debating finance- related global issues with IIMA taking the lead in mentoring this effort. It is in this context that Money Manager represents the culmination of a year’s efforts to push the envelope at every stage. Right from taking internationalizing the scope of Money Manager to putting together views from 13 eminent personalities from the fields of finance and economics, Money Manager 9 has carved an exclusive niche for itself, which we hope will continue to reflect in the quality of future editions of Money Manager. Lastly, I would like to thank the entire team of 23 extremely motivated Betans who made this year so successful for the club and for each other. Signing off… Anindya Dutta Coordinator, Beta
Money Manager Team — Editors-in-Chief Tanu Singh V M Avinass Kumar
Managing Editor Anindya Dutta
Editorial Board Anuj Dayal Kunal Singal Gaurav Singhal Gautam Dhond Gourav Dhavale Pratik Gupta Sayali Kale Sitaram Agarwal Soumyajit Mitra
Faculty Advisors Prof. Ajay Pandey Prof. Joshy Jacob Prof. Atanu Ghosh Prof. Rakesh Basant
Coordinating Committee Anindya Dutta (IIMA) Priyank Patwari (IIMB) Priyesh Jaipuriar (IIMC)
Design Coordinator Sandeep Dalmia
Layout and Identity Designer Prachi Chaudhari
Coverpage Design Kartik Krishnan Junaid Hasan Hashmi
Money Manager / January 2011
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FROM THE EDITORS DESK “
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When written in Chinese the It isn’t so much that word “crisis” is composed of two hard times are coming; the characters - one represents danger change observed is mostly and the other represents soft times going opportunity.” Groucho Marx John F. Kennedy
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Finance as a business enabler found its biggest purchase in the west with mounting business and consumer needs for investment destinations. With easy money, unfettered financial product innovation and light-touch regulation, the financial markets put money into everyone’s hands including that of those who couldn’t afford the cost of using money. The levels of growth were so gargantuan that it had to come to a halt or at least slow down at some point. However, quite unexpectedly, it resulted in a financial crisis which had just one parallel in history. The post crisis world of 1929 resulted in a world war and the baton of global economic domination passing to the United States of America. The situation today is not too dissimilar. However, the roles are reversed with the Asian Tigers, Brazil, Russia and the Indian Elephant looking to occupy that spot. If out of place quotes could so effortlessly morph into relevance for the modern day, the quotes by Groucho Marx and John F. Kennedy, men who had little to do with the world of finance, take the cake. It is indeed the disappearance of soft times for the western democracies. Here on things will move but at the pace determined by the Emerging Markets. But things are not going to be hunky-dory for the Emerging Markets either. As Kennedy succinctly put it – it is danger when they tread the greater heights, but it’s also opportunity that beckons. How the emerging markets grab it and how the western democracies battle it out to maintain their supremacy will indeed be a fascinating contest. But one thing is clear at the moment – the 4
Money Manager / January 2011
power balance of global finance is not what it used to be and it may never revert in our times. This forms the core of our thought process and led to the creation of the theme for the 9th edition of Money Manager – “The New World Order of Finance”. This issue of Money Manager is punctuated with interviews of people from all walks in Finance - Bankers, Regulators, Policymakers, Investment Managers and Academicians. The student articles are exceptional in their focus, coverage, quality of analysis and the insights they provide. We have tried to accommodate opinions of every colour to give you a holistic perspective of the state of affairs in global finance and economics broadly categorized under Financial Products, Currencies, Regulatory Bodies, Emerging Markets, the Indian perspective and Challenges to the evolving New World Order. We would like to express our heartfelt gratitude to the illustrious people who have consented to provide their views and thoughts on the topic, jury members who have adjudicated the student entries and UBS who have sponsored Beta’s activities this year. We hope this edition gives you a lot to think about and even more to discuss and learn.
Please do send in your feedback to beta@iimahd.ernet.in Tanu Singh V M Avinass Kumar
CONTENTS 08
— COVER STORY
08 THE NEW WORLD ORDER-THE AFTERMATH OF THE FINANCIAL CRISIS
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— GLOBAL CURRENCIES – A TECTONIC SHIFT OR A MUTED WHIMPER? 18 INTERVIEW WITH ARVIND SUBRAMANIAN 22 INTERVIEW WITH RITESH DUTTA
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— FINANCIAL PRODUCTS – IS THE INNOVATION TREND TRULY OVER? 26 INTERVIEW WITH HAROLD KIM
29 INTERVIEW WITH BRUCE TUCKMAN
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— REGULATORS –OMNIPOTENT WATCHDOGS OR LIBERAL BYSTANDERS? 32 INTERVIEW WITH SHYAMALA GOPINATH 36 INTERVIEW WITH STEVE YOUNG 39 INTERVIEW WITH VIRAL ACHARYA
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— EMERGING MARKETS – EPITOMES OF RESILIENCE OR TICKING TIME BOMBS? 44 INTERVIEW WITH RANODEB ROY
47 INTERVIEW WITH SANJAY NAYAR
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— THE DOMESTIC VIEWPOINT – IS INDIA POISED TO RULE AMIDST THE RUINS? 52 INTERVIEW WITH JAHANGIR AZIZ
55 INTERVIEW WITH MONTEK S. AHLUWALIA
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— CHALLENGES – IS THE NEW WORLD ORDER PROGRESSIVE OR REGRESSIVE? 60 INTERVIEW WITH SWAMINATHAN AIYAR 63 INTERVIEW WITH AMAR BHIDE
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— STUDENT ARTICLES
68 GLOBAL CURRENCIES- A TECTONIC SHIFT OR A MUTED WHIMPER? 74 CHINA’S DOLLAR TRAP- A HISTORICAL PERSPECTIVE. 83 LIGHTING UP DARK POOLS 87 REGULATION IN INDIAN SECURITIZATION MARKET- PRUDENT OR PUNITIVE? 90 DOLLAR CRISIS- REAL OR IMAGINARY
OPINI
ANALYSES 6
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ONS
VIEWS Money Manager / January 2011
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COVER STORY
THE NEW WORLD ORDER
the aftermath of the financial crisis
David Rockefeller speaking at the Business Council for the United Nations in September 1994 mentioned, “We are on the verge of a global transformation. All we need is the right major crisis and the nations will accept the New World Order.� 14 years later, the world witnessed the worst financial crisis since the events that followed Black Thursday in October 1929. The aftermath of the financial crisis has pointed to significant shortcomings in the macroeconomic structure of large western democracies and the susceptibility of their real economy to shocks in the financial economy. 8
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More importantly it has had a deep impact on the critical stakeholders in the financial system. The hold of the Dollar over world trade is being questioned. Financial product innovation has come under the scanner. The apparent failure of regulatory mechanisms has sparked intense debates in the developed and developing world. The Emerging economies in Asia (Ex-Japan) and the BRIC Economies have weathered this storm much better than expected and have in fact come out stronger. But there are enough cracks in the new world order that is indicative of a threat to this optimism for the emerging giants. Money Manager / January 2011
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COVER STORY
global currencies —
With the end of the Bretton Woods Agreement following the Nixon shock in 1971, US dollar for all practical purposes replaced gold as the benchmark standard and emerged as the dominant currency and reserve of the world. This was caused by a variety of factors which included notably, the dominance of United States as the major trade player of the world, the deep and flexible financial systems of the US including an active secondary market for dollar denominated instruments, the emergence of petrodollars and the unparalleled political power of the US. The US dollar had characteristics that favoured it to be used for all the three purposes of money: as a medium of exchange, as a unit of account and as a store of value. Although post 1971, the developed world moved towards a flexible exchange rate regime, holding foreign exchange reserves (primarily US dollars) was seen vital to maintain financial stability and prevent temporary exchange movements from interfering with broad fiscal and monetary goals. The last two years, particularly in the aftermath of the global crisis, have seen growing concerns about the validity of US dollar as the dominant currency. This has stemmed from a host of reasons, chief amongst them being the weak fundamentals of the United States as underscored by its huge federal debt that touched 94% of the GDP in the fiscal year 2010, soaring unemployment (9.8% in November 2010) and mammoth budget deficit to the tune of $1.42 trillion in 2009. Adverse economic impact caused by the United States’ military adventures and the hoarding of dollar reserves by countries like China seeking to increase export competitiveness through depreciated domestic currencies. This has led to protesting voices from several quarters seeking an end to the dollar hegemony and a shift to an alternative order anointed by other monetary units. Events which have made this shift noteworthy include the purported talks by OPEC to move to denominating oil in a basket of currencies comprising euro, yen, gold and a new currency unit for members of the Gulf Co-operation Council; the tiptoed movements of China and other countries to diversify their reserves away from the US dollar; bilateral talks by China with countries such as Korea, Russia and Malaysia to settle trade in renminbi and reduction in the share of US dollar in global foreign exchange transactions. However, the prevalence and velocity of US dollar puts it in a different league altogether from its competitors, atleast as of now. Its closest contender would be Euro which has around half the share of US dollar in global foreign exchange transactions. While the Euro area is larger than the United States in economic terms and is integrating further with the growth of its capital markets, it is far less liquid. Also the credit quality of Euro bonds differs from country to country and questions are being raised about the fiscal sustainability of a few members. The yen suffers from the same problem as well and an ageing 10
Money Manager / January 2011
population raises question marks over the future credibility of the Japanese economy. Further, neither the Euro-zone, nor countries like Britain and Japan wield as much political power as the US. This brings China into the picture. While the economic and political clout of China is close to that of the US, Chinese secondary markets are woefully underdeveloped as compared to their American peers and the depth of renminbi would have to increase significantly, if it is to take the place of the US dollar. Moreover, the renminbi is still not fully convertible and the political stability and monetary policy of China is yet to command complete credibility from the international community. The Special Drawing Rights (SDR) suffers from none of these drawbacks. It does not engender conflicts between short term domestic and long term economic objectives (the Triffin dilemma). Its implementation would not require a large scale overhaul as systems already in place can serve the function. It would also not lead to a single country getting cheap credit from the rest of the world and receiving seigniorage gains in the process. The composition of the same which at present stands at 44.1% USD, 37.4% EUR, 9.4% JPY, 11.3%GBP can be made flexible to include varying shares and introduce new currencies of the emerging economies, making it more stable than any single currency. The concept of SDR is certainly laudable and an effective long term solution. In particular, its case as a unit of account seems very strong. However, its use as the medium of exchange would imply the loss of considerable sovereign authority which does not concur with popular sentiment around the world. Further, the credit quality of SDR bonds would be the credit quality of member country issuing them, the volume of which would depend on global distribution of economic power bringing us back to the credit quality of the Western world. Also, a full blown implementation would imply creation of SDRs worth more than $3 trillion as they currently stand at only 4% of the global reserves. All these reasons militate against the immediate or short term use of SDR as the store of value or medium of exchange.
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The concept of SDR is certainly laudable and an effective long term solution
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COVER STORY The outlook therefore, is not so radical in the short term. The flexibility, innovation, depth and volumes of the US financial system would ensure the continuance of dollar as the dominant currency for some time now. The tipping point might occur when measures such as the TARP cause the cost of dealing in US dollars to exceed the benefits of doing the same. While an abrupt shift seems unlikely, the movement of global trade and reserve holdings from US dollar to other alternatives would continue as the US fiscal burden coupled with its near zero interest rates makes investment in dollar a highly unprofitable venture.
financial products —
The most significant trend in the financial sector, in the last two decades, that has shaped the current structure of the banking sector has been the advent of derivative products and securitized products that provide higher yields to the banks and enhance their margins particularly in an extremely competitive environment. As the wave of innovation through “securitization” and “derivatization” spread throughout the industry creating an extremely opaque and complex financial product ecosystem, so did the need for risk management practices and regulatory control mechanisms. However, the vanguards of financial products innovation were always miles ahead of those wearing regulatory shoes or those instituting the risk-management tools, methods. Financial innovation has been on the rise since late 1980s. It was during this period that the US banking sector had witnessed a tide of multi-billion mergers and acquisitions including those of Citicorp and Travelers, J.P. Morgan and Banc One, Chemical and Chase and many more. What was originally a fragmented banking sector turned into a highly consolidated one and the incentive beyond operational efficiency was to enable cross selling of products. This trend shepherded the products contrived on Wall Street into the portfolios of risk-averse pension funds and mutual funds. Post 9/11, the Fed followed a regime of low interest rates to boost the economy. With near zero interest rates, investors- individual as well as institutional, solicited products that could enhance their yields. Structured products built over securitized products - Collateralized Mortgage Obligations (CMOs) and their credit counterparts- Collateralized Debt Obligations (CDOs) flooded the markets. To achieve even higher yields, multiple levels of CDOs were built over underlying CDOs and the investors lost sight of the ultimate underlying asset. Thus, the mushrooming market and increasing competition in the structured products space paved the way for products with complexity that was unfathomable for the targeted investors to understand their risk-return profile, for regulators to implement effective capital requirements and for the credit rating agencies to assess the credit quality. The bubble blew-up finally with Lehman Brothers & Bear Stern disappearing from face of Wall Street and the outstanding trillions of dollars securities turning toxic.
In the aftermath of the crisis, financial innovation and securitization has been labelled as evil and irrational exuberance. However, most of the innovations arose out of the need of financial institutions and investors to hedge their risk exposures or to meet the needs of market. Securitization has been denounced as the nonpareil behemoth that propelled the banks and financial institutions into making irresponsible loans and then selling them off, with the help of good ratings from credit agencies, to unwary investors seeking above normal returns. This argument creates an abomination towards financial innovation as the root-cause of the iniquity that led to the financial breakdown. However the fallacy here is probably not the innovation, but the inability of credit agencies and regulators to assess the risks, speculative activity superseding the core activities of banks, and the investors forgetting the old maxim- there is no such thing as a free lunch. As we stand at the cusp of a recovery – the future of financial product innovation is very much in the balance with more aware regulators and stringent norms. At present the vanilla products are dominating the street – mainly due to higher spreads in markets which are relatively illiquid. There are three primary factors behind this. One, the role of the exotic products in exacerbating the recent crisis has made the investors uneasy with such products. Secondly, at present the vanilla products are offering high yielding investment opportunities. Banks are able to achieve high yield by relatively risk free investments - borrowing short term funds at near zero rates from Central Banks and investing in the rally in Treasury bonds fuelled by the Fed’s quantitative easing. At the same time, the uncertainty in corporate bonds and the European and emerging markets sovereign bonds are providing opportunities to make significant profits by second-guessing policy action which has become predictable in the aftermath of the Lehman debacle .
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As we stand at the cusp of a recovery- the future of financial product innovation is very much in the balance with more aware regulators and stringent norms
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Since 2008, the US banks have increased their holding of cash and securities from 14% to 19% of the book, while the size of loans have reduced from 58% in 2007 to close to 50% of the books. The third factor is the new set of capital constraints being anticipated with the BASEL III is making it imperative for banks to accumulate more of Tier I securities, comprising primarily of vanilla products including equity. The first factor- reluctance of investors suggests that exotic financial products may not flood the markets again. However, as imperfections created by the Fed’s policies recede and the European uncertainty subsides, simple products would Money Manager / January 2011
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COVER STORY
start yielding nominal returns. At that point, it is highly likely that the investors seeking higher yields would start picking up the unconventional products again. It follows from Hyman Minsky’s theory that financial stability sets the stage for future crisis, because the stability fuels high yield- high risk investments. Although, the experience of the last recession would make a case for rating agencies to be more vigilant towards these innovations, enough questions in that domain still remain. The last factor curbing innovation at present is regulations. Although it seems a strong factor, this is the least probable factor to hinder financial innovation in future. Historically, regulations have been backward looking and would probably enforce constraints on financial institutions so that they cannot get away with similar misrepresentations and negligence as last time. However, the regulations, such as Dodd-Frank Bill and the in process Basel III, target the banks primarily. Financial institutions like hedge funds and reinsurance firms provide mechanisms for the banks to transfer risks out of the banking system and regulations have still not adequately touched them. Thus, with the new regulations coming into effect, financial institutions, and not just banks, would carry on the innovation trend to minimize the effect of new regulations on profitability. Also, there are various avenues in the financial sector that need innovation. Loans and credit to small businesses has dried up and Fed’s QE-II to incentivize banks to lend money to them is not really working. Also, with the new Basel III requirements of higher capital needs for loans to non-rated businesses, banks would be less willing to lend to these businesses. Also, unlike the big corporations, they do not have access to the Commercial Paper market. There is an irrefutable need for innovation to design products that can provide incentives to the banks to put their money to giving loans to the small businesses and households. Emergence of CDS exchanges is a positive move towards addressing concerns raised by the OTC market having an influence in exchange traded securities. However, the regulatory system is yet to counter the parallel innovation of financial products in the OTC market. Many of the current innovations in securitization evolved from OTC products that were later brought into the main fold. So the innovation has happened on those frontiers were largely outside the purview of the regulators till they attained macroeconomic significance. Innovation as we see it is coming within the ambit of the exchange, but only after taking roots elsewhere in the non-exchange segments of the financial markets. Promoting value-additive innovation in the exchange segment can, hence, be the perfect antidote to create a resilient financial product market To summarize, the innovation trend may not pick up till there are concerns around recovery. But, with greater stability, innovations in products would be imminent. The silver lining is that the lessons from the last crisis may pave the way for a more vigilant stand from the investors and the rating agencies, and a more responsible set of financial innovations to meet the need of the financial sector. 12
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regulatory mechanisms and responsibilities —
The essence of free market capitalism has been the freedom associated with financial markets - the ability of private entities to chart their growth path and more importantly the omnipotence of the market in deciding who survives and who does not. The one phrase that regulators all over the world have lost sleep over is without a doubt “Too big to fail”. The Global Financial market has evolved in such a way that some private players become systemically important giants. Governments more often than not are caught between saving some firms which turns out to be very costly and facing failures that threaten to bring down the entire system. Governments have also had to contend with financial concentration where the banks and financial institutions kept getting larger through inorganic growth – this meant that failure of one institution will destroy nearly a tenth of the entire market – case in point: AIG. Regulators have 2 key mechanisms in their repertoire to tackle this issue - they can deem certain institutions as “too big” and fragment them with firewalls or increase capital adequacy whereby winding down firms during bust a less painful process. The regulators have opted for improving capital adequacy norms at present – however, with the “Volcker Rule” – a combination of the two is expected to be adopted. The Volcker Rule however is making the system more complex as against fundamentally revamping it and is seen as delaying the coup de grace that failing financial giants will go through. But a key element of financial regulation – those of firms that operate across borders has not been addressed. Lehman’s responsibility that was spread across more than 3000 legal entities and the issue of an Icelandic Bank that has failed to pay back nearly $6 Billion to creditors in Britain are critical examples of how a mechanism for cross border regulation has still not been strengthened. This also raises the question of regulators straddling the issue of taxpayers’ vs private creditors which has resulted in a slightly philosophical issue of regulators’ responsibilities. Regulators have also set a bad precedent previously with generous treatment of derivatives and the significant counter-party risks they pose. So essentially the regulators need to revisit their role as a watchdog of taxpayers’ money and examine the foundations on which the current mechanisms of subjective handling of systemically critical entities rests. The Basel regulations in its avatar as Basel 3 are bleak as they now replace the mantra of capital efficiency with robustness. In the pre-crisis scenario banks could manage with common equity as little as 2% of risk-weighted assets.
COVER STORY However Basel 3 is expected to increase this to nearly 4.5%. Hybrids will be discouraged with the focus on core high-quality Tier-I capital. However the most important fundamental shift comes from the rules being supplemented by a leverage ratio as against just risk-weighted models. “Procyclical” measures that allowed banks to store up capital in boom times for lean period was originally seen as profitsmoothing, but this is now going to be the philosophical basis of the new regulations. Moving along after the crisis with banks starting to repay the TARP funds and gaining on profitability, these measures of restrictions will surely face some opposition. With lesser govt. control, how the regulators handle the capital situation will be a key parameter of their learning from the financial crisis.
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(iv) The market as an unbiased leveller – Risk taking comes with the downside which is consequent on the entities actions and inactions. (v) The fundamental benefit of financial innovation, that is delivering value, will drive more innovation or curb it on the basis of market reaction. These have clearly not been the case and the regulatory bodies world over should examine the fundamental assumptions of finance on which they have built the legal framework of securities and financial markets regulation. Clearly a new and bold paradigm for regulatory function and responsibility needs to be established – and that needs to come from the regulators themselves.
The regulators need to revisit the emerging markets their role as a watchdog of taxpayers’ money and examine the foundations — the crisis raised questions about the Emerging Market (EM) on which the current mechanisms of Ifstory, the post-crisis EM resurgence has laid them all to rest. Not subjective handling of systemically only were the EM economies less affected by the crisis, they have also been the first and the fastest off the block when the recovery critical entities rests set in. There are several reasons for this rapid recovery of the
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As much as microprudential regulations impact operational level aspects, the falling dominos impact of the financial crisis can be attributed to poor macroprudential regulatory thought process. The biggest question lies in who should be doing this regulation across borders, markets and global powers. Morgan Stanley’s ex-CEO John Mack, late last year, made a case for an uber-regulator – a global systemic risk manager. IMF has been suggested as a potential candidate – but experts, believe that IMF as a regulator who can tell the SEC to buck up on certain regulations and norms is a pipe dream. Yes, the IMF can support troubled economies – the Greece recovery plan lending testimony to that – but dictating global monetary and regulation involves many principal-agent problems. Pricking bubbles again comes at an economic cost and the responsibility here is not clearly divided between the Central Banks and the Financial Services Authority. From a financial standpoint – some key points and assumptions that go into financial regulations are being questioned. They are: (i) Market prices truly build into them all information i.e. information asymmetry is assumed – the Efficient Capital Markets hypothesis. (ii) The positives of securitization – allowing people to take rational risks and improving liquidity. (iii) Mathematical and quantitative modelling and credit rating to accurately measure risk.
emerging markets. Structural changes introduced in the aftermath of the South East Asian crisis, reduced reliance on Western exports due to growth in inter-EM trade, relatively under developed financial markets, higher reliance on domestic savings and prudent regulation have all contributed significantly to EMs faring better during the crisis. Similarly, a timely and adequate policy response through fiscal and monetary stimuli & strong domestic and inter-EM trade have helped in the post crisis EM revival. Looking ahead, the growth in inter-EM trade such as Asian commodity imports from Latin American countries, stronger inter-EM financial flows for example two-thirds of Chinese FDI is from other Asian EMs and the accumulation of forex reserve buffers by EMs have helped reduce EM dependence on Western trade and capital. However, the EMs will continue to remain dependent on foreign investment to pursue their growth plans and on Western demand for their exports. Consequently, the decoupling though in progress is far from complete as the transmittal of the crisis to EMs through trade and capital channels displayed. Now that brings us to the following question: Is the post crisis EM resurgence sustainable or is it a bubble? When the sub-prime crisis first broke out, some optimists had gone to the extent of calling EMs the new safe haven - especially after fears of a U.S. recession made tens of billions of institutional money flee U.S. stocks for EM ones. Though the ‘safe haven’ claim proved to be exaggerated, the EM’s thriving current account surpluses, underleveraged corporate balance-sheets, 50% share of world GDP and 4% average growth during the crisis are strong reasons to believe that the EM growth story will continue for quite some time. However, we need to remember that not all Money Manager / January 2011
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COVER STORY characters in it are alike. A Korea or a Hungary is less reliant on domestic consumption as compared to Asian powerhouses China or India with their huge & growing domestic markets. Badly hit by the crisis, East European EMs are worse off today as compared to their Asian counterparts. Also, fortunes of certain EMs like Russia and certain Latin American countries are strongly linked to commodity prices. Further, the EMs as a group bears certain common risks. Shallow financial markets expose EMs to asset price inflation due to foreign capital inflows as the current episode of accommodative U.S. monetary policy is showing. Nouriel Roubini and Robert Zoellick have warned about a bubble forming in EM assets. Foreign exchange volatility remains a concern for investors affecting returns as well as export competitiveness. Political and policy risk continue to be pervasive factors be it the Khodorovsky verdict in Russia or the Cairn–ONGC dispute in India. To summarize, we believe that the EM growth story remains robust albeit considering the aforementioned risks. The growth story would be accompanied by growth in financial markets although such growth would definitely be characterized by the conservatism that has worked for the EMs in the past. A focus on domestic demand to reduce export dependence and deepening of financial markets to reduce dependence on foreign capital are lessons of the crisis that are likely to be implemented and create the platform for a shift in global power to the Ems in the long term.
the indian viewpoint —
The crisis and events in the last 2-3 years have uniquely positioned India in the global landscape. It is important, however, to assess the impact of the crisis on India’s economic and financial systems separately, particularly given the limited integration between these two systems in India. From an economic perspective, the crisis and its far-reaching global impact has left India in a position of relative strength driven primarily by a burgeoning middle class, favorable demographic trends and robust consumption. In fact India has strongly rebounded in the last couple of years, with growth having been recorded at 7.7% in FY2009 and expected to clock in excess of 8.5% in FY2010. The two major reasons touted for this economic resilience has been the strength of the Indian banking system as demonstrated by strong credit growth even during the peak of the crisis (24.1% credit growth in FY08 and 17.1% in FY09) as well as the relatively lesser dependence of the economy on exports to the Western world. No doubt India came through the crisis unscathed as a result of fundamentally strong macroeconomic and policy management, both in terms of fiscal and monetary policy formulation and implementation.
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As India now goes beyond crisis and recovery management and embarks on a path of high growth, several structural deficiencies however remain. Supply side constraints created by physical infrastructural quantity and quality deficits, skilled workforce shortage due to inadequate spending on health and education, spiralling inflation and issues related to governance continue to limit India’s growth ambitions. It is in this context of overcoming some of these constraints that the strengthening of the financial market ecosystem should be addressed by policymakers. Financial market reform can create an environment conducive for increased financial integration which will result in the opening up of new, efficient and cost-effective methods of financing, thus lowering intermediation costs.
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The crisis and events in the last two-three years have uniquely positioned India in the global landscape
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This in turn will tremendously improve the productivity of capital and will have far-reaching consequences for several cashstrapped sectors such as education, health and infrastructure which are expected to be the backbone of Indian growth in coming years. For example, the Indian physical infrastructure landscape is suffering from a huge supply deficit, and innovative forms of financing can help plug the supply-demand lag in this sector. Further, broadening and deepening of financial markets can provide domestic savings access to a variety of financial products as well as asset classes in the form of investment opportunities and provide an additional thrust to improving domestic savings (Already amongst one of the highest in the world with Gross Domestic Savings amounting to over 37% of GDP in 2008-09). It is in this context that the need to create a more robust corporate debt market has been raised. An efficient corporate debt market can create high yielding allocation opportunities for savings and can concurrently meet the financing needs of businesses, thus providing a fresh impetus to sustainable long-term rapid growth in India. Although the emergence of this new world order as a result of the financial crisis has opened up several new opportunities for the Indian economy, there are also heightened concerns regarding the sustainability of the Indian growth story. These concerns are particularly pressing given the heightened uncertainty regarding India’s ability to manage natural resource requirements or its ability to initiate widespread governancerelated reform with the aim of securing domestic health, education and infrastructure needs. In this context, the creation of a sovereign wealth fund will allow India the much needed financial
COVER STORY power to transfer excess foreign exchange reserves to meet India’s infrastructural requirements on one hand, and also to secure energy-related assets in what could be high-yielding overseas investment opportunities. Moreover, as the Indian economic clout grows in international circles, there is no doubt that savers and investors will find themselves operating in an increasingly complicated globalized world of risk and uncertainty in this new world order developing in the aftermath of the global financial crisis. It is essential hence to create a vibrant risk management and hedging environment in order to sustain an environment of continued savings and investments. It is in this context as well, that Indian policymakers need to encourage financial innovation such as the creation of a credit derivatives market, a structured products market and interest rate futures market which will help financial intermediaries manage risks more efficiently. There is no doubt that a sour taste has been left in the mouth by the global financial crisis which was fuelled by unregulated financial innovation encouraged by benign policymaking. However, to use the crisis as an excuse for putting financial reforms on the backburner will continue to aggravate concerns regarding India’s ability to accelerate growth in the future. There is unquestionably a need for pro-active prudential regulation. However, the regulatory response cannot be extremely dovish or hawkish when it comes to addressing issues related to financial reform and inclusion. Regulators will have to calibrate their responses so as to retain caution but not at the cost of allowing the benefits of financial markets reform from accruing to the real economy. The fact remains that despite a fundamentally strong growth story, India stands on the cusp of a variety of opportunities waiting to be grabbed. All that is required is a little bit of political boldness, rigorous macroeconomic management and institutional activism to ensure that India can make the most of what lies ahead. Whether policymakers have the appetite to act with grit and gumption, still remains to be seen.
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challenges to the new world order —
The crisis that began with the fall of Lehman Brothers in September 2008, has jolted the fundamentals of the economies and the financial markets world over. From the fall of the biggest banks in the United States to the debt crisis of the Euro zone, the world of finance is no longer the same. But more than two years later, the world does seem to be a safer place and the markets have regained some shine. But the critics still point out to the dangers that are lurking in the economies. The crisis brought with itself not just far reaching changes in the regulatory structure of different countries but also the fear of protectionism. There were indications that the advanced economies would resort to protectionist measures in the future to boost employment and output in their respective economies. Continued high unemployment (~10%) in the US raises concerns on these aspects particularly given heightened political pressure on US policymakers in this regard. Moreover, the Chinese government’s reluctance to appreciate the currency on one hand and the increasing US current account deficit on the other hand are creating an environment of major global imbalances again posing a challenge to the stability of the world’s financial system
Another problem in the stability of the world economic system would be the different pace at which the advanced economies and the emerging economies are recovering
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Though the advanced economies were recovering, the emerging economies are racing ahead of the advanced economies. The financial markets in the emerging economies are back to their pre crisis level and countries like India have seen record inflows in the past few months. Not only are the emerging markets a preferred destination for investment but people are touting it as a major shift in the financial hubs of the world. But critics are questioning whether this growth is sustainable or not. Central bankers have come up with new regulatory measures such as the Dodd Frank Act, Basel III but these measures fail to deal with the problem of systemic risk in the financial Money Manager / January 2011
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COVER STORY system or the risk posed by institutions which are “Too Big To Fail”. The regulators are tightening the systems but would it put an end to the “dangerous” innovations or would it hamper the financial innovation in the coming future is a question that remains unanswered. The crisis has definitely uncovered gaping holes in our economies and the financial markets but the measures taken so far do not seem to be enough to avoid the next big crisis. It is without doubt, hence, that we are slowly graduating to a new global economic and financial landscape, created out of the ruins of the global financial crisis of 2008-09. How this world will shape up remains to be seen, but there is no uncertainty that global stability is still a distant dream and that this new emerging world order will redefine the way we look at the financial and economic world for decades to come... -
Anindya Dutta Gaurav Singhal Gautam Dhond Kunal Singal Tanu Singh V M Avinass Kumar
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GLOBAL CURRENCIES
A TECTONIC SHIFT OR A MUTED WHIMPER?
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INTERVIEW WITH ARVIND SUBRAMANIAN Currencies that have dominated world trade have made an exit that has often been preceded by a crisis and succeeded by the rise of a new economic superpower and its currency. It is the same view that some experts hold with the USD right now, while some believe that its sway is intact. Through this interview with Dr. Arvind Subramanian, a currency expert, Money Manager captures his views on the evolution of the currency regime and the power balance it will create.
Arvind Subramanian is senior fellow jointly at the Peterson Institute for International Economics and the Center for Global Development and senior research professor at the Johns Hopkins University. He obtained his undergraduate degree from St. Stephens College, Delhi; his MBA from the Indian Institute of Management at Ahmedabad; and his M.Phil and DPhil from the University of Oxford, UK. 18
Money Manager / January 2011
From 1987, when the dollar’s end as a global currency for trade was sounded, the USD has moved from strength to strength through a number of crisis situations. How do you think the credit crisis has affected this position and are there any fundamental macro-economic shifts that point towards the same?
Continuing on that note, Sovereign wealth funds in the Middle East and China have considerable power in their ability to control the global currency and bond market. What role do you think they will play in determining the currency regime in the future, especially in the light of China pushing very strongly for SDRs.
In the post-war period, there have always been questions raised about the dollar as a dominant currency. First the dollar’s role was questioned in the late 60’s and the early 1970’s and as the Bretton Woods system broke down, in part because the dollar was very weak and so the American Policy makers felt that they will not be able to sustain GDP growth and implement the domestic policies when constrained by the Bretton Woods system. This was followed by another crisis in the mid 80’s when in fact the dollar became strong and in this recent crisis again, the dominance of the American currency has been questioned and for a number of reasons. This is because the United States being has been the source of the crisis and mismanaged the financial sector which has made people worry about good policy decisions. As a result the US fiscal situation has deteriorated quite rapidly and so there are questions about the ability of US to put its public financing on a sound footing.
So China’s strategy now is not to push for special drawing rights although they did it to send a strong signal. It’s kind of implicit that there is a plan to slowly but steadily promote the use of its own currency and China has been doing a lot of things to encourage the use of its currency in terms of financial co-operation with other countries, getting cheaper currencies denominated in renminbi, agreements with a number of countries: Russia, Brazil, Argentina and Middle-Eastern Countries. So the Chinese strategy now, of course, is to make Shanghai an international financial centre. China is going to gradually but steadily make the renminbi stronger and insofar as they have both the economic dominance and the reserves (two and half trillion dollars of reserves) they would be in a strong position to make the Renminbi strong.
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I don’t think the outside world can bully or coerce China into changing its currency model
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Unless the political system can absolve itself, the US public debt can grow very enormously and that will again signal an American weakness and therefore a weakness of the Dollar. The irony of course is that even though the crisis originated in the United States, in the initial phase of the crisis, the dollar actually strengthened, because people said “Oh my God! The world is collapsing but the safest place in the world is United States” and now, of course, the crisis in Europe is deepening and people do think that, “Well certainly compared to Europe, the US still remains a strong economy with a strong currency”. The huge new development, however, that has been changing the stage is the rise of China and the Chinese currency which I am writing about in my next book. So the fundamental shift that has been taking place is the emergence of the Chinese economy and the Chinese currency.
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With nearly two and a half trillion dollars of reserves invested in US Dollar denominated securities, how do you think China’s dollar trap coupled with the Current real estate bubble will play out in the near future?
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I think the usage of the phrase “Dollar Trap” is a little too strong. Fundamentally China will only change its currency policy when it is confident it will not affect its long term growth. So I don’t think the outside world can bully or coerce China into changing its currency model and we have seen that over the last one year, China has been absolutely adamant and stubborn in not changing its policy. It has found that having an undervalued exchange rate has helped its long run growth. So it’s going to stick to its strategy until it feels it is in its own interest to change the strategy and insofar as issues like overheating and bubbles building up are concerned, it will use other instruments like monetary policy and fiscal policy to cool down the economy. It will not change its exchange rate policy very dramatically. Coming to the dollar trap, I think that the calculations the Chinese have made for the long run is that, yes, there would be a huge capital loss on these reserves, but over the last twenty thirty years, the higher growth and the higher exports that they Money Manager / January 2011
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have got from this exchange rate policy will outweigh those costs that they will have to suffer. In the meantime they will try and do everything to postpone that loss or to reduce that loss, by diversifying into other currencies or promoting their own currency. But at some point they have to take that loss- there is no avoiding it. But the long run calculation is that it’s a price worth paying for the higher exports and the higher growth that has been caused over the last 25-30 years.
Prof. Roubini’s prediction of an impending correction is very much linked to the Chinese dollar trap and the heating of the Chinese economy. With QE2 and easy credit, do you think there will be a medium term correction in the dollar in the next couple of quarters?
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Well, some of the correction is taking place through higher inflation because remember what we care about is the appreciation of the dollar in real terms. So even if they don’t change the dollar and the renminbi rate, higher inflation in China means that some correction is taking place to some extent. But I do not share the view that there would be a major correction over the next couple of quarters because the correction would be slow and gradual to minimize the political cost. Remember if the currency appreciates very rapidly, some sectors will become more unprofitable than other sectors. There would be a lot of political adjustment cost to that and hence the correction is not going to be soon and it’s not going dramatic. It will be slow and gradual.
When there was a call for SDR’s, Gordon Brown mentioned about a second Bretton-Woods. What is your take on this? What will be the avatar of this institution? Is the IMF authority and attitude as a regulator robust enough to take on this mantle along with the World Bank – as some kind of a super-regulator?
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There are many aspects to this international monetary system question. It’s true that the IMF has been strengthened but it’s basically been strengthened to provide money to countries that encounter a problem. There is no assurance at all that IMF will be given the task to be a super regulator and that it will be effective in being the super regulator. One of the tasks that people want to give it that it should determine what the currency value should be between the different countries. For example, it should have the power to tell China to change its exchange
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rate policy but now that’s not going to happen because China is not going to allow it to happen. So the IMF authority, in a new BrettonWoods as a super regulator is going to be very limited because on major policy issues like currency, monetary policy and regulation of the financial sector, the big countries will not want to give away the authority or the sovereignty to do so. China is not going to give away the authority to determine its exchange rate policy to the IMF as a super-regulator - No more than the US will be willing to give away its monetary policy authority. So that’s not going to happen. Therefore, as a super-regulator, I think the role is going to be much more along the lines of what it has been doing will be limited and relatively ineffective.
With the Greece crisis, the reputation of euro as a chief trade currency has been severely affected. What do you think will be the impact of the stretched economies, like the PI(I)GS in the Euro zone? What is lacking in the Euro to be the next currency hegemon?
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Let me take it a step back: the next hegemon is going to be China - thats the big macro-shift thats taking place. China’s role in world GDP and in world trade is expanding rapidly. I think the euro as the next hegemon was a question that was very interesting in the early 2000s. It is less interesting now because after the Greek crisis people are even wondering now whether Euro currency as a zone can even stand together. They have this big problem between the core countries which is Germany, France and to some extent Italy which have actually not suffered the crisis, which are actually doing quite well compared to the periphery countries which are not doing very well at all.
The troubles in these countries are far from over. Not only are they far from over, people think that there’s no real light at the end of the tunnel for these currencies. The only way to come back on a sound footing is to make it grow and get rid of this huge amount of debt that their governments have taken on. So unless some resolution is sought for the problem of the peripheral countries, the whole fate of the euro as a currency and the euro-zone, as a project of economic integration, is in question. Unless, some drastic solution has been found, I don’t think that’s going to change.
So what policy measures do you think the major economies of the euro zone should take to address the issue there?
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Well, first of all, many of these debts will have to be written off. I don’t think Ireland, Greek, Spain & Portugal will pay off the debt that they have. So what Iceland did was to repudiate all its foreign debt or most of it and Iceland bounced back. So first the debt would have to be brought down to a manageable level which means that the Germans and the French will have to expect that their banks which have lent to these countries will also have to take a hit. Second, these countries will have to find new sources of growth. You can’t grow at 2 and 3 and 4 % and hope to be able to repay your debt. Now for that the hurdle is that they will have to introduce structural reforms and countries like Germany will have also have to provide much more demand for these countries in the short run. But, in fact, just the opposite has been happening - Germany has been running a huge current account surplus which is the opposite of what these countries need.
Regional trade agreements have played a significant rule in countering the currency domination by the dollar. How do you think, the prevalence in growth of such regional trade agreements and free trade agreements will decrease the impact of one single currency holding’s sway over the world trade?
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China is taking a number of policy initiatives to promote the Renminbi - one of these initiatives is actually in regional trade – to promote the Renminbi. So it’s not that China is promoting regional trade agreements per se but the intensification of trade links is being used by China to promote its currency. So part of the strategy of China to make renminbi a world currency is by making it a regional currency and then a world one.
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INTERVIEW WITH RITESH DUTTA The Currency supremacy issue has swayed considerably over the last year – just when the Euro looked strong enough to topple the dollar, the PIGS crisis happened to considerably lessened its credibility. Add to this melting pot the Chinese inflexibility with the Renminbi and we have a near deadlock on the “What’s after the dollar?” question. We sat down with Ritesh Dutta of UBS to discuss the Sovereign Debt Crisis in Europe, China and the G20. The excerpts follow.
Ritesh Dutta is Global co-Head of FICC Emerging Markets at UBS Investment Bank, based in Zurich. Previously he worked in various roles for UBS across Rates, FX and Proprietory trading in Mumbai, Singapore and London. He is a CFA charter holder and an alumnus of IIM, Ahmedabad. 22
Money Manager / January 2011
Since the termination of Gold Standard, the USD has been the base for international currencies. However, with the US deficit increasing and also QE raising concerns over the strength of US Dollar, how do you think the role of US Dollar will change?
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The dollar remains the world’s pre-eminent reserve currency by default rather by choice. At present, there are simply no other viable alternatives. The long-term future of the Euro remains far from certain and, in light of the sovereign crisis, the pool of investible EUR-denominated reserve assets has declined materially. While Special Drawing Rights (SDR) are increasingly viewed more favourably, there is scant liquidity available. [The currency value of the SDR is determined by summing the values in U.S. dollars, based on market exchange rates, of a basket of major currencies (U.S. dollar, Euro, Yen, and Sterling.] At the same time, the vast majority of global reserves continue to be denominated in dollars and to allow a rapid decline would damage many sovereign portfolios so it is in nobody’s interest to rock the boat. After all, it was the intervention of emerging markets to control the value of their currencies which got themselves into this mess in the first place, so they should not heap all the blame on the Fed and QE.
Prior to the crisis, there were increased speculation of Euro assuming a prominent position as an international currency and countries such as China had started building reserves of Euro. Now with the European Sovereign crisis in light and a slight possibility of exclusion of some countries from Euro Zone, how do you see the Euro evolving in the near future?
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It is too early to tell, but conditions in the Eurozone are likely to deteriorate before they improve, and the governments in the region know this. UBS is calling for fiscal guarantees, which we believe to be the basic building blocks of fiscal union, to be in place by the end of this year. Without movement towards fiscal convergence it’s going to be very hard for the Euro to maintain credibility.
Prior to the European Crisis, south-east Asian economies had been working towards establishing a single currency. As of now, the process seems to have been halted. What would be the advantages for these countries to move ahead with this monetary integration, and do you think after what we have seen in Europe, they would move ahead?
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There is little political support for such a project today, and the Eurozone crisis has probably undermined the entire process. All is compounded by the tendency for local governments/central banks to see currency devaluation as a mechanism to increase competitiveness. Of course, if you are a member of a currency union you forgo this option - but never say never!
Despite the international pressure and increasing US efforts, China has de facto maintained its stand on keeping Yuan undervalued. Also, China has over $1.5 trillion worth of US treasuries and has retained its position as a major buyer during US Treasury auctions. With this in mind, do you think that there is any possible economic way that US can influence China to appreciate its currency?
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Notwithstanding any protestations from the Fed, the US has already exerted influence through quantitative easing - albeit that the transmission mechanism is subtle. Soon after the launch of QE2 (ostensibly to fight deflation), there was a sharp rise in global inflationary expectations which, in turn, has lead to a global jump in input costs. In China, the need to curb inflation is a priority, but the authorities there will also be anxious to avoid a collapse in asset prices. In light of this, we do not expect aggressive interest rate hikes. This just leaves the CNY as a tool, and it’s about time it was applied.
Money Manager / January 2011
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In the last two years, G20 has increasingly supported SDR as the international reserve currency for the future. With concerns over both USD and Euro, do you think a currency not controlled by any single country, rather than by a multilateral organization like IMF could emerge as the preferred currency for international transactions?
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The SDR is not a transaction currency – it operates on a claims basis and supply is determined by special allocation which involves a high level of bureaucracy. Given that the US has a blocking veto over any IMF decision, we doubt that it will be considered a viable alternative. The IMF is not a settlement bank. Simply put, the discourse has not advanced far enough for people to consider alternative reserve/international currencies.
In the light of all the regulatory interventions that are taking place (such as rate cuts, reserve enhancements etc.), do you believe there should exist “Global guidelines” for capital flow controls that every nation should adhere to, as suggested by the IMF recently?
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Rules are routinely broken so it is futile for the IMF to impose them in the first place. While there appears to be progress towards reaching an agreement on current account targets, we are only cautiously optimistic at this stage. It is about politics as much as economics. Emerging market countries may be warming towards current account targets but, as we saw at the November G20, they managed to get the developed world to agree to tolerate short-term capital controls as well. In particular, with the US still engaged in QE and other major central banks exercising emergency policies, the scope for compromise is limited. All remains a free-for-all. “The views expressed in the interview are his own and do not necessarily reflect those of UBS”
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FINANCIAL PRODUCTS
IS THE INNOVATION TREND TRULY OVER?
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INTERVIEW WITH HAROLD KIM
The global economic crisis of 2007-08 has significantly affected the financial landscape in terms of the nature of financial products which will be traded in the markets in the future. As the markets continue to be uncertain about the nature of recovery, the Money Manager team sits down with Dr. Harold Kim, to discuss how he sees the overall landscape for investing in structured investment products shaping up.
Dr. Kim is currently the Managing Director and Head of the Cross Asset Group for Citigroup Global Markets in Hong Kong, covering financial intermediary sales and investor structuring for equity, fixed income and hybrid products. He originally started at Salomon Brothers (a predecessor of Citigroup) in 1993, and has since served in a variety of capacities at Salomon/Citigroup. 26
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Post crisis how has the attitude of clients changed towards structured products? How has Citi’s portfolio of products evolved in response to this shift in attitude?
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The onset of the financial crisis resulted in a decrease in activity across all investment products, not just structured products, as risk aversion increased and people looked to invest only in safe assets. Once the markets started to settle down and risk aversion decreased, we saw people broadening their range of investment products, understandably beginning with products that they were familiar with. The crisis refocused people on making investment decisions that they understand, which is good. However, these new investments were not limited to simple vanilla products. What was interesting about this process was that, in some markets, we saw reacceptance of products which are relatively exotic and structured to a reasonable degree. Asia was not hit by the crisis as heavily as the developed world, and by some measures the level of structured investment activity has already recovered to pre-crisis levels. For example, in Korea, in the equity-linked securities market the volumes are close to pre-crisis highs. In India, the equity markets are very strong, and we are seeing strong appetite for structured products. In fact, we have a capacity constraint in India where as soon as we have capacity to issue a product, the product is taken up. So if you compare investment behavior pre-crisis and what we are experiencing now, with the exception of some countries and client segments, it’s actually not that different in Asia. For structured investment products in Asia, the reacceptance of these products has been quite fast. What has changed is that the product mix has shifted towards what people view as the asset class with the most favorable risk versus reward ratio. Immediately after the crisis hit, the volume of equity products, which traditionally has been the largest asset class segment, dropped in favor of fixed income products. We saw a rapid increase in simple credit and rate products. Now, with the equity market strengthening, that shift has gone back towards equities, though the mix is not as skewed as it was pre-crisis. I would estimate our pre-crisis product mix to have been about 85% equities products and 15% FICC products. If we look at our current product mix, it is roughly 60% equities and 40% FICC. Equity still represents the major asset class, but credit and rates in particular and FX have gained wider acceptance in terms of structured products.
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Has Citi’s geographical focus changed in response to the crisis?
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Yes and no – Citi is still very committed to Asia as a whole, but our focus within the region varies; the answer is country, product and customer-dependent. In some countries, like Korea, the volumes are reaching pre-crisis levels. In other countries, like Taiwan where the regulatory response has been much stricter, markets are still closed, and as a consequence our focus has been reduced. In India, our volumes are down from 2007, but this decrease is not due to a fall in investor demand, but due to a decrease in our capacity to issue product.
Given investors’ preference for simpler products, going forward, do you see the financial services industry continuing to be a hotbed of innovation in product design?
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There has been a lot of talk about the preference for simpler products, but if you look at our business as it has evolved from 2007 to now, we actually have a large percentage of business being done in what would be considered complex products. The difference is that, these complex products are simple for the customer to understand. I think this trend will continue. For the last 30-40 years, the financial services industry has been an industry focused on innovation, driven by a variety of factors. Crisis and regulation breed opportunities for innovation. Demographic trends breed opportunities for innovation. If you think about Asia right now: where we stand in terms of demographics, over the next several decades, Asia is going to get older, it’s going to get richer and get more middle class. At the same time we have very underdeveloped capital markets to enable this increasingly wealthy middle class to invest and save for retirement. As a result, we are going to see a real increase in capital market innovation to satisfy this huge oncoming demand for retirement products. The products will not be limited to vanilla equity and mutual funds, but will include more complex structured product solutions that will deliver good long term investment value. We are at the cusp of another wave of very productive innovation.
With the equity market strengthening, that shift has gone back towards equities, though the mix is not as skewed as it was pre-crisis
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Money Manager / January 2011
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There are some substantive changes in regulations related to trading of financial products and managing financial intermediaries. In the past we have seen new structured products emerge in response to regulatory changes. How do you think changes in the regulatory framework will affect financial innovation going forward?
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That’s a hard question to answer right now, because the regulatory environment is still changing. A good example is what is going on in the US. The Dodd Frank bill has outlined the intended guidelines for the new regulations, but the actual rules have not been determined yet, so it’s very hard to say how the industry will respond.
Do you feel that there would be a preference for specific products given the Dodd Frank Bill or products which can take better advantage of the environment given those kinds of conditions?
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Again. it’s hard to say without seeing the actual regulations, which are expected to be put in place over the next year. In fact, the uncertainty around the changing regulations is one of the biggest issues now facing product providers.
Thank You for agreeing to talk to us. Do you have any additional comments?
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First of all, thank you very much for the opportunity to speak with you. Given your intended audience, there is one point that I would like to leave you with. I talk to journalists quite a bit, and they invariably ask similar types of questions. In general, people are always looking for a simple solution to the problems at hand. “Leverage is bad. We should get rid of it.” “Derivatives are bad. We need to get rid of them.” But in fact, markets are more complex than that, and simple solutions are not available. As MBA students, you need to understand that complexity. When you address the question of what caused the financial crisis, “Was it derivatives? Was it the hedge funds?”, it is very easy for the press and the public to assign blame and demon28
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ize one or two instruments or actors as the simple cause of the crisis. In fact, the crisis was caused by a combination of factors -- regulatory guidelines got too loose, credit standards were too lax, risk management fell apart, rates had been kept too low for too long, rating agencies did not do their jobs, etc. The financial crisis was not caused by any one event or factor, but by the interaction of all of these events and factors. There was a regulatory change in the US to encourage home ownership. Since it was a political imperative, the banks got involved, the Fed kept rates low, credit levels were not monitored correctly, the events all cascaded into each other. Everybody had to play their part to cause the problem, and unfortunately everybody did. The result was the worst financial crisis since the 1930s. As the markets recover, we are still looking for solutions for better ways to invest in general. The current economic environment is causing numerous challenges for investors. For example, interest rates in Hong Kong are at or near 0%, and not surprisingly people are looking for innovative investment ideas that will give them some yield. In and of itself, this search for yield is not a bad thing. The difficulties come when products are misused and abused. Everything in life, even good things, that are overused or misused can become harmful, including derivatives and structured products, which are powerful tools but sometimes easy to misuse.
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The financial crisis was not caused by any one event or factor, but by the interaction of various factors
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Globally we have huge disparities in economic growth rates right now between developed and emerging markets. We have lots of liquidity being created. In Asia, we have a demographic problem that will manifest itself over the next 20 to 30 years. As we move forward and look at how to solve the financial problems we are facing, it is innovation and derivatives and structured products that will actually help us remedy these imbalances, save for the future and allow inter-generational wealth transfer effectively and efficiently. If we didn’t have capital markets, the economies of the world would not have grown as fast as they have in the recent past, and looking forward, capital markets will only be an enabler of future growth.
INTERVIEW WITH BRUCE TUCKMAN Financial products follow a cycle in their innovation – in OTC markets where they grow in size and impact macroeconomic trends then coming under the purview of the exchanges and then being standardized. When this trend is bucked some systemic risks are wrought. Dr. Bruce Tuckman, an authority on financial products regulation, was at IIMA this November for a brief lecture on ways to reduce systemic risk in OTC derivatives markets. The following are excerpts from an interview with Team BETA.
Dr. Tuckman, a Director at the Center for Financial Stability, is a world renowned authority in fixed income markets. Along with being Managing Director and Global Head of Quantitative Research for Prime Services at Lehman and then Barclays, Dr. Tuckman has also held important teaching positions at Stern and Anderson (UCLA). He completed his PhD from MIT in 1989. Money Manager / January 2011
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Bruce, to start off, could you give our readers a brief background of how OTC derivatives might be in for a big change?
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Well, Dodd-Frank gives regulators the authority to determine which instruments have to be cleared and which will be exempted from clearing requirements. A big question facing regulators is how wide they will cast the clearing mandate. If the span is too narrow, not much will be done with respect to their mandate to reduce systemic risk in these markets. If the span is too broad, these instruments might be prevented from being used to carry out efficient economic transactions and systemic risk might increase as instruments not really appropriate for clearing are forced into clearing houses.
Which do you believe would be the first derivative instruments to be cleared?
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Dealer-to-dealer, a lot of Credit Default Swaps and Interest Rate Swaps have already moved to clearinghouses. With respect to customer transactions, the most likely to move are credit default swaps on corporate indexes and perhaps some well-known individual names in addition to generic interest rate swaps. However, this probably won’t do much with respect to the problems that led up to the financial crisis. Counterparty default on these relatively simple and liquid instruments was manageable even at the worst times during the crisis. The problems stemmed from more complex and illiquid securities. Should or will the regulators push these securities into clearinghouses? I think not. For example, setting prices and margin requirements for CDS on illiquid mortgages is too hard a problem for market participants to outsource sensibly to clearinghouses.
So if shifting derivatives to clearinghouses is going to be so ineffective, why the huge interest on the part of the regulators to make it happen?
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During the crisis the regulators were shocked at how difficult it was for them to get information about the exposures of large financial institutions to each other. As a result they started to push the industry to clear some of the more liquid products. In the ensuing political discourse, however, all derivatives got lumped together and Congress wanted to do something big. This led to the potential for overkill with respect to pushing derivatives into clearinghouses, but I don’t think the regulators themselves will make this mistake. And, by the way, the market for a lot of the structured products that played a part in the crisis has, in the aftermath, dried up of its own accord. 30
Money Manager / January 2011
How do you envisage a possible clearinghouse structure for derivative instruments?
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There are three theoretically possible levels of clearing. The first or most basic requires only 3rd party pricing and collateral management. The second level requires a central counterparty that stands between every trade. The third requires standardized products. I have made the argument that the first level goes a lot of the way to accomplishing the regulators’ goal of transparency. I and others have made the argument that central counterparties can, for many reasons, become a source of systemic risk during a crisis. But the road lawmakers and policy makers are travelling is toward the central counterparty model.
Final thoughts on the current direction of regulation and any suggestions?
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Here are my broad comments. The current path of regulation runs the danger of making the probability of a crisis less remote but the severity of a crisis, when it hits, much worse. We have to stop implicitly and explicitly encouraging leverage and the growth of financial institutions to behemoth proportions. We have to make sure that there is enough fear of losing money throughout the system so that there are many eyes on risk: regulators simply cannot do it on their own.
REGULATORS
OMNIPOTENT WATCHDOGS OR LIBERAL BYSTANDERS?
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INTERVIEW WITH SHYAMALA GOPINATH If the financial crisis has done anything, it has definitely brought into focus the role that central banks and regulators play in ensuring the financial health of the economy. The RBI has been at the forefront of laudable policy decisions that have kept the rupee in check as also ensured that the financial markets have grown steadily. We take Smt. Shyamala Gopinath’s views on the problems she foresees going ahead and on international collaboration for financial markets regulation.
Smt. Shyamala Gopinath is the Deputy Governor of the Reserve Bank of India. Smt. Gopinath has handled some of the critical portfolios in the Reserve Bank, such as, financial markets, including regulation and management of government debt and exchange rate, management of foreign exchange reserves, and banking regulation and supervision. 32
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In the backdrop of the global financial crisis, has there been a significant change in the overall approach to the regulatory framework governing the financial services industry from the RBI’s perspective?
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The financial services industry in India operates in a very different context compared to the developed markets, which were the epicentre of the crisis. There is no doubt a fundamental shift in the regulatory approach towards the financial sector globally and the jurisdictions worst affected by the crisis have already moved ahead in strengthening the regulatory framework. Many of the issues are also getting discussed/pursued at various multilateral fora such as G20, Financial Stability Board, Basel Committee on Banking Supervision, International Accounting Standards Board etc. in which India is a key member. RBI’s regulatory approach in the near future would be significantly conditioned by the guidance issued by these bodies on a variety of issues such as capital adequacy, provisioning, liquidity risk management, systemic risk regulation especially the macro-prudential regulation, regulation of compensation practices, regulation of securitisation activities, etc. Quite apart from the global agenda, there are various India-specific issues that will be addressed, particularly in regard to strengthening the regulation of NBFCs and enhancing transparency and mitigating risks in the OTC derivative markets.
What do you think will be the primary task which regulators worldwide will seek to address in the future as a sense of calm and reason returns both to the financial markets as well as the overall economy? How would you contrast that to the nature of the regulatory role played before the crisis?
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The primary task for the financial sector regulators, and which is already happening, is to reorient the regulatory and supervisory frameworks and correcting the misaligned incentive structures for the industry. The objective is twofold: one, reducing the probability of occurrence of systemic crisis and two, containing the impact of such a crisis, if and when it happens again. The following initiatives have been initiated internationally in this regard: -Strengthening the Basel II capital adequacy framework and introducing liquidity measurement standards.
-Instituting a macro-prudential approach to supervision and assigning a clear mandate to a systemic stability regulator. -Expanding the perimeter of financial sector surveillance to ensure that the systemic risks posed by unregulated or less regulated financial sector segments are addressed. -Ensuring that prudential regimes encourage incentives that support systemic stability and discourage regulatory arbitrage, and assure effective enforcement of regulation. -Improving the capacity of national authorities to respond to systemic crises, including by establishing mechanisms for coordination both within and across borders. -Strengthening the OTC derivatives market and incentivizing moving standardized products onto exchanges In contrast, regulatory role played before the crisis was basically minimalist in nature, focused largely on individual institutions, segmented in scope, done in silos displaying undue faith in the market discipline, devoid of any big-picture awareness on the part of the regulators. The overall framework came to be known as light-touch regulation focusing on individual banks and institutions, disregarding the interconnectedness among these entities and the systemic risk the interconnectedness could pose to the financial stability. The potential adverse implications of fallacy of composition were completely ignored.
Despite the crisis, several observers warn that the nature of systemic risks in emerging market economies is different from those of the developed world. In fact there are already whispers of the possibility of asset bubbles in this part of the world given the global imbalance of capital flows. How do you think regulatory policy should respond to such heightened risk perceptions?
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It is true that the nature of risks faced by emerging countries is different from the developed countries. The RBI has recently come out with its 2nd Financial Stability Report which brings out the nature incipient risks. The Report notes that the tail risks to financial stability are largely exogenous given increasing correlation between global growth and growth in EMEs, including that in India. The finance channel has assumed greater importance increasing the pace and degree of contagion from disturbances abroad. If recovery is derailed in the advanced economies, it will be difficult to remain decoupled notwithstandMoney Manager / January 2011
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ing the domestic orientation of economic growth. Similarly, business cycle synchronisation of the Indian economy with most of the advanced economies and EMEs has increased. The policy agenda in most EMEs in recent months has been dominated by the management of capital flows. India’s dilemma is somewhat contrarian to this. Our concern has been not so much the quantum of flows, which we have been able to absorb because of the widened current account deficit, but rather the nature of these flows. Much of the capital has come in the form of short term portfolio flows and debt flows which are significantly prone to sudden stops and reversals. The external ratios would need to be watched carefully. On the asset price front, housing prices have risen sharply especially in some pockets and the sector remains susceptible to asset price bubbles driven by capital flows. Credit growth remained healthy and alluring housing loan schemes continued to be offered by the banking sector. Against this backdrop, the Reserve Bank has tightened the prudential norms (LTV ratios and risk weights) for housing credit.
As the world emerges from a crisis which has been attributed primarily to shortcomings in regulatory oversight, how do you see regulatory authorities’ worldwide respond and shape policy going forward? Do you see greater international collaboration amongst regulatory agencies to respond to an increasingly globalized financial system?
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Greater international collaboration is already happening as far as etching out the regulatory agenda for the global financial system is concerned. The proactive initiatives taken by the G20 in the immediate aftermath of the crisis laid the foundation for developing a framework for repairing the financial system in a globally coordinated manner. However, let me add that while broader alignment with the international standards will be imperative, the local jurisdictions will need to have the space to frame policies and take suitable actions in their own context.
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RBI’s approach has been to encourage market development keeping in consideration the overall macroeconomic stability 34
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At a time when the entire world is shying away from the concept of securitization, given the legacy associated with it over the last two years, you have advocated the idea of “sustainable securitization” in India. Can you explain how do you see securitization as a concept pan out in the coming years in India, and what would it mean for the Indian financial markets in terms of innovation in product design?
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The principle and economic rationale of securitization is indeed sound and it can rally help the banks in credit creation, which is a fundamental requirement in a growing economy like India. However, it needs to be sustainable. By sustainable I mean that the securitization activity should grow and develop in such a manner that it does not promote risky models and complex product designs which are difficult to understand and price. It also means that the activity should not create misalignment of incentives among various players in the securitization chain. If these pre-requisites are absent, the securitization Securitization framework in India is considered to be reasonably prudent and not overregulated. RBI guidelines on Securitization issued in February 2006 are applicable only to standard assets which ensure that securitized assets are healthy and performing at the time of securitisation. Besides, there are built in prudential measures to contain risks. -Firstly a prescribed stringent criterion for “True sale” of the asset ensures total proper de-recognition thereof from the balance sheet of the originator. -Secondly, RBI consciously discouraged securitisation to be used as mode of profit garnering by improper valuation. Thus, profit is not allowed to be recognised upfront, but has to be amortised over the period of securities. -Thirdly in order to discourage originator to have further interest in the securitised asset, stringent measures are prescribed for treatment of credit enhancement when provided by the originator. -Fourthly, adequate safeguards have been built in to ensure that credit enhancement provided by originator is not camouflaged as liquidity facility or any other service provided by originator. Thus, banks in India did not have incentive to resort to unbridled securitisation as observed in “originate-to-distribute” and “acquire and arbitrage” models of securitisation in many other countries. Recently, additional norms have been proposed requiring a minimum lock-in-period and minimum retention criteria for securitising the loans originated and purchased by banks. The final guidelines in this regard will be issued shortly.
Market observers have said that we need to develop robust secondary corporate bonds market and structured products market in order to create a strong financial market ecosystem in India. How would you respond to this demand particularly in the light of the crisis?
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Our approach has always been to encourage market development keeping in consideration the overall macroeconomic stability. In respect of all the markets mentioned by you, we have been constantly endeavouring to develop viable frameworks. After introduction of 10-year IRF, products for different maturities are being considered including 92-day, 2-year and 5-years. The CDS is proposed to be allowed while trying to address the downsides. Various initiatives have been taken to further develop the corporate bond market. The intractable issues pertain to the structural elements relating to the lack of appetite for credit risk among non-bank institutional investors, particularly insurance funds and pension funds.I would just like to mention that development of new markets is gradual process and takes time.
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FINANCIAL INSTITUTIONS THE NEW ENVIRONMENT additional regulation and opportunities driving strategic changes
Everyone thinks about restrictions the moment you mention Basel III and Dodd-Frank. But Steve Young sees it as an opportunity – an opportunity to define new growth paths and develop new strategy. He argues, in his article for Money Manager, very cogently as to how the current financial regulations are designed not to stifle financial services firms but to help them carve their niche in the market. Read on to find out more.
Steve Young, a professor at Fisher School of Business, started his career in public accounting and worked on Wall Street with Salomon Brothers. He has also worked with Banc One Capital Markets, Stonehenge Partners and Century Surety Group. He holds a bachelor’s degree in accounting from The Ohio State University and a master’s degree in finance from the Harvard Business School 36
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the recent history
new regulation
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First, let’s take a brief look at the changes that have occurred during the last 20 years that shaped the regulatory and competitive environment prior to the financial crisis. One of the results of the stock market crash and great depression of the 1930’s was the passage of The Banking Act of 1933, a law that established the Federal Deposit Insurance Corporation (FDIC) in the United States and introduced banking reforms, some of which were designed to control speculation. This act is most commonly known as the Glass–Steagall Act, after its legislative sponsors, Carter Glass and Henry B. Steagall. One of the most important elements of this law was to separate investment banking and commercial banking functions in order to prevent speculative activities by financial institutions. Some provisions of the Glass Steagall Act, such as Regulation Q, which allowed the Federal Reserve to regulate interest rates in savings accounts, were repealed by the Depository Institutions Deregulation and Monetary Control Act of 1980. Then, provisions that prohibited a bank holding company from owning other financial companies were repealed on November 12, 1999, by the Gramm–Leach–Bliley Act. These changes along with other deregulatory actions during the same time period effectively allowed commercial banks, investment banks and insurance companies to begin directly entering each other’s core lines of business. In addition, during this same time, new entity structures such as hedge funds and private equity firms emerged and grew rapidly in a largely unregulated manner. As a result, in the years leading up to and including the financial crisis, the financial services sector was characterized by an almost “Wild West” strategic approach. Whatever line of business was fast growing and seemingly profitable quickly attracted new firms. Regional commercial banks merged to become national money center banks. Larger commercial banks acquired regional, well respected investment banking firms and began underwriting new securities for their commercial clients. Investment banks started private equity firms. Junior partners at bulge bracket firms left and formed hedge funds and raised billions of dollars almost overnight. Mortgage brokers popped up on every city block and grew like weeds hidden within the shadow banking system fed by investors’ never ending appetite for high yielding securitized investments. Large insurance companies merged with large banks to offer all types of financial services to Fortune 500 clients. Old line investment banks transitioned from partnerships to public companies and in doing so raised tremendous amounts of capital. In summary, many financial service firms’ strategy was to be a “one stop shop” for some targeted segment of the market as the industry experienced a deregulatory and business friendly environment buoyed by a steadily growing national economy.
During the summer of 2010, Congress passed the most sweeping changes in financial regulation since the great depression. The act, whose common name is, “Dodd-Frank Wall Street Reform and Consumer Protection Act” (H.R. 4173), provided for a council to address risks posed to the economic stability of the US by large interconnected financial institutions both in and outside the financial markets, promote market discipline by dissuading financial market stakeholders of the idea that the federal government will protect institutions from losses, and respond to emerging threats to the US’s financial stability. One of the primary pieces of the Dodd-Frank regulation was the increased reporting both by companies who were already subject to a significant amount of reporting and those who were exempt. Exempted organizations now required to report range from hedge funds to bank holding companies and could go as far as divisions of larger more complex institutions like GE Capital. All those mentioned are subject to differing levels of scrutiny based on business, interrelationships and amount of risk posed to the greater system. In addition, the recently passed financial overhaul requires commercial banks to jettison any proprietary trading they undertake with their own capital, including bets on commodities. Some large financial firms are already moving to close down proprietary trading operations after more than five years of rapid expansion. The bill gives banks nearly a decade to end speculative derivatives trading to comply with the so-called Volcker Rule, named after former Federal Reserve Chairman Paul Volcker who first proposed it. The exits by J.P. Morgan Chase & Co.’s and Goldman Sachs Group Inc. from proprietary trading represent a quick strategic shift and sent a message that Wall Street banks are moving quickly to comply with tough new market regulations. J.P. Morgan has already informed roughly 20 commodities traders on the bank’s proprietary desk that their jobs are being eliminated, according to a person familiar with the matter. Goldman Sachs has decided to close its principal strategies unit, which does its proprietary trading, according to someone familiar with the situation. However, a permanent reduction in speculative activity isn’t in cards. Hedge funds and other investment groups are expected to fill some of the void, and analysts are hopeful that rules will still allow for banks to serve clients. Regulators haven’t comprehensively defined what constitutes “proprietary” trading, which is often intertwined with deals done on behalf of clients, transactions still allowed under Volcker Rule.
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new strategies and opportunities —
In this new regulatory and slow growth economic environment, financial services firms will choose strategies that fit best with their relative competitive position within the industry. Many firms will focus on a “hedgehog” strategy and concentrate on core competencies while divesting ancillary business units. For example, commercial banks will return to their credit roots with traditional lending activities. Also, high profile firms such as Goldman Sachs are likely to return to strategies focusing on core functions such as traditional investment banking services like underwriting securities and mergers and acquisitions, while jettisoning activities like proprietary trading in order to comply with new regulations and repair their public images. At the same time, firms like State Street and BONY Mellon will continue with their laser like focus on fee based services such as custody and wealth management which served them well during the financial crisis. In addition, all strategies adopted by financial services firms will need to provide for a rebuilding of adequate regulatory capital levels and a repayment of TARP funds where appropriate. In contrast, hedge funds and private equity firms will set strategies that seize on new market opportunities created by the financial reform. For example, lines of business that have fallen from the larger firms or the shadow banking system, will likely end up with newly formed hedge funds that find a way to remain lightly regulated. Furthermore, private equity firms will invest substantial funds in troubled financial
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firms where they smell an opportunity to create value and make money. For example, in early 2009, the Federal Deposit Insurance Corp. reached a preliminary agreement to sell the remains of IndyMac Bank one of the biggest bank failures in U.S. history to a team of high-profile investors, suggesting there is private money willing to invest in troubled banks if the government agrees to shoulder heavy losses. The investment team, which includes affiliates of private-equity chieftain Christopher Flowers, hedge-fund investors George Soros and John Paulson, and computer mogul Michael Dell, will contribute $1.3 billion in capital toward a purchase of IndyMac Federal Bank. However, at the same time, make no mistake that many firms, like Goldman Sachs, have raised huge amounts of capital and will not hesitate to enter new or re-enter old lines of business that prove profitable and can provide a sustainable competitive advantage. The shadow banking system is temporarily dead on its feet, but do not be surprised if it comes back to life as part of investment banks, hedge funds and other financial firms’ strategies when the public outcry over the recent financial crisis subsides as government officials move onto the next national crisis and the seemingly always short memories of investors quickly fade. In summary, the future strategies of financial services firms from commercial banks to hedge funds and everyone in between will vary depending upon the ultimate outcome of the new financial regulation and each firm’s relative position within the financial services industry. For some larger firms, this will mean a return to core operating strategies and historically profitable lines of business that will provide for a restoration of much needed regulatory capital. However, for other smaller and more nimble firms such as upstart hedge funds with immediate access to vast amounts of capital, their strategies are likely to focus on opportunistic niches that have been created by increased regulation and the financial crisis itself.
INTERVIEW WITH VIRAL V. ACHARYA What do you think led to the financial crisis? “Banks passing on the credit risk of subprime mortgages …” Think again. This is what Prof. Viral Acharya had to say to Money Manager when he was in India to talk about the book he is co-editing - -“Regulating Wall Street: The Dodd-Frank Act and the New Architecture of Global Finance”. MM quizzed him on what he thinks led to the financial crisis and global regulation of financial markets. Read on.
Viral V. Acharya joined Stern School of Business as a Professor of Finance in September 2008. Prior to this, he was a Professor at the London Business School and an Academic Advisor to the Bank of England. Professor Acharya earned a B.Tech in Computer Science and Engineering from the Indian Institute of Technology, Mumbai, and a Ph.D. in Finance from Stern School of Business. Money Manager / January 2011
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The dodd-frank act and the new architecture of global finance Prof. Viral Acharya was in India to give a talk on the new book that he has co-edited -“ Regulating Wall Street: The DoddFrank Act and the New Architecture of Global Finance”. The talk focused on the regulatory structure being built in America following one of the worst recessions which have hit the U.S economy since the Great Depression. The recession, which was mainly the result of the financial crisis which hit the banking system has its roots in the subprime mortgage market which crashed following large scale defaults by homeowners. Talking about the roots of the financial crisis, he presented a version different from the popular theories which float around the press today. Regarding the most popular claim, that of banks passing on the credit risk of subprime mortgages to the market.
What is your view on the reasons behind the crisis?
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China’s huge appetite for US Treasury bonds lead to a crowding out of investment space for ‘safe assets’. Investors turned to other sources, the prime among them being AAA rated products created by banks which were higher yielding as well. This had the direct effect of banks originating mortgages by the dozen and repackaging them into MBS products, the AAA rated tranches being sold to investors (the so called pension funds in Norway etc). This however is the popular view. Data shows that around 55% of those MBS tranches were held by banks, broker dealers and government agencies themselves, which belie the claim that foreign investors were driving up the demand for subprime assets. Banks hence did not transfer the credit risk to other investors who had the appetite for such ‘AAA’ rated products. In our view, having a lesser capital requirement for AAA assets allowing for higher leverage (c. 5 times) and lax regulations which allowed Fannie Mae and Freddie Mac to venture into the subprime space were the main drivers behind the demand for subprime mortgages. These factors were one of the major incentives for banks to create more of these structures and trade it amongst themselves. Regulatory assessment of risk was also not quite what it should have been. As the total no. of assets held by banks grew at a phenomenal space, the risk weighted assets grew at a very slow pace compared to that. This indicates a lack of transparency more than anything else.
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Post the financial crisis, there are many new regulations that have come up with the most significant one being the Dodd Frank Act. What does the Dodd Frank Act aim to regulate and how?
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Post the Financial crisis, it was clear that allowing banks to go bust was not the right way to contain risk and Systemically Important Financial Institutions (SIFIs) have to be regulated in a better manner. The Act deems institutions as SIFI, regulates them and proposes and orderly liquidation procedures ruling out taxpayer funded wind downs and requires that creditors and shareholders bear all costs and if necessary ex post levies be imposed on other surviving SIFIs. There is greater protection for the end users of financial products with the Bureau of Consumer Financial Protection writing rules to govern such products & services offered by banks & non-banks. The Volcker Rule reinstates a limited version of the Glass Steagall Act with restrictions being placed on their prop-trading activities. There are proposed rules for regulating Over The Counter products, increased transparency in the positions of banks, separation of non-vanilla positions into well capitalized subsidiaries.
According to you, what are the elements that are still missing and have not been addresses so far?
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The Act addresses most of the key issues when the Systemic risk posed by Too Big To Fail (TBTF) institutions. However, it ignores the other element of Systemic risk, when too many small institutions fail (akin to the scenario faced during the Savings & Loan crisis of the 90s). The uninsured deposit sector has been left out. As seen post Lehman bankruptcy, money market funds faced a lot of redemption pressures which were even more aggravated in the liquidity crunch being faced then. It could have also put a cap on the $ amount the Fed can loan to ‘non-banks’. Also, as of now, banks have a free put option, wherein they have a free line of credit from the Fed when times turn bad without having to pay up anything upfront. This creates a moral hazard for banks to not be prudent about their risk taking behavior.
What in your view are the key elements of systemic risk which still remain?
What do you think would be the effect of the Dodd-Frank Act on Emerging Markets?
The U.S housing sector is far from perfect. No measures have been taken yet to prop up the credit worthiness of home borrowers, so we can still expect further defaults. So far, via the TARP program only leverage has been reduced and recapitalization has taken place to some extent, but it may not be enough. Some pockets remain unaddressed like Fannie Mae & Freddie Mac. The importance of small institutions still has not yet sunk in. The Repo Market, the Money Market still pose a significant systemic risk to the financial system as a whole. The balance sheet of banks still look fragile and their assets need to be strengthened further.
There is no doubt that many Emerging Markets got thrashed when the crisis broke out. It reinforced the view that markets are now globally connected and the image of being insulated from the global financial world remains largely a myth. It is now even more obvious that a stable financial sector in the U.S would benefit all economies in general and help stabilize the financial world. In my view, the banking sector will be under duress in the US once subjected to Basel 3 norms when they will be faced with harsher capitalization requirements while the economy continues to roil. This in my view is an excellent opportunity for Emerging Markets banks with a strong capital base to enter the US. A global M&A could be on the cards. However, all of this needs to be vetted by the domestic regulators who should feel comfortable with such a system.
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Would a system of having ‘Full-recourse’ to the assets of borrowers help in preventing or mitigating the effects of such crisis in the future?
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A few states in America and a number of European countries, do have such laws which allow full recourse to the assets of borrowers in the event of a default. In the European countries at least, there is anecdotal evidence of fewer mortgage defaults which can be attributed to this law. It has several advantages as in providing the ability to borrow more by pledging more assets. Homeowners are also less speculative while mortgaging their homes or assets.
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Recent regulations create a moral hazard for banks to not be prudent about their risk taking behavior
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What are your views on the financial innovation. Do you think that the markets will continue to come up with new products?
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The first thing which needs to get right is the correct Cost of Capital for the financial sector. Risk needs to be appropriately priced and if the risk of collective failure becomes high, restrictions need to be put in place. In such a background, if innovations don’t have the effect of increasing correlations, they are not a bad idea as such. The role of clearing houses becomes even more important in fostering such innovations and mitigating their ill effects by setting exposure limit and reducing counterparty risk. Money Manager / January 2011
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And finally, your views on the Euro Bond being floated around?
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In my view the Euro Zone will act like a clearing house, should the Euro bond ever actually take place. The ECB could issue joint liability certificates and facilitate the liquidity of these bonds. Currently, it deals with the countries on a case by case basis. First it was Greece, then Ireland and now Spain or Portugal could be next on the cards. In views of the current scenario, ex-ante an arrangement with the member countries could have reduced the overall burden on the Euro zone and the situation may have been better.
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EMERGING MARKETS EPITOMES OF RESILIENCE OR TICKING TIME BOMBS?
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INTERVIEW WITH RANODEB ROY Emerging Markets have been the buzz word for the last 5 years – be it hedge funds, PEs or sovereign wealth funds – these markets have been the watched keenly by investors of all colours. Investment Banks have also made strong inroads into capturing a part of the value in the financial markets in emerging Economies. Money Manager sits down with Ranodeb Roy to discuss Morgan Stanley’s take on how the emerging economies’ story will shape up on key macroeconomic indicators.
Mr. Ranodeb Roy is the Managing Director, Head of Interest Rate Currency Credit, Asia Pacific in Morgan Stanley. Prior to joining Morgan Stanley he worked at the FICC group in Merrill Lynch in Hong Kong, New York and Tokyo. He has also worked at Barclays, Peregrine and the Bank of America. An alumnus of IIM Ahmedabad, he has a degree in Computer Science and Engineering from IIT Kanpur. 44
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Are we going to see a global power shift as several emerging markets continue to outperform their global peers financially and economically?
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Do you see currencies in these markets continue to strengthen with respect to the USD in the near and medium term and what are some of the tensions which these currency skirmishes would create?
What kind of finer issues such as fiscal policy, regulation of financial markets and firms, as well as general governance standards will play a crucial role in driving sustainable growth in EM economies?
Asian currencies are still undervalued compared to the USD. Based on pure fundamentals, as well as trade surplus and capital flow trends, AEJ currencies should appreciate against the USD. This could lead to a lack of perceived export competitiveness, and some central bank intervention to make the strengthening slower, but the general trend will be intact. However, it is important to take the value of the EUR into context as often the trade weighted index for AEJ currencies need to be taken into account and EUR is an important trade partner. If EUR weakens significantly against the USD, it automatically re-values Asian currencies against the trade basket.
Yes we believe so. Emerging Markets, especially the BRIC Countries and in addition to that, Korea, South Africa, Indonesia, Turkey will drive strategies for global growth and have already been driving a power shift globally. China, India, Korea, Indonesia and Australia to begin with will lead this power shift.
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Apart from the ones mentioned above, there are also other factors which will play an important role such as Monetary policy, Transparency, Openness to capital and current account flows, Opening currency to market forces, Controlling corruption, Controlling Inflation, increasing labour and service sector productivity and stability of government.
How far do you believe in the Asia decoupling story with reference to its economic growth and its markets? What are some of the broad macroeconomic factors which can upset the growth in the coming years?
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Asia (ex Japan) - AEJ is intertwined with the global economy. As of now growth in AEJ cannot offset shrinkage of Europe and US, but the linkages will be increasingly decoupled. Ability to control inflation, prevention of over-heating in certain sectors of the economy such as resources, construction and housing, run-away over–lending, unfettered growth of consumer finance (keeping it in line with income levels), environment and health care may impact growth in emerging markets.
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Will the shortcomings in innovations in structured financial products limit the financial growth of the emerging markets? What are some of the economic reforms which are necessary for increasing the financial stability along with deepening and integrating them?
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Not in my opinion. Innovations in securitization are growing hand in hand with development in EM. Microfinance is a good example. Capital account convertibility, free float of currencies, ability to use derivatives for hedging, broadening of the securitization market and development of a liquid corporate bond market are some measures that will help in deepening and integrating the financial markets in EMs.
How do you see the balance in banking and markets in India evolving in the coming years?
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I think both will increase, with markets gradually taking a bigger role. Look at the growth of the mutual fund and insurance sectors in India. It has totally transformed saving habits and grown with the market.
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What are your views on the real estate bubbles in emerging markets especially in specific pockets of the AEJ region?
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China, Russia and India have recently started adding gold to their reserve buckets. Do you see any implications of the changing reserve portfolios in emerging markets? Is China’s State directed lending and NPAs in their portfolio a matter of concern?
— There is a huge demand-supply gap in quality housing in high demographic countries such as India and China. As a result potential bubbles may arise in certain areas, but the market dynamics and timely intervention from regulators will by and large control them in Asia.
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These economies have added gold on account of lack of currency choices and seeing a massive monetary stimulus in the US caused central banks to worry about debasing their reserve currency. This is a healthy trend. Other commodities such as oil may be next. Speaking about China, when an economy grows fast, this kind of lending is important to jump start certain aspects of public infra-structure spending. As long as Banks have prudential norms, and stay away from speculation, it could be under control. Eventually when growth slows, it could lead to NPA in certain sectors, but it is not an issue right now.
INTERVIEW WITH SANJAY NAYAR Emerging Market dynamics is an altogether different ball game given their positive recovery post crisis. But it’s not all hunky-dory as some have coloured it – they have their own issue of depth of capital markets and inflation to cope with at present. We discuss with Sanjay Nayar, Country Head of KKR & Co. his outlook for these markets and the reforms they need to put in place to ensure that their growth trajectory is uninhibited.
Mr. Sanjay Nayar is the CEO and Country head of Kohlberg Kravis Roberts & Co (KKR) in India. Prior to joining KKR, Mr. Nayar was the CEO of Citigroup, India and South Asia, and a member of Citigroup’s Asia Executive Operating Committee. He is a postgraduate in management from the Indian Institute of Management, Ahmedabad, and a bachelor in Mechanical Engineering from Delhi University. Money Manager / January 2011
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The recovery from the financial crisis seems lop-sided in nature with most emerging markets returning to pre-crisis levels of growth as opposed to the developed world. How do you read this growth imbalance from the perspective of the emerging markets?
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Yes, the crisis has been very lop-sided in its impact. The domestic growth in the emerging markets is primarily being driven by consumption because of shift in demographics especially in Latin America and in Asia. The second thing is that these countries have attracted a lot of capital and that has propelled growth as well. Thirdly, almost all the emerging markets are partially closed economies. They are not all open on the capital account and therefore, they have not been as impacted by the crisis as others except to the extent of capital flows that have gone out of the equity markets. Secondly, if you are export oriented like SE Asian economies, you got hurt. But other markets including India have been pretty insulated from that. The recovery has, therefore, been faster and given the demographic shift in local consumption, it is bound to show up in robust growth numbers.
What are your views on the extent of development of secondary market in emerging economies? Primary market for equities, in some countries even debt, is reasonably well-developed. But without a strong secondary market for securities - how will foreign investors and PEs hedge investments?
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I do not think any of the emerging markets have really well developed capital markets. Let’s talk about India. In India we have a very broad based equity market but not very deep. Besides being broad based in terms of the number of companies, it is pretty shallow in terms of floating stock and the type of investors is quite limited. FIIs are a pretty significant contributor at the margin, but the retail investment in India is no more than 6% of the total household savings. Pension and insurance money is not even worth talking about.
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So, I think the combination of lack of reforms and the lack of an equity retail culture have really kept our markets rather shallow. But they have pretty high velocity as against depth, and, the velocity is high because of the nature of investors. While you may have few classes of investors, they are pretty trading oriented. And, of course, the FIIs which are coming on the back of relatively inexpensive money tend to trade a little more. So there is no doubt that there is a build-up of foreign holding in India which is a good sign. It gives the impression of a very throbbing primary and secondary market. But frankly, When you get down to looking at the breadth of investors, type of investors and the size of the deal you can get done, they are pretty small and if that is the backdrop it does make the private equity or long only investors think very hard about how much you want to put into a stock or a company because you have to keep the exit in mind. Be it 5 years, 6 years or 10 years later.
Sustained periods of low interest rates in the developed world have resulted in speculationdriven surge in commodity prices in the last quarter. How serious is the threat of inflation to emerging markets?
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My personal view is that easy money from the west does create a relatively high degree of capital flows into the emerging markets and all markets are tackling it differently. If there is an absorption capacity in the economy, you can absorb these capital flows as long as they are going into creating real assets. So if somebody is raising money for a new factory, doing a rights issue, doing a secondary offering, starting a new project and as long as the money is finding its way into real assets after the initial deleveraging is over, then I would say that you have a pretty decent absorptive capacity. But if you don’t have absorptive capacity which I believe is India’s case mainly due to lack of reforms, (evidenced by a pretty low capital expenditure to GDP and a low spend on physical infrastructure) - then it is an issue. When that happens and the flows just keep coming in, they find their way into commodities, real estate, currency and the stock market. So, it begins to inflate asset values without creating real assets. So I am not sure if it is a bubble or bubble magnitude but there is no doubt that the valuation of assets, be it currency, equity, commodities or real estate is obviously much more than what it should be. China is absorbing these flows well because they are creating a lot of assets. I think other markets have some form of capital controls and taxes. But in India we have not done any of that.
One of the central themes of 2010 was the devaluation of the US dollar relative to several emerging market currencies, raising concerns on capital inflows spiking valuations as well as hurting the competitiveness of export-oriented industries. How do you see this playing out ahead and what should be the role of the regulators in this regard?
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I think this is a question everybody is struggling with. We have seen different regulatory responses from different countries. My sense is that emerging markets have got an emerging problem of how to tackle inflation. They are to an extent fighting inflation by increasing rates. So if you take the system intervention route by increasing rates, it should work the way theory would work, which is - increasing rates would slow down the growth in these economies and then the relative advantage would come down. Increased rates can also attract increased flows! But everybody is tackling it differently as every country has its own uniqueness. The issue in India is however one of not having adequate absorptive capacity. But we have a large current account deficit which probably needs these flows. In a way we have a financial imbalance with a large current account deficit. So, the flows are helping us. My guess is that we have chosen to not put any tax measures or gate keeping taxes but other markets like Brazil are contemplating such a move. Thailand is going to do something. Different markets are reacting differently. The regulators should take a balanced view between a few issues – what volatility can they live with, where are the flows going – are they creating real assets or speculative assets, and thirdly, do they have a strong enough financial sector which can withstand a dramatic outflow. Finally, exports are important but fortunately or unfortunately imports are also critical for us. It depends upon the priorities of the government. If you want to keep oil prices down in rupee terms, you are happier having an appreciating rupee but if you want to encourage exports, you are happier having a depreciating rupee.
India’s GDP growth target of 9% for this decade is heavily dependent on industrial growth and infrastructure. Non-Govt equity investments in India have been consistently low, what would you attribute that to? What financial market reforms are required to bring in more private equity and foreign equity investments?
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India is a market that has a heavy preponderance of local savings (close to 35%) which is an excellent starting point. The first reforms you would need are local capital markets reforms to be able to tap local savings into the real sector. That should be high-priority. Bond markets are pretty underdeveloped for many reasons – one of the key being that we have a very overbearing government deficit and a very heavy borrowing programme so that takes away most of the liquidity and savings and leaves very little for the real sector. But if there was a step wise reduction of the fiscal account and you open up the insurance and pension sector, you would find a very meaningful shift of savings into the real sector. But for that, you need to create the right set of instruments - corporate bonds, municipal bonds and infrastructure bonds. So there is a whole regime of debt market reforms that needs to be created. The second thing is that there are certain sectors helping which will help improve financial services and those are – the banking and the insurance sector. For whatever reasons they have been kept shut for really long but they need to get opened up because not only will this bring in high quality long term capital but also excellent business practices and better practices in risk management, innovation and it will drive better risk allocation. I think the third aspect is one of financial inclusion how do you extend banking, insurance wealth management to a larger audience in India. For that you require reforms again. This does not necessarily mean giving new bank licenses – we need a paradigm shift in two aspects. 1- We do pre-empt a lot of banking liquidity into preferred sectors like priority sector lending, agri-lending, exports and government deficit. We have to cut that down and move the burden away from the financial sector so that the money can be made available to the real sector. 2- The second shift that we need to do is make some of India’s banks bigger. You cannot have a small State Bank of India. By any measure, compared to China or Singapore we have banks that are small on all counts - be it asset size, market capitalization, ATMs or branches. The biggest issue is that local savings get pre-empted by large fiscal deficit, and a large population remains unbanked.
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Markets like Brazil and Mexico have done some very interesting reforms. They made their banks bigger - whether by letting foreigners buy in or just intra-country consolidation. SBI should go and buy smaller banks. We need bigger banks in the beginning of an economic cycle - banks with large balance sheets and funding capabilities for large infrastructure projects. The size reforms which are the consolidation reforms, and, the whole change in the mindset on how to pre-empt liquidity and deposits in the banking system are two major changes that we need to encourage. These are real actions we need to take otherwise we are going to be facing severe liquidity problems when the capex cycle starts and the growth becomes real. When that happens, you are going to find the banking system and financial markets very inadequate compared to the need.
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DOMESTIC VIEWPOINT IS INDIA POISED TO RULE AMIDST THE RUINS?
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INTERVIEW WITH JAHANGIR AZIZ The ‘India Decoupled’ story on the face of it looks rosy and hints at the resilience of India’s financial economy to global shocks. However, the impact on the real economy has to be acknowledged, which in turn may have significant implications for the financial economy as it evolves. Dr.Jahangir Aziz’s opinions in this interview shed insight into how India should strengthen its macroeconomic fundamentals to evolve a complete financial markets ecosystem.
Jahangir Aziz is the India Chief Economist for JP Morgan Chase. Before joining JP Morgan, he was Principal Economic Advisor to the Indian Ministry of Finance. Jahangir has a PhD from the University of Minnesota and spent 13 years at the IMF in the Research and Asia Pacific departments. He was the head of the China division from 2004-08. 52
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Although the Indian financial markets have been resilient to the financial crisis, there have been several aftershocks in the last couple of years. Could you please explain the structural fallacies that have resulted in a critical impact on the real economy? If this trend is to be maintained, how will this affect the evolution of the credit markets in India?
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Over the years, India’s policymakers have designed a financial system that operates in silos. This was done in order to provide stability to the financial system by ensuring that shocks in one part of the system did not migrate to the rest of the sector. Such a system works reasonably well when shocks are small. A modest shock to an asset class is absorbed through a modest price change in that asset class. However, when the shock is large like in October 2008-- because assets have limited substitutability, the price changes in a particular asset class are much larger than warranted. The only escape valve in the financial sector is equity and to some extent the overnight interbank market. That is where directly or indirectly all the participants in India’s financial system meet to trade their asset positions. This too is by design. But the end result is that we will continue to see large (larger than needed) price fluctuations in the equity market and in the call money rate. Such unwarranted price volatility raises the cost of intermediation and with that the cost of credit.
You had mentioned in the NY Times that to maintain the 8-9% pace of growth, India must ensure low cost of capital and private investment in the future. With the structure of the financial markets in India, to what extent will the FIIs impact this growth trajectory?
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The structure of India’s financial system, while, helpful in preserving stability, intermediates savings and investment at a high cost. Consequently, foreign funds, not just FII investments but external borrowing by Indian corporates, will remain an important source of affordable finance. It is not that India does not have sufficient domestic savings. It does. It’s just that the savings is intermediated at a very high cost to investors.
The critical factor in the boom in India has been the supply constraint – the growth has been demand led, which is affecting the prices and the inflation has been up and down. How does this portend for India in the next few years as an emerging financial market as against China, whose growth is pretty much supply driven?
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This is a crucial difference between China and India. Because India is chronically short of supply, the lack of demand, especially foreign demand, is not that much of a binding constraint. This is a critical advantage when global demand is likely to remain soft for some time. At the same time, India desperately needs to ease these supply constraints failing which rising domestic costs could crimp growth. This is why the reluctance of Indian corporates to resume investment in earnest over the last two years is a worry. Growth in India over 2003-08 has largely run on investment and this engine has not fired at all outside the infrastructure space since the October 2008 crisis.
To fuel growth, heavy investment is required in infrastructure development and education. This raises a key question about harvesting the savings which is close 35% of the GDP in India. To what extent is financial deepening required in India and how should this be better accessed?
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I do not think that financial deepening will raise the level of domestic savings that much. Some of those who are outside the formal system will be brought into the system but that does not increase the total quantum of savings. Those who choose to remain outside the system for tax and regulatory purposes will remain regardless of financial deepening. Indeed it is quite possible that with financial deepening if access to credit also expands then we could see a decline in household savings rate. People will no longer need to save up to make durable purchases or investments. They can get bank credit based on future income stream. And this is a good thing. The key to raising domestic savings is fiscal consolidation and reducing the government pre-emptive capture of financial resources in the guise of “prudential regulations.” Financial deepening is required to allow better access to the formal financial system and to reduce the cost of intermediation. I do not think overall mobilization of resources will increase very much because of financial deepening. Money Manager / January 2011
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You have stressed upon the need for financial sector reforms consistently. Steps have been taken by the RBI to ease up financial enabling with more banking and micro-insurance licenses. How do you think this will impact the financial sector development in the next few years? What will be the effect in organizing micro-investment and micro-credit from a greater financial inclusion perspective?
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Microfinance is a critical link in the overall financial system. However, the process may not have been managed well. Banks funded MFIs as a way of reducing their own cost of meeting the government’s priority lending requirements, not necessarily as a viable long-term business. This was one of the reasons behind the recent blow-up in the microfinance world. My guess is that the recent controversies will result in regulatory changes. Hopefully they will be moderately invasive. And hopefully the reformed MFIs can go back doing the business they are good at-reaching people that are beyond the reach and scope of banks. More bank and MFI licenses are important to increase competition and it is encouraging that the RBI is looking to do so.
As a leading economic figure, you have consistently stressed the need for financial market integration in India. How do you propose this financial market integration should happen?
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The key is to recognize that by keeping asset classes closeted in silos only ends up raising the volatility in prices and thus raises the overall cost of credit. And this is on top of the relatively smaller size of the Indian market compared to global flows. It will be a long time before our markets reach a size that will be able to withstand modest shifts in global portfolio allocations without going into a tizzy. In the meantime we can reduce some of this unwarranted volatility by removing the investment restrictions imposed on our large financial institutions like pension funds and life insurance companies. It would also help if the corporate bond market is helped to be expanded. All this again requires the government to reduce its borrowing requirements, i.e., embark on serious fiscal consolidation. More importantly, the regulatory framework needs to be streamlined and reoriented away from regulating asset classes to regulating institutions, with institutions being allowed to trade across all asset classes. In this regard, we need to move to a qualified foreign and domestic institutional investor framework away from this ad hoc investor-specific and asset-specific framework that we have at present.
Indian regulators have often been urged to develop a better atmosphere for a deeper debt markets and facilities for securitization. From the viewpoint of an International Investment Bank, what do you think is the outlook for the Indian Debt market? How do you expect regulations to pan over the next 2 years?
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The October crisis is a serious push back against any extensive deregulation of the debt market. The naysayers’ ultra cautious position has now been significantly strengthened by the seeming success of the Indian markets in the face of the global crisis. Even today there are hardly any noteworthy analyses of why the Indian system survived relatively unscathed. It is pretty much presumed that it was because of the invasive regulations and therefore the regulations are good. While some liberalization will probably happen, it will require resurgence in private investment first. If the private investment cycle turns around sharply, then the financing pressure on the government’s ambitious infrastructure program will be severe. Once faced with a significant increase in financing costs for its infrastructure investments, the government will likely move towards opening up the debt market. As long as banks are able to relatively cheaply finance infrastructure projects, which so far has been possible because of lackluster private investment demand, the pressure on doing anything meaningful to develop the corporate bond market will be mild.
INTERVIEW WITH MONTEK S AHLUWALIA Post the financial crisis, experts across the world have mentioned it will be Advantage India for the next decade. But for that to happen, the financial markets in India need to attract more equity and foreign investments to funnel the funds for the need of corporate India. Dr. Montek Singh Ahluwalia, who has been at the helm of policymaking in India, shares his views on Advantage India and financial markets regulation needed to strengthen the India growth story.
Dr. Montek Singh Ahluwalia is the Deputy Chairman of the Planning Commission of India. He had previously served as Finance Secretary, Ministry of Finance; Secretary, Department of Economic Affairs; Special Secretary to the Prime Minister; and Economic Advisor, Ministry of Finance. He earned his B.A. (Hons) degree in New Delhi and his M.A. and M. Phil. degrees from Oxford University. Money Manager / January 2011
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FII investments have been rushing into India, with the country seeing record inflows over the last few months. However, does the India growth story have the necessary momentum to sustain sufficient interest from the financial world going ahead, or are the realities of structural deficiencies not being reflected in the optimism?
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Well, You know financial markets very often experience a kind of irrational exuberance but they also experience a lot of irrational panic. My feeling is that the basic judgement about the India’s growth story being a strong and solid one is valid. But of course you know financial markets like in other situations are likely to show volatility around this basically strong forecast. But that should not worry us because that is the nature of financial markets. This will average out. They may get unduly optimistic at some point they may become a little pessimistic at some point. But I think we should be able to manage that kind of volatility. I don’t think you can get away from the volatility in the financial markets. You just have to concentrate on strengthening your own growth story. And the more you do that, from experience, they will in fact show less volatility. I think the key the key issue is not that whether the financial markets are volatile but are they more volatile in the Indian situation than for other countries. I don’t think that is the case. They have shown much more volatility in other countries than they have shown for India.
Since 2008, there have been structural changes in the global economy which have heightened concerns regarding inflation. How serious are the concerns from the Indian perspective? How does India respond to this situation where zero interest rates over a long period of time in the West is fuelling speculative action in several commodities?
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Well, I think there is a legitimate concern that if you have excessive monetary quantitative easing in the industrialized countries, it could fuel speculative asset bubbles and also speculative commodity bubbles. But in our case, the Indian market is not that open, so therefore the transmission effect directly to domestic markets is less. However if it leads to commodity inflation in the world, that will certainly affect us. I think in general around the world, particularly in the emerging markets, there is a heightened concern about inflation and we are also concerned about the build up of inflation in India but fortunately for us the growth story is very strong. And our growth rate has been a little higher than what we originally thought it would be. But I think the inflation is above our comfort level. It is not a big problem, inflation is coming down but we will have to remain watchful.
What are the implications of weakened developed markets for India? Does this impact the As a policymaker, would the excess of the inflows way India will shape the path of its own ecoworry you with regards to the long-term sustain- nomic growth in coming years? Will there be a ability of the Indian growth story? Do you think major realignment in national policy in this new that Indian financial markets are not as intimately world order which is emerging? connected with the real economies as in the western economies?
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No, I think our financial markets are less integrated with global markets. But financial markets are very important. So, if Indian financial markets are seriously disrupted, it will certainly affect Indian growth. But Indian financial markets are not that linked to global financial markets but over time this linkage will only increase. So, I think we need to be careful that this linkage is not putting in a situation of undue volatility or vulnerability. But I don’t think that at present it is.
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Well, I think our national policy should be aimed really at strengthening our own economy and the agenda for doing that has been well established and we should concentrate on that. Whether the international environment deteriorates a little bit, I don’t think it alters what is the optimum policy for us, it may alter the outcome of optimum policy. But I think we should be concentrating on taking care of the problems that we know are serious at home and they need to be addressed. So I would not be too distracted by the changes going on in the global situation. I think we should remain focussed on the agenda we set for ourselves. India’s growth is largely constrained by factors internal to India not by global developments.
A lot has been said about the need for structural reform to develop a strong financial market ecosystem in India. Do you think that in the long term, in the backdrop of the global economic crisis, policymaking must be focused towards strengthening these markets for sustainable economic growth?
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No, it is certainly true that debt markets in the global situation are much stronger. An important reason for that in India, of course, is that the fiscal deficit is quite high. The amount of sovereign debt that is available at any given time is very high. The government has said that they will reduce the fiscal deficit. If they reduce the fiscal deficit, then the available savings will look around for other assets because the yield on sovereign debt is likely to go down. As long as the government’s fiscal deficit is huge, it is very difficult for savers to prefer corporate debt. They may prefer corporate equity as there is a big upside but they would not prefer corporate debt. So really reducing the fiscal deficit is very crucial. I think another important thing is that we do need some institutional changes - more competitive insurance markets because these are the institutions that look for a high yield long term debt. That is happening but it is happening a bit more slowly than it should. But it will happen.
The belief that the developed financial markets of the world were efficiently regulated was completely shattered after the financial crisis. What do you think should be the role of regulators in the wake of aftermath of the financial crisis, particularly in India which is expected by many to take leadership in this new world order?
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You know financial market regulation is important everywhere. I think it is true that in our case the financial system was fairly tightly controlled. But let me say that I would say that in our case, a lot of freedom that other market players had was simply not available to our financial markets players. You know a good regulation is not one where you simply tightly control the institutions but rather the institutions have flexibility but they have a regulatory and a supervisory framework which emphasises that they do not take risks. In our case we did not allow them to take risks anyways. Basically, we are transiting towards a more liberal structure of the financial system which will give people more of a choice. As we do that we have to learn from the fact that extreme liberalisation but no supervision is a very bad idea.
I think globally there is a lot of thinking going on about how the financial markets should be regulated and how they should be better supervised and we have to learn from that too. The main learning that has come out really is that financial markets have to be well capitalised and that in boom years the inevitable tendency to give low quality lending i.e. reduce the quality of lending should be regulated. Both the regulatory and the supervisory systems should try to achieve that objective. Also there must be much more attention towards macro prudential regulations rather than micro prudential regulations. Both are important but micro prudential regulations are essentially the regulations that prevent an individual firm from taking risky decisions in an otherwise stable environment. Macro prudential regulations relate not to the decisions that individual firms may take but to instability that may come into the system because of a general change in the market conditions which will affect everybody. You can have a situation where each individual entity looks as if it is stable as long as macro conditions remain okay but if macro conditions change substantially, each one of them becomes instable. How do you avoid such a condition is the really the great test.
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One thing which has been produced post crisis is a better appreciation of the relative strengths of India
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With respect to increasing accessibility to the Indian financial markets, do you think there should be a greater focus on encouraging retail investments to increase the scope of financial inclusion?
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I am not sure if I want to push retail investors to pick individual stocks. As long as you have enough mutual funds being made available to investors, you have institutions looking after the interests of the retail investors and performing some kind of an averaging role. I think it will be a long time before our markets can have a large individual investor base. Money Manager / January 2011
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Broadly, has the financial crisis been a blessing in Would it be fair to say that you see the balance of power in global policymaking shifting in disguise for the Indian economy? coming years?
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I would not call it a blessing but there is no doubt that it has shown up a very significant weakness in the industrialized world. And therefore when people look at the relative attractiveness of investing in the emerging markets, they now appear to be a much better bet in the terms of long term returns and I think India is very well positioned in that context. That part is good. But maybe that realization could have come without having a financial crisis. I would put it that the financial crisis has imposed quite a lot of costs on the global economy not so much costs on us but some costs on us as well. However, one thing it has produced post crisis is a better appreciation of the relative strengths of India.
What are the advantages or the relative strengths that you see and how can India reap benefits from these?
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The major benefit that India would reap is that investors would perceive that the long term value of investing in India is higher than what they otherwise thought. Earlier they thought that they were getting fairly riskless returns in the United States and now with the deleveraging that has taken place and it continues to take place, such returns would not be possible. So, if people want better returns they will have to accept little bit higher risk and that will drive them to emerging markets and therefore to India.
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Well, that is not because of the financial crisis that is because of the underlying growth of the economic momentum– China, India and other countries in Asia. Definitely, the centre of gravity is shifting slowly. But these should not be exaggerated. Looking 25 years from now it definitely looks that the relative strength of Asia will be significantly higher than what it is now. And that is a good thing.
CHALLENGES
IS THE NEW WORLD ORDER PROGRESSIVE OR REGRESSIVE?
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INTERVIEW WITH SWAMINATHAN AIYAR The financial crisis has changed the global markets. Yes. But is this change going to last? Are the changes sustainable enough to herald a new system entirely? Are there fundamental flaws that work against the creation of a global financial ecosystem? These are some of the questions that will go through your mind when you think of challenges to the new world order. Mr. Swaminathan Aiyar puts into perspective, in no uncertain terms, his viewpoints regarding these issues. Read on.
Swaminathan Anklesaria Aiyar, Consulting Editor of The Economics Times, has been the editor of two of India’s biggest economic dailies, Financial Express in 1988 and 90 and The Economic Times in 1992 and 94. For two decades, he was also the India Correspondent of The Economist, the British weekly. He is a graduate of St. Stephen’s College, Delhi, and Magdalen College, Oxford. 60
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What are the elements of systemic risk, which you think are still present in the international financial system? How seriously do you think are these concerns being treated by regulators worldwide?
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There have always been vulnerabilities in the financial system. Fundamentally all financial systems are vulnerable. The banking system is fundamentally a con game since depositors are guarantee freedom of withdrawal, which is possible since the deposits are lent out to others. This makes it vulnerable when trust is called into question. The financial and banking system is so complex now that, in any government’s perspective, it is too large to fail. The financial system is so interwoven and interconnected that investment banks cannot be allowed to fail and they have realized that the international community’s backing is there and they are too big to fail. Even though the capital requirements have been raised for the international banks after the crisis, they have been given time till 2018 to cover these requirements, which is very gradual. Even today there are questions about the solvency of the western banks and they have been given considerable time to build up their balance sheets. So to an extent the vulnerabilities still exist, but the government guarantee is what is making the difference.
Do you think the regulations being made right now are making the system much more complex than they were before?
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Well, to begin with, the system itself is becoming much more complex than it was before. Complex derivative products did not exist earlier, and financial innovation is happening at a rapid pace. There is now a provision now that most derivatives will be traded through exchanges. But with the pace of financial innovation, there will be more products that will be created and they will not be traded on exchanges to reduce counterparty risk. Given that we are having more of innovation resulting in more instruments and thus more of financial headaches, vulnerability is very much there in the system. In my opinion, nothing that has been done can prevent a future systemic risk from coming in. Trying to keep pace with financial complexity has been happening for a hundred years. The complexity has increased, there have been the occasional crises and we have had the cleaning up act in the form of greater regulation and we have carried on. So, in my opinion, the key issues of concern will be the relationship governing commercial and investment banking and the regulation of counterparty risk in securitized financial products.
Given that governments worldwide are involved in fire fighting exercises in a bid to support flagging financial and economic systems, do you think there are concerns regarding government introduced distortions posing new dangers to this new world order?
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The issue is not in regulations, but the impact. The emerging economies in Asia and Africa have exhibited considerable resilience in surviving the impact of the financial crisis. Therefore the outcome is that the emerging markets and BRICs have increased their credibility as investment destinations. But the ultimate power balance remains with the west and this has not been affected by the financial crisis which affects economic growth only marginally in the emerging economies. When it comes to regulation in the western financial markets, the impact will be aimed at improving the creditworthiness of the local market and not against the emerging economies.
Are there any specific spill over effects which you think emerging economies will face as a result of corrective policy actions in the developed markets, particularly as a result of specific global imbalances which we are seeing currently in global trade and currency markets?
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There will be some attempts at protectionism by the economies. The war between the free-market lobby and protectionism will always exist and both sides have won some victories in the last 50-60 years. The real problem however is with the shift in manufacturing capacities being handed over to the emerging economies in the 1950s and 60s. This has moved abroad from the developed countries and it is not moving back even if protective tariffs are brought in place. This will only raise domestic prices without creating jobs or new investment, which, therefore, is not likely. Conventional tariffs may not be the case for services. Off-shoring, which represents a very visible segment of the imports of western economies, is a small part of total imports, and any measures to curb this will be populist rhetoric. Secondly, India & China can push for procurement and tendering by moving the WTO and end up getting a favourable outcome.
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Do you think that globally tightened and stringent regulatory measures will have drastic consequences for financial innovations like CDOs? Is that a serious concern in the financial market ecosystem?
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The point is there will be no end to financial innovation and it is for the regulators to decide when and how to regulate as new products keep coming up. But the whole point of innovation is about overcoming the regulatory barriers. This is the struggle. It is possible that regulators can pick up sufficient systemic and economic risks in products, but not all. The regulators should come up with disincentives to prevent risky innovation that exposes vulnerabilities in the market
What are the disincentives do you think the regulators should put in place?
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There are a large number of tools at the disposal of the regulators. Capital requirements for trading in specific securities should be increased. Some securities can be altogether scored off the sheet – like in India right now with some securities. CDOs came into play only after the US passed regulations legalizing their trading. So the regulators will have to play their cards carefully in harnessing the advantages and negate the ill-effects of financial innovation.
How do you see the regulatory agencies perform the balancing act so that meaningful innovation necessary to fund our future growth does not get stunted? Microfinance for example is an area where securitization of micro-loans has great social implications. This is obviously enabling better risk management and common man’s access to credit.
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Microfinance is an area where political sensitivity is high. You also have govt. backed microfinance schemes and they are competing with the private sector. The govt. will look to promote its own business. In India, this assumes special significance, as there is a political culture of encouraging default. Andhra Pradesh which has been a pioneer in micro-finance has a repayment rate of only around 90% in government-created self-help 62
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groups, when private microfinance enjoys around 98% repayment rates. If you have a situation where politicians constantly want to waive loans and get votes, microfinance gets exposed to a new risk. Securitization is ultimately a way of getting the loans off the books of the microfinance institutions and into those of the banks. This in principle is a great concept, but with the political ramifications of this industry, in a culture where default is encouraged for political gains – securitization can become a problem.
John Mack of Morgan Stanley made a case for an “uber-regulator” in the backdrop of the financial crisis. Do you see the movement for unification of all regulatory agencies under one umbrella as a distinct possibility? Do you see a strong motivation for such uber-regulators emerging in specific regional blocs like in the case of the Euro zone?
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The complexities are so great that a single regulator may not do. On the one hand there is a problem of a unified coordinator to monitor the activities of the regulatory agencies. Then there is a problem of acquiring particular expertise in a function. However, I have no over arching view on this. But within India, if we were to have insurance companies regulated by each state and banks regulated by each state, it would be very inefficient. So the point lies in unifying the banking & insurance regulators in the case. So ultimately it is about striking a balance in the function performed and the coordination between regulatory bodies.
INTERVIEW WITH AMAR BHIDE Capitalist economies have been defined by one factor very strongly – freedom of the Capital and currency markets. But the very same markets have now been subjected to regulations which are amongst the most stringent in their history. Amar Bhide, expresses his unequivocal view points on the the loopholes in financial policymaking and the dangers such regulations pose to the world economy.
Amar Bhide is currently the Thomas Schmidheiny Professor at The Fletcher School of Law and Diplomacy at the Tufts University. He is the author of A Call for Judgment: Sensible Finance for a Dynamic Economy published in 2010. Prof. Bhide earned a DBA (1988) and an MBA (1979) from Harvard. He received a B.Tech from the Indian Institute of Technology in 1977. Money Manager / January 2011
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Over the last two years many of the western economies which once extolled the principles of free trade, had to resort to more regulation and protectionism in order to boost their economies and protect local industries. How do you see this affecting the process of globalization and integration of financial markets around the world?
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I think the globalization of financial markets is largely independent of the globalization of real economies (which I think of as the growth of trade and the flows of direct investment). The two globalizations can advance strongly together or they can come to a halt together but the factors that drive them are different. Opposition to the integration of the real economies tends to come, unsurprisingly, from owners of businesses in the real economy and unionized workers employed in the real economy. Business owners and workers usually know little about finance or capital flows. It’s usually the central banks who worry about the flows of capital and who try to restrict the flows of capital. Of course if you had another financial collapse it would halt both capital flows and trade flows so you could see both globalizations stop due to a common cause.
One more thing that we have seen during the financial crisis is the importance of the role of regulators which you have mentioned in your book- “A Call for Judgment” as well. We have seen that regulators tend to follow the advancements that happen in the industry rather than trying to be more proactive and their policies are never pre-emptive. Do you see the role played by regulators across the world getting more dynamic in coming years and to move in line with financial innovations and the way things happen in the financial industry?
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As I have argued in my book and as other people have argued as well, regulators got seduced by claims for financial innovations to a degree that made no sense, perhaps because regulators and innovators were indoctrinated in the same ideology. They bought into the theory of complete markets and a slew of other assumptions of modern finance. I do not think that, at least in the US, the cast of characters and their mindset has changed much.
We now need much stricter regulation, but not in every area of finance. I argue in my book that securities market regulation is probably unnecessary or even counterproductive whereas banking regulation is and always has been crucial. One can easily imagine a securities market functioning more or less satisfactorily without much regulation. A stable banking system seems inconceivable without fairly tough laws, however. But what we had over last 30 years was securities regulation, which probably wasn’t necessary to start with, becoming tighter and banking regulation, which absolutely needs to be very tough, becoming looser. This divergence may have been partly due to the differing mindsets of regulators. Lawyers have pretty much dominated the enforcement and formulation of securities laws. In banking, economists have had much more influence as the Federal Reserve’s role in bank regulation has grown.
So you are still concerned about misregulation?
—
I think the problem has become worse, if anything. The Dodd-Frank Act is practically unenforceable because it places a mountain of new responsibilities on regulators, a great many of which have nothing to do with maintaining financial stability. I think regulators are going to be overwhelmed and less capable of focusing on what is really important.
Could you please illustrate some of the events in 1990’s and 2000’s which connect to what you have been saying from the regulation point of view and that have enabled the finance industry to make such innovations and deviate from how the banking practices had been in the 70’s and 80’s.
—
My book traces back the unravelling of the banking system to the 70’s. To summarize the argument very briefly: The Banking acts of 1933 and 1935 had created a pretty good structure for bank regulation. This was the culmination of an evolutionary process that had started in the early 1800’s.The acts were deficient in one important aspect however as they preserved a highly fragmented banking industry that was out of sync with the real economy. After the first and second industrial revolutions, the real economy became quite concentrated with the top 500 companies accounting for about half of real economic activity. And big businesses needed big banks to extend credit. But because of an ancient fear of the concentration of finance, banks weren’t allowed to grow. They couldn’t open many branches and they could not operate across state lines. So we had a mismatch between industry, with big companies like General Motors and Boeing, and small banks who could not satisfy their credit needs. If you put that aside, bank regulation was well done.
Unfortunately, the inflation that started surging in the early 1970’s made it impossible to sustain what had been an an important piece of the banking acts, namely the regulation of interest paid on deposits. The rule back then was: 0% interest on demand deposits and interest on time deposits to be regulated by the Fed. As long as the inflation rate was close to zero, people tolerated getting no interest on their demand deposits, but as inflation jumped to 4-5%, a 0% interest rate on demand deposits became untenable. Money market funds were established that bought risk free treasury bills that paid close to the inflation rate and shares in money market funds became a compelling substitute for bank deposits. That was the beginning of the end. Money markets funds stopped buying just treasury bills. They bought higher risk instruments such as commercial paper that could give money market fund holders even higher rates of return. And besides having the freedom to pay higher rates than banks, money market funds did not have to pay salaries to lending officers or bear any other due diligence costs. They were pure free riders. At this point the banks could have made the argument to regulators that this was ridiculous: money markets comprised an unregulated and uninsured deposit taking system that regulated banks could not compete against. But banks did not do this, because the ethos in ‘70s favoured deregulation and the freeing up of all markets. Rather banks lobbied to start their own money markets funds. The supposedly more progressive banks of the time also became enamoured with the business of securitizing credit and selling and speculating in derivatives instead of making old fashioned loans and lobbied for more banking powers. By 1990, most of the restrictions on what banks could do, which had been imposed by the 1933 and 1935 bank acts were gone all but in name. The actual repeal of the Glass-Steagall Act in 1999 was to some degree almost a formality. The particular manifestation that the 2008 crisis took may have been the result of what happened in the previous five or six years but the deep corrosion of the foundations of the banking system had occurred well before 2000.
“
Whether it is quantitative easing or stimulus packages, it all strikes me being not much better than black magic
”
The Fed recently announced another round of quantitative easing and there is lot of hype about what Fed has been doing - whether it is actually having the desired effect Fed wants to achieve. Do you think Fed’s policies - trying to push medium and long term interest rates down, like quantitative easing is working and at a larger level, do you think Fed is currently running out of monetary policy tools which it has in order to boost the economy?
—
I am sceptical of the role of government in managing business cycles. I can’t prove that governments can’t control business cycles but I see no evidence that they can. The kind of evidences that people produce to argue for doing this or the other to speed the recovery seems unconvincing. To me, economies have quite a capacity for self healing and regulators have no reliable tools to speed this process. Whether it is quantitative easing or stimulus packages, it all strikes me being not much better than black magic. Think of medical devices designed with the best knowledge we have of human physiology and tested extensively on animals. Yet they routinely fail when used in the human body because of complex interactions that no one can anticipate. I don’t think our knowledge of the economy is any better than our knowledge of human physiology so it is imperative that we proceed with extreme caution, avoiding treatments that may or may not work in the short term but very likely could have huge long term consequences. Why risk the long term fiscal stability of the economy with measures backed by far less evidence than we demand before allowing a new drug or medical device to be put into use?
You have written -an article in WSJ- “Lets break up the Fed!” where you criticized the Fed and you advocate breaking it up. What structure do you have in mind when you talk about breaking up the Fed?
—
At a minimum, the structure should be like that of the ECB. The ECB is primarily responsible for monetary policy and has no bank supervisory or oversight responsibilities. Let me also say that getting that right structure is necessary but not sufficient. You can have the right structure and regulators can still mess it up. But if you have the wrong structure, you virtually mistakes. Money Manager / January 2011
65
Absolutely. There has been a lot of hustle in the currency markets of late, with the Chinese issue and concerns around Euro rising again with Ireland’s bankruptcy and other bailouts. It seems that the currency markets are acting as an impediment to the already weak recovery of the world. So how do you see the impact of these currency wars on the global recovery and can the regulators or industry do something to curb this?
—
The role of developing countries in the whole recovery has kind of changed in last 2-3 years and the impact of crisis was quite a bit limited in these countries. How do you see these economies responding going ahead, and do you think there will be some growth offset in the recovery and some sort of response from the developed economies to curb this growth offset?
—
Currency markets are capricious. There is rarely much rhyme or reason for why the Euro oscillates as it does for instance. I make a little bit of money on it periodically, so I am not complaining loudly (laughs). And from a policy point of view, what is the alternative? The volatility of the currency markets is like the monsoons in India, you wish they were more regular and predictable, but they are not.
The fact that Brazilian finance minister mentions the term “currency wars” and then this entire hype about this whole issue is a bit disconcerting that over the last 6-7 months there has been so much talk about it.
—
It may seem to the Brazilians that the Fed has embarked on a proactive policy to debase the dollar through quantitative easing. But I don’t think competitive devaluation is what the Fed has in mind. It’s just an unfortunate side effect, which is one more reason why we should not have quantitative easing.
66
Money Manager / January 2011
Most economic policies in large countries tend to be based on domestic factors; China is a bit of an outlier in this, it is the only large economy that I can think of, that is highly dependent on what happens outside and likewise the outside world has now become incredibly dependent on what Chinese do and don’t do. The Chinese are in some sense prisoners of their own success: they have this fantastic manufacturing and export machine but in the end it produces US treasury bills and the Chinese cannot eat US treasury bills in the long run. And the more they accumulate these T-bills, the harder it becomes to do anything about them.
STUDENT ARTICLES
“
FIRST PRIZE
GLOBAL CURRENCIES a tectonic shift or a muted whimper? With the world seeing a crisis every half a decade, it looks quite imperative to hedge oneself against billions of dollars piled up in one’s Treasury. In the wake of the ‘Chinese Suspicions’ we explore the reasons why Dollars was like an ‘Unparalleled Ruler’ in the 1980’s who had no other opponents to challenge him in his prime, but now after almost two decades he has become weak and is susceptible to challenge by the new-age warriors (Euro, Renminbi, etc). This article identifies the need to end the ‘Dollar Hegemony’ and then explains the inability of Euro, Renminbi, SDR, WOCU, etc to replace the dollar. Thus in such times the best possible and most efficient solution is a set of norms imposed (possibly by the IMF) on ‘Reserve Currencies Management’ that will be followed by each country.
the authors — Sumit Agarwal 2nd Year student at MDI, Gurgaon Pursuing dual degree in Finance and Marketing along with CA, CFA, CAIA and FRM. He developed a strong foundation during his graduation in Economics
Devi Prasad Biswal 2nd Year student at MDI, Gurgaon Pursuing dual degree in Finance and Strategy along with CFA He gained very strong analytical skills during Computer Science Engineering
Aditya Narayan Jha 2nd Year student at MDI, Gurgaon Pursuing dual degree in Finance and Information Technology along with FRM. He finds his interests in Psychoanalysis and Behavioral Finance 68
Money Manager / January 2011
history of rise of the ‘dollar’ (usd) —
The Dollar supremacy story started with the establishment of the Bretton Woods system in 1944. By the end of World War II, a vacuum was created in the international financial system due to the downfall of Pound Sterling. A requirement of a new global currency to rejuvenate the world economy got 44 allied nations to gather in Bretton Woods where dollar took over the role played by pound sterling/gold in previous international financial system. In 1971, when the Bretton Woods system was revoked by U.S, there was no currency which could challenge dollar to become the international currency. Thus, a free floating regime ensued with dollar continuing as the dominant currency (dollar - fiat system).
FIRST PRIZE
—
US: The Shrinking Superpower It was assumed that, American military dominance in the Middle East and a series of “regime changes” would eliminate the eurothreat that dollar had while quoting oil. An opposite chain of
Increasing US Debt The U.S national public debt has reached around 67% of its GDP in 2009 (much higher than historic level of 30%-50%) and the official non-partisan Congressional Budget Office predicts it to cross 100% of GDP (by looking at the current policies) by the end of the decade. It found that a 5% increase in the outstanding stock of US treasury debt relative to Eurozone government bonds is associated with an 8% depreciation of the dollar on average.
W.BUSH
CLINTON
CARTER
NIXON FORD
KENNEDY LBJ
. THE NATIONAL DEBT AS A PERCENT THROUGH 90% TRUMAN OF GROSS DOMESTIC PRODUCT SEPT 30 2008 . 80% [DATA FROM WHITE HOUSE.GOV] . 70% . 60% . 50% . 40% . 30% . 20% . 10% . 0% . . . . . . . 1950 1960 1970 1980 1990 2000 2010
Source: MDI Library database
Source: Circles Phenomenon Research International (CPRI)
some of the prominent reasons of concern with dollar hegemony
events has occurred, with the impetus coming, not from OPEC, but from an increasingly confident and assertive Russia. Putin made his stand clear - a straight bargain chip with the EU and an implicit threat to the United States (export oil in Euros). The “sole superpower” cannot stop him, but must instead come up with terms that outweigh the benefits of Euro-shift. The Bush Pirate’s quest for a global market subordinate to American fiat has failed. This shift in the global relationship of forces should have been expected when Bush declared war against world order. It is the logical result of, and answer to, the president’s 2002 ultimatum, “either you are with us, or against us.” The planet now prepares to turn on its own axis. Henry C. K. Liu got it right in his farsighted Asia Times interview, “The War that may end the age of superpower.”
IKE
Post the 1973 Middle East Oil crisis, US made unofficial pacts with major oil producing nations to provide military cover and political support in exchange for trading oil denominated only in US Dollars with all other countries. Hence, for a country which did not have enough oil reserves (or did not want to utilize them because of strategic reasons), the only way of procuring oil was to pay with dollars. Thus, with increasing demand for oil across the globe, the demand for the dollar was artificially inflated, thus making the dollar a globally circulated currency. The deregulation of financial markets post Cold War further facilitated the flow of cross border funds routine. With the US government supporting the Dollar participation in international markets and helping it become the reserve currency for most of the countries since two decades; Dollar currently stands as the most credit-worthy, most liquid and the deepest currency in the world. The recent global turmoil and financial crisis in the U.S threatened to dethrone the dollar. Economists and analysts around the world have not restrained themselves in pointing out the weaknesses of the dollar. As Kenneth Rogoff, former IMF chief economist puts it- There are “lots of reasons to be concerned about the dollar. But a weaker dollar is a fantastic boost for the United States, and it’s a problem for the rest of the world”.
Thus foreign governments worry that the US might consider reducing the real value of debt by allowing for a higher inflation rate and hence effectively reduce the real value of their investments. China which is believed to be holding $ 1.2 trillion of its reserves (out of around $ 2.6 trillion) in dollar assets would lose $ 1.2 billion for every 1% weakening in the dollar
Dollar’s diminishing role as a Reserve Currency Even though the dollar still dominates the reserves held by most of the major countries, a recent trend has been that of diversification to other currency assets. China has recently made investments in yen assets (thus $ losing around 8% to the ¥), while both Russia and Brazil have been net sellers of the US treasuries in the past 12 months. “The real concern remains ongoing fall in foreign demand for US treasuries as issuance is expected to rise over the next several years on larger fiscal deficits,” says Michael Woolfolk, senior currency strategist, The Bank of New York MelMoney Manager / January 2011
69
FIRST PRIZE lon. Without greater foreign demand, domestic demand may not keep pace, he points out. “If so, higher interest rates will be the eventual outcome,” he says.
The Asian Region Currency Partnership
Japan, under the leadership of then Prime Minister, Yukio Hatoyama led the charge to form a regional currency partnership based on closer ties between itCURRENCY COMPOSITION OF FOREIGN EXCHANGE RESERVES (WORLD) self, China and South Ko[IN USD MILLIONS] 2002 2003 2004 2005 2006 2007 2008 2009 rea. At the Association of 1795994 2223203 2655173 2843625 3315575 4119398 4210072 4563579 ALLOCATED Southeast Asian Nations RESERVES (ASEAN) discussions in CLAIMS IN USD 1204673 1465752 1751012 1902535 2171075 2641671 2698423 2837121 late November, 2009, the 0.659297 0.659472 0.669053 0.654811 0.641276 0.640945 0.621688 % CLAIM IN USD 0.670756 trilateral meeting unaniSource: International Monetary Fund mously concluded saying - “until now we have been too reliant on the United States” and ‘Black Gold’ set to be quoted in “we would like to develop policies that focus more on Asia”
non-dollar Currencies
Middle Eastern nations and OPEC members are increasingly getting inclined towards non US Dollar trading baskets. There have been confirmed talks between Gulf Arab and Chinese representatives in Hong Kong of oil trade in non-dollar denomination. Brazil along with India has shown interest in collaborating in non-dollar oil payments. Iran and Venezuela have taken the lead and have proposed trading oil to a basket of currencies, but haven’t yet garnered enough support from the OPEC nations, mainly Saudi Arabia. Iran has increased the amount of its oil export earnings in currencies other than U.S. dollars to about 70 percent. Moreover as previously mentioned the world second largest exporter, Russia has even started trading oil in Euro terms. Putin did that intentionally in order to remove US self – proclaimed supremacy over the world. Putin had seen Bush beating the flesh out of the Middle- East in its undercover of helping Saudi Arabia getting independence from Saddam Hussain reign.
Decreasing share of dollars in global forex market The share of the USD in the global forex market has decreased gradually albeit in small amounts over the past decade. This underlines the fact that market players are gradually
“
‘WOCU’ could be the foundation to a future unified currency which would act a totally apolitical instrument
”
increasing transactions in currencies other than dollars and hence other currencies are set to gain significance importance in the future. The share of major currencies in the foreign exchange market as of April 2010 is shown in Figure 2. 70
Money Manager / January 2011
CURRENCY DISTRIBUTION OF GLOBAL FORIEGN EXCHANGE MARKET TURNOVER 2002
2003
2004
2005
US DOLLAR
89.9
88.9
85.6
84.9
EURO
37.4
37.4
37.0
39.1
JAPANESE YEN
23.5
20.8
17.2
19.0
POUND STERLING
13.0
16.5
14.9
12.9
AUSTRALIAN DOLLAR
4.3
6.0
6.6
7.6
increasing risks with weakening dollar —
Credit Risks With decreasing footprint of United States as the military and economic superpower and increasing US debt, serious credit issues on the US government abilities to defend its securities might crop up. Additionally, considering the plethora of recessions that have been seen during the last decade the future decade promises the world to be a cyclone. In such uncertain events, the US government will definitely have a tough time ensuring its ability to be the world’s greatest creditor.
Devaluation Risks The US government is coming up with expansionary fiscal and monetary policies quite intermittently post 2008 crisis. Also incentives of the US government to have slightly higher inflation back home to reduce debt burden, have made the Chinese Treasury a bit suspicious about holding dollars. In its effort to slightly diversify its holdings, it suffered huge losses on account of dollar devaluation. The Chinese are riding a tiger without a way to get off it.
FIRST PRIZE
— Euro The euro is often seen as the challenger. Its large denomination banknotes have been instantly adopted around the world. Even though the Eurozone is faced with similar challenges as the U.S, the outstanding stock of U.S treasuries grew at a double pace of that of Eurozone government bonds since the start of 2009. The Federal Reserve reckons that half of the dollar bills ever printed circulate outside the United States, representing an amount of $400 billion while, the European Central Bank reports having shipped in just one decade about €100 billion worth of banknotes outside the euro area. These are impressive numbers but they refer to just one aspect of what makes a currency international. The foreign exchange reserves of central banks are held in interest-yielding public debt instruments, not cash. Obviously, these must be safe instruments, which would presumably exclude a large number of Eurozone governments. The safest euro-denominated instruments are issued by the German government. Central banks want these instruments to be not just safe, but quickly sellable in case of emergency. Unless the market is deep enough, emergency sales may resemble fire sales that entail capital losses. The market for US Treasuries is the world’s deepest. The total value of existing US public debt instruments is nearing $9 trillion, of which $500 billion is traded on an average day. German debt instruments amount to about $1 trillion, with an average daily turnover of less than $30 billion. The situation is similar for French debt instruments. The United States, thus simply plays in a different league. Of course, things can change over time. Turnover can increase but German government debt will remain small, unless it is multiplied several times over, in which case it would be relegated to junk status. Bank for International Settlements surveys also indicate that euro turnover beyond Europe is only around 20% where as the Dollar is more evenly distributed all around. Although the European Union has European Central Bank, there is no single European treasury. Instead, there are 27 European treasuries. Investors cannot easily track or influence fiscal policy on the continent. Also the ECB does not have a goal of Internationalization of the Euro. Similarly, Euro lacks depth and liquidity in capitalmarkets.UK is still not part of the Euro zone which leaves London, a major financial centre still without Euro monetary controls. The events of the Euro crisis of 2010 have also brought severe doubts to the credibility of the Euro and the existence of the Eurozone in the future. But, we believe that the Euro has overcome the challenge by providing the financial support to Greece (and implicit guarantees to other states in need) and hence has strengthened further.
Renminbi Currencies like Renminbi are likely to achieve international status as it is issued by a large emerging country. However, Renminbi as a replacement is a very long proposition. For this to happen not only the Chinese economy has to grow considerably bigger (which it very likely in the near future) but also it must develop large financial markets, fully integrated in world exchanges, and the Chinese government must issue top-rated public debt instruments. Currently, renminbi is plagued by lack of full convertibility and the Chinese markets are not integrated and for various reasons, the financial credibility of local authority is limited. Even with China’s increasing importance in the international trade markets, it is not necessary that other countries use the Renminbi as the invoice currency as historically neither Yen (almost half of Japan’s exports are invoiced in dollars) nor Sterling (almost quarter of Britain’s exports are invoiced in dollars) gained such prominence. Similarly for Renminbi to be a major reserve currency, central banks around the world will have to divest from U.S. assets and Treasury bonds causing USD prices to crash and Renminbi Prices to rise drastically, resulting in paper losses, which would cause major loses to the Chinese reserve dollar assets.
The Phoenix - I: SDR Special Drawing Rights (SDRs) were created by the International Monetary Fund in 1969 in an effort to stabilize the international foreign exchange system. Its value is based on a basket of four key international currencies – US Dollar, Euro, Yen and British Pound. The exact amounts of currency making up SDRs are determined by the IMF Executive Board in accordance with the relative importance in international trade and finance every five years. The currency composition of the SDR for the period 2006-2010 is 44% USD, 34% EUR, 11% JPY and 11% GBP. The IMF’s so-called Special Drawing Rights could be used as the basis for a new currency. Arguments against making SDR the world’s reserve currency include the fact that the US dollar, the Euro and the Pound – which make up the large majority of SDRs – have all lost value since late 2007 when the recession began.
COUNTRY WEIGHTINGS NOVEMBER 2009 INDONESIAN IOR POLAND POZ NETHERLANDS EUR KOREAN KRW AUSTRIAN EUR
BELGIUM EUR
TURKEY YTL
MEXICO MXN INDIAN INR CANADA CAD BRAZIL BRL SPAIN EUR UNITED STATES USD RUSSIA RUD ITALY EUR
UK UBP
FRANCE EUR
GERMANY EUR
CHINA CNY
JAPAN JPY
Money Manager / January 2011
Source: www.wocu.com
seeming alternatives
71
FIRST PRIZE Why replace a falling dollar by an index which so heavily includes the dollar? Also, SDRs do not contain participation from emerging markets, like the Chinese Renminbi, Indian Rupee, Australian Dollar or Canadian Dollar, all of which are important benchmark or secondary global reserve currencies. However, even if the dollar is replaced by the SDR, the IMF does not have the financial prowess to safeguard the exchange risk. SDRs would have to be delinked from other currencies and issued by an international organization with equivalent authority to a central bank in order to become liquid enough to be used as a reserve. To make SDR the principle reserve asset, close to $3 trillion in SDRs would have to be created (Currently, it comprises 4% of world reserves). There is a need for a wider basket of currencies in SDR in order to be accepted as a global currency. It would provide a more efficient, fairer and more stable basis for our globalised economy. But however, this is not a quick or a short or easy decision and if at all it happens it would be quite revolutionary.
The Phoenix – II: World Currency Unit (WOCU) The ‘WOCU’ is a synthetic currency, introduced by WDX organization & created from a balanced basket of the currencies of the top 20 countries in the world ranked by GDP, weighted based upon each country’s GDP as a proportion of the total GDP of those top 20 countries. Hence WOCU being a balanced basket of 20 economies makes its structure much less volatile. ‘WOCU’ could be the foundation to a future unified currency which would act a totally apolitical instrument, thus avoiding international disagreement over a particular currency becoming the global reserve currency. Compared to the SDR, the ‘WOCU’ is better balanced and its constituent currencies are updated every six months compared to 5 years in case of SDR. Since it has no political interference, it is better suited to the conduct of global trade in the 21st century. However problem like lack of financial muscle to safeguard exchange rate risk remain. The following graph shows the stability that ‘WOCU’ has as compared t o a single currency – Euro.
1.800000-
VOLATILITY FROM BASELINE- USD PRICE BASED
1.6000001.400000-
EURO
1.000000-
Source: Ian Hillar Brook (WOCU)
1.200000WOCU
0.8000000.600000-
72
Money Manager / January 2011
2009-
2008-
2007-
2006-
2005-
2004-
2003-
2002-
2001-
0.200000-
2000-
0.400000-
diversification argument: way forward —
There are numerous factors which play in favor of the dollar including its size, liquidity, depth of US capital markets and stability of the dollar asset markets, particularly the short term government securities market where the central banks tend to be the most active. The foreign exchange reserves of central banks around the world are held in treasury bills. The total amount, $4.4 trillion, is about ten times the value of greenbacks held outside the United States with the dollar’s share of foreign exchange reserves currently at 62 percent. Another factor which favors the dollar is the natural advantage of its incumbency. As one study (Goldberg and Tille, 2005) concludes: ‘The role of the dollar as a transaction currency in international trade has elements of industry herding and hysteresis’ that mitigate risks against rapid change. Thus, often ingrained habits and institutional rigidities have favored the continued use of the dollar. But it might be possible for there to be a tipping point when everyone starts migrating directly from the dollar to another, it is not necessary for only one international currency to exist. For such a transition international bodies like the IMF can possible come up with ‘Code for Reserve Currencies Management’ similar to Basel II norm for Bank Capital Management. - Countries would seek to optimize the Markowitzian Risk-Return characteristics of their foreign exchange reserve portfolios by diversifying them. - The sheer size of today’s global market means there is enough room for liquid and deep markets in more than one currency. -The view of there being only one international currency is inconsistent with history- there were three international currencies before 1914 (British Pound, French Franc and German Marc), the Dollar and the Pound shared international primacy in the 1920’s and 1930’s and even today almost 38% of identified reserves are in currencies other than dollars. Hence while the idea that there would be a sudden switch to another international currency seems a bit farfetched as of now, it is more likely that the Dollar, the Euro and the Renminbi would share the roles of invoicing, reserve and settlement currencies in the years to come. Each of these currencies has its own concerns: -America’s twin fiscal and external deficit may weaken the demand for Dollars. -Concerns about the European Union and its ability to hold together its members in the light of the Greece Debt crisis might undercut the Euro.
FIRST PRIZE 0.5 0.5
-Although China is gaining prominence in the international stage and encouraging the international use of the Renminbi, there is a long way to go before it is an attractive vehicle for international investments and holding reserves due to its currency convertibility norms. But the fact that each of these currencies has underlying questions would mean that none of these currencies would singularly dominate and there would be a global market for all three. Future may hold for us a ‘Currency War’. Such an idea would eliminate inefficiencies and would bring handsome opportunities for the investors!
CURRENCY FORECASTS EURO/USD
0.5 0.5 0.5
A
S
0.5
O
N
D
J
F
M
A
M
J
J
A
S
O
N
D
J
F
M
2010
2009
0.5
A
M
J
J
M
J
J
M
J
J
2011
JAPAN YEN/USD
0.5 0.5 0.5
A
S
0.5
O
N
D
J
F
M
A
M
J
J
A
S
O
N
D
J
F
M
2010
2009
0.5
A 2011
UK POUND/USD
0.5 0.5 0.5
A
S
N
D
J
F
M
A
M
J
J
A
S
O
N
D
J
F
M
2010
2009
0.5 0.5
O
A
references
2011
Articles in Journals
SWITZERLAND FRANC/USD
- IMF, 2010, “IMF Research Bulletin”, Vol 11,
0.5
Number 2, Pages 1-12
0.5 0.5
- Global Finance, 2009, “Dollar Secure in A
S
N
D
J
F
M
A
M
J
J
A
S
O
N
D
J
F
M
2010
2009
0.5 0.5
O
A
M
J
J
its Role as World’s Key Reserve Currency,
2011
Analysts Say”, Sep, Pages – 1-4
CANADA CAD/USD
- Ian Hillar Brook, 2009, “The World Currency
0.5
Unit: What does this mean for treasurers?”,
0.5 0.5
Feb, Pages 1-9 A
S
N
D
J
F
M
A
M
J
J
A
S
O
N
D
J
F
M
2010
2009
0.5 0.5
O
A
M
J
- Cofer, 2010, “Currency Composition of Of
J
2011
ficial Foreign Exchange Reserves”, Pages 1-8
MEXICO MXN/USD
- Ronald Mckinnon, 2002, “The Euro versus
0.5
the Dollar: Resolving a Historical Puzzle”
0.5
Feb, Pages 1-4 A
S
N
D
J
F
M
A
M
J
J
A
S
O
N
D
J
F
M
2010
2009
0.5 0.5
O
A
M
J
J
2011
BRAZIL/BRL/USD
0.5 0.5 0.5
A
S
O
N
2009
D
J
F
M
A
M
J
J
A
S
O
N
D
J
F
M
2010
A
M
J
J
Source: Global Finance, 2009
0.5
2011
Websites - Retrieved Nov 3, 2010, from http://www. globalresearch.ca/articles/BLA310A.html - Retrieved Nov 3, 2010, from http:// www.nytimes.com/2008/05/11/business/ worldbusiness/11iht-11goodman.12761804.
-FORECAST
- Retrieved Nov 3, 2010, from http://www.washingtonpost.com/wp-dyn/content/article/2009/03/23/AR2009032301782.html - Retrieved Oct 28, 2010, from http://www.colinandrews.net/2012-Economy.html - Retrieved Oct 29, 2010, from http://www.wocu.com/wocu/the_charts.php#nov2009 - Retrieved Oct 30, 2010, http://www.colinandrews.net/2012-Economy.html Other Sources - Most traded currencies 2010 - Most popular currencies - What Are The Exotic Currencies And How It Affects The Foreign Exchange Markets.mht (MDI Library database) - Factsheet -Special Drawing Rights (SDRs).mht (MDI Library database)
Money Manager / January 2011
73
SECOND PRIZE
CHINA’S DOLLAR TRAP a historical perspective
the authors —
Aravind Vijayasarathy N
a PGP2 student at IIMA and follows the financial markets with keen interest. He can be reached at 9aravindv@iimahd.ernet.in
S Harun Thilak a PGP2 student at IIMA and interned with Nomura in Singapore. He can be reached at 9sharun@iimahd.ernet.in
V M Avinass Kumar a PGP2 student at IIMA and his areas of interest include M&A and financial and economic history 74
Money Manager / January 2011
The Great Depression’s impact was accentuated in Europe by the hammering of the chief currency of the region at that time – the Pound-Sterling. The party to be majorly blamed in this regard – The Bank of France which mismanaged its reserves of the Sterling in the late 1920s and early 1930s. This resulted in large scale contraction of European economies that had a feedback effect on the US. The second crash of the world markets in 1933, post a nascent recovery period from 1929, can be in part attributed to this. Fast-forward to the 21st century, a crisis of similar proportions is unfolding, so is a recovery. Here too is a nation, China, an emerging superpower that has driven itself into a dollar trap and is on tenterhooks as to how to manage its reserves. What China does from here will have implications for the recovery from this crisis and the future of the international monetary system. Through this paper we seek to analyse factors that will influence China’s decision making and address 3 key questions. How China can react to this situation and what will be its impact? What lessons can China learn from France’s debacle? and What significance it holds for the nascent recovery from the global financial crisis of 2007?
SECOND PRIZE
40000-
GOLD STERLING
OTHER UNDOCUMENTED
1935-
1934-
1933-
1932-
0-
1931-
20000-
1936-
source: bank of france archives
60000-
1930-
The period during the late 1920s and early 1930s was a period where international cooperation was intertwined with conflict. During this period, the global superpowers Great Britain, the United States and France established a gold exchange standard. The re establishment of the gold exchange standard was discussed vehemently in the Genoa Conference of 1922 and it was taken by the above mentioned superpowers in the late 1920s. It enables central banks in these countries to hold foreign assets denominated in gold convertible currencies as part of their foreign reserves. In each country, parity was constituted between the prevailing currency and gold which was maintained through coordinated action on exchange markets. The gold exchange standard found its backing from the superpowers in order to prevent world deflation by reducing the risk of monetary gold scarcity (BIS 1932, Hawtrey 1922)
80000-
1929-
—
CHINA’S CURRENCY RESERVES AS % WORLD GDP 100000-
1928-
france’s foreign reserve management – 1930s
DOLLAR
was to limit the risk of capital loss on its sterling holdings on the account of a highly probable sterling devaluation. Paul Einzig (1932) believed that French monetary authorities were using their reserves as a “fighting fund” in the financial war against Britain. On the other hand, Bouvier (1989) believed that the accumulation of large gold reserves were part of a holistic strategy employed by France to make Paris as a major financial centre. However, the Bank of France could not simply liquidate all its sterling holdings in one-go as it was concerned that its actions would have brought about widespread criticism as well as hastened the fall of the sterling. It started converting its sterling holdings to dollar and gold in the late 1920s at a temperate pace.
france’s reserve policy in the gold exchange sterling trap standard — — The Bank of France was a private organization during this period and its motives outlining its reserve policy can be attributed to minimizing the risk of capital loss. Its foreign reserves were allocated between the sterling, dollar and gold. After the franc was stabilized in 1926, the French government mandated the Bank of France to buy foreign exchange on the market, in order to avoid excessive currency appreciation (Blancheton, 2001). Exhibit 1 shows the portfolio composition of the reserves held by the Bank of France. In the late 1920s Bank of France held more than half of the world’s volume of foreign reserves. However, there were some pressing issues with the gold exchange standard. The currency parity with gold established during the stabilisation years was a major cause for concern. It was believed that the sterling which was stabilised at its pre-war gold parity was overvalued compared to currencies like the franc and the reichsmark (Keynes, 1925). Moreover, France along with the United States were criticised for hoarding gold. Bank of France anticipating a sterling devaluation started rebalancing its reserves portfolio by liquidating its sterling holdings for the dollar and gold. Many theories have been put across for this rebalancing. One clear aim of the rebalancing
From 1929 onwards, it became clear that France was trying to offload its sterling holdings in favour of the dollar and gold. Exhibit 1 shows the variation in the portfolio composition of the reserves held by the Bank of France. Exhibit 2 shows decline in the Bank of France’s sterling reserves during this period while Exhibit 3 shows the corresponding increase in the dollar reserves. The liquidation of France’s sterling holdings expedited the fall of the sterling leading to its eventual devaluation in 1931. The major consequence of the sterling’s devaluation was a capital loss of about 2.3 billion francs on the Bank of France’s sterling holdings. This loss had a disastrous impact on the Bank of France and it required the support from the French Treasury to cover the losses (Moure, 1991). Furthermore, the Bank could no longer have autonomy over its foreign reserves policy. One question which is relevant and concerns us in this paper is – If the Bank of France had expected a sterling devaluation, why did they still have to suffer a huge capital loss? This is the quintessential trap that a country which holds a large amount of foreign currencies as part of its reserves finds itself in when the currency is on the verge of devaluation. Any offloading of the currency holdings would hasten the process of devaluation thereby leading to large capital losses. In that scenario, what could a central bank do? Let us examine what the Bank of France did in the 1930s. Money Manager / January 2011
75
SECOND PRIZE FRANCE’S GOLD RESERVES DURING
BANK OF FRANCE’S STERLING BALANCES (IN MILLIONS POUNDS)
50-
160
BANK OF FRANCE’S DOLLAR BALANCES (IN MILLIONS $) 700600-
X
X
200-
1935-
1934-
1933-
1932-
1931-
1930-
1929-
1928-
100-
1936-
300-
source: bank of france archives
500400-
The Bank of France had started offloading its sterling holdings from the late 1920s as shown in Exhibit 2. However, it could not go all-out in its off loading for the fear of completing destroying the sterling, incurring massive losses and completely annihilating the international financial system. It had to be prudent in its offloading of its sterling holdings. It was carrying out its offloading in small measures and even had a change in attitude towards the sterling. As seen from Exhibit 2, between October 1930 and June 1931, it stopped offloading its sterling reserves and intervened in the exchange market in those early months to support the sterling. It also granted credit of 25 million pound-sterlings to the Bank of England in July 1931 (Moure, 1991). But all this was not done as a long term measure to prop up the sterling. Bank of France wanted to minimise its risk exposure and began offloading its sterling reserves as soon as the sterling strengthened. This temporary support for the sterling is clearly in line with what can be expected from a large player in the foreign exchange market who possesses considerable sterling reserves. The Bank of France officials have been quoted as saying that “(we) seized every chance to liquidate our sterling pound holdings but circumstances were far from favouring full implementation of this policy”. The Bank further said that it did not want to “provoke the depreciation of a currency in which it had considerable holdings”. These responses show that the Bank of France was well and truly caught in the sterling trap and the only option was prudent support of sterling and consequent offloading of sterling reserves in order to limit the capital loss of its reserves. The lack of cooperation between central banks of the industrialized powers was one of the key triggers of the sterling selloff by France. Central banks were driven by two motives – the first was to minimize capital loss on their positions and the sec76
Money Manager / January 2011
15-
FRANCE
105-
1932-
1931-
1930-
1929-
1928-
1927-
1926-
1925-
1924-
1923-
UNITED KINGDOM 1913-
0-
source: seeking alpha, 2009
20-
1936-
1935-
1934-
1933-
1932-
1931-
1930-
1929-
1928-
20
source: bank of france archives
25-
80
0
UNITED STATES
30-
120
0
THE GREAT DEPRESSION
45-
ond was a profit motive. The Bank of France’s gold policy during times of Gold exchange backed currency has played an equal part in the monetary contraction of the great depression. The sterilization of these gold reserves without expanding money supply led to a sharp upward rise in the price of gold. This fuelled a bubble that very literally burst on the face of Europe deflating the price of the gold and also dragging down the value of the sterling with it. While these served the needs, in times of profit, a genuine value creation need during downturn was not understood. It is anybody’s guess as to where the pound sterling may have headed post-the Great Depression. But the untimely hammering of the Pound Sterling by France not only resulted in loss of capital on its portfolio, but also effectively transferred the effect of the declining dollar to the pound and the great depression to the rest of Europe.
what france could have done —
France could have obviously sought to reign in a control on the franc by paring it against the pound and rallying. Gold reserves should have been monetized to create money supply. However, this would have fuelled inflation in the short run but would have helped France realize its goal of minimized capital loss in the forex reserves as well as an appreciation of its gold reserves.
“
In the foreseeable future the replacement of the dollar as a global currency seems highly unlikely
”
SECOND PRIZE
chinese dollar trap and impact on global trade — Extent of China’s Dollar Reserves and rationale
CHINESE EXPORT AND IMPORT $ BILLION,
.
1200
.
1000
.
800
.
400
.
200
.
0 M12
1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009
600
6.000
7.000
5.000
6.000
4.000
5.000
3.000
4.000
2.000
3.000
1.000
2.000
0
1.000
. .
M12
GOLD PRICE(RHS)
CUMULATIVE DEMAND(LHS) CUMILATIVE SUPPY(LHS)
CHINA’S PURCHASES OF US SECURITIES 900800-
2000
07
08
09
source: setser, 2009
0-
CHINESE PURCHASES OF TREASURIES AND AGENCIES
OFFICIAL PURCHASES OF TREASURIES AND AGENCIES
2008-
06
2007-
05
1002006-
04
200-
2005-
03
300-
2004-
02
400-
2003-
500
500-
2002-
1000
600-
2001-
source: the asia-pacific journal, 2009
700-
1500
0 JAN 01
ASSETS V US TRADE DEFICIT, $ BILLION, ROLLING 12M SUMS
M12 2000-
2500
source: market oracle, 2010
.
YUAN/OZ 8.000
1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009
source: seeking alpha, 2009
. .
2009
.
2008
.
2007
.
2006
.
2005
. .
2004
.
2003
.
2002
1995
.
2001
.
0.0%
2000
.
1.5%
1999
0.5%
2.0%
1998
1.0%
. . . .
2.5%
1997
3.0%
1996
3.5%
GOLD PRICE TRENDS IN CHINA TONNES 7.000
. . . .
4.0%
source: market oracle, 2010
1400
CHINA’S FOREX RESERVES TREND 4.5%
IMPORT EXPORT
ROLLING 12M SUMS
1600
.
From the year 2003, China has been accumulating its reserve of dollars by consistently devaluing the renminbi. Labour efficiency in china makes it an attractive destination for FDI and Chinese produce is price competitive thereby making it a highly export oriented economy with huge trade surpluses. This trade surplus allowed China to accumulate dollar denominated reserves and thus buy more political and economic clout in the asian hotchpotch. China’s total forex reserves stand $2.5 tn. which is by a distance the largest in the world and more than 60% of this is dollar denominated. China’s percentage of world reserves also rose considerably to rech nearly 5% of the entire world forex reserve, putting it in a vantage position. The Exhibits 5,6,7,8 and 9 succinctly sum up the situation of rising reserves, devaluation of the currency as well as the rise in gold prices.
US TRADE DEFICIT
Money Manager / January 2011
77
SECOND PRIZE
chinese dollar trap —
In the early 2000’s, China followed an aggressive export-led growth strategy. This was mainly a consequence of the increase in consumption patterns in the US and other Western countries, which led to the increasing demand for Chinese goods and services. As a result, China began accumulating large trade surpluses. This led to an increase in the inflow of foreign capital. Since China’s Central Bank, the People’s Bank of China (PBOC) decided to follow a fixed-exchange rate system and pegged the Yuan against the dollar, China had to buy out the dollars that were flowing in. This led to an accumulation in foreign exchange reserves to the tune of $2 trillion (around 1/3rd of China’s GDP). This “Dollar Trap” offers a risky proposition as the safety of investing in US Treasuries has decreased after the credit crisis. Experts have suggested many ways to escape this dollar trap. China is considering offloading its foreign exchange reserves, but the inflow of such a large amount into the world economy might lead to the devaluation of the dollar, which again would affect China’s reserves. In order to avoid this, China is pushing for an alternative form of reserve currency, namely, the SDR (Special Drawing Rights) (Krugman, 2009)
ment bailouts and packages of their own. Around 45% of this investment is in infrastructure. This is primarily in fixed assets and active promotion of public goods. But there is little incentive for local governments to invest in public goods and as a result, more new factories are being built to enhance China’s manufacturing capacity. This would only attract more foreign investment into China and would not directly solve the dollar trap problem at hand. (Yu, 2010) The dollar trap has also severely impacted Taiwan, as it faces further pressure to get incorporated with the Chinese mainland. The Chinese government is pressurizing the US to aid the incorporation of Taiwan in a deal which includes a promise not to dump dollars into the US. One of the strategies adopted to escape the dollar trap has been promotion of outward FDI in developing countries. China has become the largest source for outbound FDI and it has been investing heavily in countries like Thailand and in Sub-Saharan Africa. The creation of the China Investment Corporation, a sovereign wealth fund to manage China’s foreign reserves is seen as a positive step in this direction. Apart from this, domestic Chinese industries continue to export large volumes of services like shipping and insurance. Large Chinese firms are actively taking part in Mergers and Acquisitions to strengthen their foreign portfolio. An example of this is Lenovo’s acquisition of IBM’s computing arm. Lastly, Chinese enterprises are seeking to move their factories to more labour intensive countries like Vietnam and Thailand. (Davies, 2009)
impact on global trade global imbalances created due to the — dollar trap China has been trying out various escape routes to this dollar trap. This has resulted in a shift in the balance of worldwide trade and is leading to the creation of various imbalances. World trade is declining at a faster pace, with constantly declining demands for exports. Wade quotes “As of May 2009, some 740 ships lie anchored in Singapore harbour, idle, unable to find cargo”. There is a high risk of China dumping the dollar in the US. But, the US has problems of its own in struggling to meet the demand for foreign loans. As a result, the Fed might resort to printing dollars. This would lead to devaluation of the dollar, impacting China adversely. (Wade, 2009) The credit crisis has affected other large economies as well. Increasing capital flows into China adversely affected trade patterns in Japan, the world’s second largest economy. Japan’s chief source of exports- the manufacturing industries, declined in growth in December 2008. It was a third lower in December 2008 than in December 2007. The Chinese Government responded to the crisis by implementing a large stimulus package. Simultaneously, the PBOC brought about an expansionary monetary policy. The government introduced a stimulus package of 4 trillion yuan for 2009 and 2010. Apart from this, provincial governments were also asked to imple78
Money Manager / January 2011
—
China’s investment of its foreign reserves in US Treasuries helped finance the “twin deficits” faced by the US, i.e. trade and capital deficits. Because of this, China became the largest creditor of the US. As a result, the fortunes of China’s accumulating dollars and that of the US are completely intertwined. In the US, unemployment and house foreclosures continue to rise, depressing the house prices further. As a result, the financial system of the US still remains fragile and there is hope that China would continue to buy US Treasuries, thus preventing the dollar from crashing. But the situation in China is completely contrary, with China looking to diversify its foreign reserves into other stable currencies. Also, China is investing majorly in countries which provide a stable environment for FDI and have stable currencies. The sectors which it is investing are metal and energy. In the metals sector, China has invested $19.5 billion in the Rio Tinto group, in Australia. In the energy sector, it has signed a $25 million oil
SECOND PRIZE pipeline deal with Russia and has provided loans to Russian oil major Transneft. It has also signed a $10 billion agreement with Kazakhstan. (Jiang, 2009) One way to tackle this crisis was the calling of the G20 summit in London in April 2009. The G20 summit arrived at a consensus on the need for tax havens and transparency in hedge funds. Much discussion took place on an alternate reserve currency, but nothing concrete was proposed in this area. Meanwhile, the US budget deficits continue to rise and China remains reluctant to fund these deficits by buying US Treasuries. This could lead to a great deal of discomfort between the US and China, especially if the US is at the receiving end.
case for sdr as an international reserve currency —
What is SDR? SDRs or Special Drawing Rights are a form of international accounting unit created by the IMF and allocated to member countries. SDRs were initially created in 1969 and were based on gold, just as the dollar was based on gold back then. Currently, the SDR consists of a basket of 4 major currencies – the dollar, the yen, the Euro and the Pound. The SDR basked consists of 0.632 dollars, 0.41 euros, 18.4 yen and 0.0903 pounds. This unit of account is nontangible and hence, transactions can be carried out in SDRs if both parties agree to it. (McCallum, 2009) Each member country is allocated SDRs by the IMF. It can convert its available SDRs to currencies of other member countries at prevailing exchange rates. When it does so, it must pay interest to the country from which it is borrowing currency. So ideally, a lender would have SDR surplus while a frequent borrower would have SDR deficits. Presently, the interest rate is around 0.5% but it could vary depending on the financial conditions and interest rate on short-term debt on all the four basket currencies.
China’s case for SDR as a reserve currency In April 2009, Zhou Xiaochuan, Governor of the People’s Bank of China issued an essay on “reformation of the International Monetary System”. He basically called for the “establishment of a new and widely accepted reserve currency with a stable valuation” to replace the US dollar, the current reserve currency. The PBOC feels that the deficiencies present in a credit-based system such as the dollar would be solved using the SDR as it takes virtually no cost to create or allocate an SDR, while the price to issue and borrow
international currency is high. (McCallum, 2009) Governor Zhou also felt that the non-use of a particular country’s currency as a global measure would help the exchange rate system of that particular country to adjust economic imbalances within the country. Apart from this, China also wants an international settlement system to carry out trade in SDR, without involving the concept of interest-rate payments, as these could vary depending on the financial situation. It also wants the IMF to actively promote SDR in trade and bookkeeping, essentially making it an official form of transaction so that most member countries will be pressured into following a similar pattern. Lastly, it wants the valuation of SDR to be improved and managed by the IMF. This could be done by expanding the existing basket to include currencies of all major economies.
Why does the SDR present a strong case for an international reserve currency? In the present system, countries without foreign exchange reserves have to accumulate reserves and the adjustment lies in the hands of the countries with a current account deficit. Developing countries would then borrow from developed countries with stable currencies at a higher interest rate. This leads to an increase in consumption in developed countries due to the increase in capital inflow .The instability of the system can be pointed out in the fact that the dollar can be devalued quickly as a result of dumping of excess dollars by countries which have them, like China. This rapid devaluation of the dollar could render the reserves of many countries worthless. (Yu, 2010). One of the most important advantages of the SDR is the fact that it is low cost and doesn’t exist as a tangible unit. Therefore, it would only require commitment from the Central Banks of member countries to accept it as a global currency. As a result, implementation of such a measure can be easily possible without any transaction costs. Secondly, this would prevent the accumulation of US treasuries as the reserves of different countries. Developed countries would be spared the burden of having to accumulate US Treasury securities for protection. The fact that a reserve currency exists puts pressure on countries to accumulate that currency. As a result, demand for that currency increases and this impacts its exchange rate. Currently, most of the world’s trade is executed using the dollar and its demotion from reserve status would reduce the demand for the dollar drastically. As a result, this might impact the exchange rate value of the dollar and devalue it, which would certainly affect the US. (Smelt, 2009). Also, an international reserve system based on SDRs would allow countries to convert its existing dollar reserves into SDRs, in order to diversify exchange rate risks. Lastly, in order for countries to place greater trust on SDR as a currency, the basket must be expanded to accommodate currencies of other large economies, in proportional weightage. Money Manager / January 2011
79
SECOND PRIZE
What are the factors that work against the SDR? The SDR essentially is an accounting adjustment unit that allows banks to readjust their forex portfolio. For the SDR to become a vehicle of global investment and to function as a currency, a separate market must be created for the same. This requires the existing forex markets and banks to denominate trades in SDR and for the IMF to control it as a global currency issuing it in times of crisis, increase supply to manage liquidity problems – in short function as a global central bank. To put such measures into place will take a better part of the decade. (Eichengreen, 2009). If we are to take the SDR’s as a solution to the volatility in the dollar in the short run it will mean that nations apart from US and China will have to assume losses in capital value by investing in SDR and see the value of their dollar reserves dip. This may not be an acceptable for players with large dollar reserves – especially India and Brazil. (Yu, 2010) Therefore, at least in the foreseeable future the replacement of the dollar as a global currency seems highly unlikely.
lessons for china from france’s debacle —
The fundamental problem with the dollar trap lies in the fact that the reputation of US as a quality supplier of financial assets has been sullied and US looks to issue debt to the tune of $4tn. over the next few years. These combined effects have weakened the dollar as an investment destination. The Bank of France, in the 1920s, without the cooperating with the other Central Banks resorted to dumping pounds in the international market in a stop-loss measure. China is in a similar position but there are some critical differences which may enable the Chinese to respond in a proactive fashion without dire consequences for the world economy. China’s trade forms close to 60% of its GDP and politically, the ruling CPC derives its power from the control of both trade and the currency – the weakening of either is detrimental to its state. The PBOC is the financial voice of the government. The PBOC has also signed significant swap deals especially with the Asian tiger economies allowing it to hedge its reserves. China has also realized its potential for expanding investment in strategic reserves of resources like minerals and oil and has taken steps to expand investment in developing nations in Africa. In the case of France, this difference played a key role as the Bank of France was not under govt. control. The Bank of France looked only to hedge its capital loss and did not cooperate with other central banks to gradually off-load its pound sterling reserves.
80
Money Manager / January 2011
If China is to go the route of France and resort to dumping its dollar reserves – it will definitely precipitate the second dip as during the great depression when in 1933 the markets crashed again after a nascent recovery period from 1929. The chain of events post a dollar dumping by China may look like this: A dip in the value of US govt. securities followed by a general loss in faith in the US govt. to repay its borrowings. The chasm between debt issued and deficit will reinforce the same. This may prompt the US to lower the debt burden on by allowing inflation. Inflation will lead to higher cost of living prompting cuts in consumption. This will lead to a general GDP shrink and demand for imports. This will have a feedback effect on the Chinese economy which is highly dependent on trade to fuel its growth. This will also be couple with loss of capital value in its current forex reserves. However, a nascent recovery has set in and liberal monetary policy of the Fed has begun fuelling consumption again. Although there is definitely a case for replacing the dollar with a more neutral and less volatile global monetary unit, the phasing out must be smooth. China has already taken steps towards the same: 1- China has already drastically reduced its purchase of newly issued US govt. securities. 2- Is pushing to strengthen the Renminbi as a medium of transaction in trade especially with Asian and African nations. 3- China is investing its dollar reserves in strategic resources such as oil and minerals in Africa. 4- China is also pushing steadily for the SDR regime to come in – this will find voice with emerging powers India and Brazil. 5- China has also entered into numerous “swap deals” with Asian central banks to facilitate offloading US securities from its large SAFE reserves. China at the moment is highly unlikely to take the route that France did during the 1920s and 1930s – thereby putting to rest fears of a double-dip arising from the Chinese side of the wall. A question to ponder for China will be the way Japan went in the 1980s. Japan was one of the largest trading nations with the US at the time. US pressurized japan into appreciating the yen so as to ease the concerns over the dollar valuation. Japanese exports started falling. In order to control the appreciation Japanese started a more liberal monetary policy by lowering interest rates in the system. This brought the exports back up but fuelled a property bubble, which then burst and resulted in the “lost decades”. China already has a property bubble going and by not allowing the currency to appreciate it is fuelling domestic inflation. How this will pan out over the next 2-3 years will be crucial to the world recovery from the financial crisis.
SECOND PRIZE CHINA’S DEVELOPMENT OF STEEL CAPACITY – OVERCAPACITY PROBLEM CHINESE STEEL OUTPUT 47 MILLIONS JUNE 08
45-mil -
- 11000 - 10000
42-mil -
36-mil -
- 9000 MONTHLY CHINESE STEEL PRODUCTION(TONS)
- 8000 - 7000
33-mil -
- 6000
30-mil -
- 5000
27-mil -
BALTICDRY INDEX
24-mil 21-mil CHINA STEEL 2004
2006
- 3000 - 2000
CHINESE STEEL OUTPUT 21 MILLION MAY 04 2005
- 4000
2007
2008
source: yu yongding, third world network.
39-mil -
- 1000 BALTICDRY INDEX
TRIFFIN DILEMMA CURVE 1 RELATIONSHIP BETWEEN DEBT/ GDP AND COLLAPSE OF DOLLAR DUE TO CESSATION OF INFLOWS
UNSUSTAINABLE RATE OF RISK PREMIUM
CURVE 2
BM2, NO TRIFFIN DILEMMA DEBT/GDP,TIME UNSUSTAINABLE POINT 1
UNSUSTAINABLE POINT 2
source: yu yongding, third world network.
THE “LOSS OF FAITH” POINT IN THE DOLLAR CREATED BY US DEFICIT RISK PREMIUM
references - Bouvier, J. (1989). A propos de la stratégie d’encaisse (or et devises) de la Banque de France de juin 1928 à l’été 1932. In J. Bouvier (Ed.), L’historien sur son métier. Paris: Editions des Archives Contemporaines. - Blancheton, B. (2001). Le Pape et l’Empereur: la Banque de France, la Direction du Trésor et la politique monétaire de la France (1914-1928). Paris: Albin Michel. - Bank for International Settlements. (1932). The Gold Exchange Standard. Unpublished document. 26 October 1932. - Hawtrey, R. G. (1932). The Art of Central Banking. London: Longmans, Green and co. - Keynes, J. M. (1925). The Economic Consequences of Mr. Churchill. London: L. and G. Woolf. - Einzig, P. (1932). Behind the scenes of international finance. London: Macmillan. - Mouré, K. J. (1991). Managing the Franc Poincaré: economic understanding and political constraint in French monetary policy, 1928-1936. Cambridge: Cam bridge University Press. - Niall ferguson, “From Empire to Chimerica”, Pg 284 -341, The Ascent of Money, ISBN 978-01413580-2, Penguin Books, August 20, 2010 - Olivier Accominotti, November, 2008, “The Sterling Trap: Foreign reserves management at the Bank of France, 1928 – 1936”, UC, Berkeley, July 25,2010 http://www.econ.ucdavis.edu/seminars/papers/472/4722.pdf - Douglas A. Irwin, July, 2010, “Did France cause the Great Depression?”, Dartmouth College & NBER, August 16, 2010 http://www.dartmouth.edu/~dirwin/Did%20France%20Cause%20the%20Great%20Depression.pdf - Melissa Murphy & Wen jin Yuan, October, 2009, “Is China ready to challenge the Dollar?”, CSIS Freeman chair in China Studies, CSIS, August 16, 2010 http://csis.org/files/publication/091007_Murphy_IsChinaReady_Web.pdf Money Manager / January 2011
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SECOND PRIZE - Bennett T. McCallum, April 21, 2009, “China, the U.S. Dollar, and SDRs”, CMU and NBER, July 25, 2010 http://www.shadowfed.org/wp-content/uploads/2010/03/benjamin_mccallum_042009.pdf - Setser, Brad (January 13, 2009) “Secrets of SAFE : A sharp slowdown in reserve growth and large “hot” outflows” , Council on Foreign Rela tions, August 16, - http://blogs.cfr.org/setser/2009/01/13/secrets-of-safe-continued-slower-reserve-growth-bigger-trade-surplus-large%E2%80%9Chot%E2%80%9D-outflows-%E2%80%A6/ - Yongding, Yu (2010) “The Impact of the Global Financial Crisis on China’s Economy and China’s Policy responses” Third World Network, August 16, 2010. - http://www.twnside.org.sg/title2/ge/ge25.htm - Simon Smelt, April 7,2009,”SDRs and Currency Reform”, Vox, July 25,2010 http://vox.cepr.org/index.php?q=node/3434 “SDRs and the Global Reserve System” Action Aid Factsheet, 2010. - http://www.actionaid.org/assets/pdf/ActionAid%20Factsheet-%20Special%20Drawing%20Rights%20%20the%20Global%20Reserve%20 System.pdf - Wade, Robert (2009) “From Global Imbalances to Global reorganizations”, Cambridge Journal of Economics 2009 33(4):539-562; doi:10.1093/ cje/bep032 - http://cje.oxfordjournals.org/cgi/content/full/33/4/539 - Jiang, Wenran (29 April 2009) “China tries to wriggle out of the US Dollar Trap” , Yale Global Online, August 16, 2010. - http://yaleglobal.yale.edu/content/china-wriggles-out - March 23, 2009, “China eyes SDR as global currency”, China Daily, July 25,2010 http://www.chinadaily.com.cn/business/2009-03/23/con tent_7607627.htm - R Agarwala, April 3, 2009, “SDR should become the global currency”, The Economic Times, July 25,2010 - http://economictimes.indiatimes.com/ET-Debate/SDR-should-become-the-global-currency/articleshow/4352573.cms - Simon Smelt, April 7,2009,”SDRs and Currency Reform”, Vox, July 25,2010 http://vox.cepr.org/index.php?q=node/3434 - Ambrose Evans-Pritchard, March 25, 2009,”US backing for world currency stuns markets”, Telegraph, July 25,2010 - http://www.telegraph.co.uk/finance/economics/5050407/US-backing-for-world-currency-stuns-markets.html 2009, “SDR & the Global Reserve system”, Actionaid Factsheet, July 25, 2010 - http://www.actionaid.org/assets/pdf/ActionAid%20Factsheet-%20Special%20Drawing%20Rights%20%20the%20Global%20Reserve%20 System.pdf - Owen F. Humpage, May 8,2009,”Will special drawing right supplant the dollar?”, Vox, July 25,2010 http://www.voxeu.org/index.php?q=node/3538. - Olivier Accominotti, April 23,2009,”China’s syndrome: the “dollar trap” in historical perspective” Vox, July 25,2010 http://voxeu.org/index.php?q=node/3490 - Menzie Chinn & Jeffrey Frankel, February 13,2008, “The Euro May Over the Next 15 Years Surpass the Dollar as Leading International Cur rency”, - International Finance, July 25,2010 http://www.hks.harvard.edu/fs/jfrankel/EuroVs$-IFdebateFeb2008.pdf Zhou Xiaouchan, March 23, 2009, “Reform the international Monetary system”, People’s Bank of China, July 25, 2010 - http://www.pbc.gov.cn/english/detail.asp?col=6500&id=178 - Paul Krugman, April 2, 2009, “China’s Dollar Trap”, The New York times, July 25,2010 - http://www.nytimes.com/2009/04/03/opinion/03krugman.html?_r=3 - Ewe-Ghee Lim, “The Euro’s challenge to the Dollar: Different Views from Economists and evidence from COFER(Currency composition of Foreign Exchange Reserves) and Other Data”, IMF, July 25, 2010 - http://www.imf.org/external/pubs/ft/wp/2006/wp06153.pdf Barry Eichengreen & Marc Flandreau, May 9, 2008, - “The Rise and Fall of the Dollar, or When did the Dollar Replace Sterling as the Leading Reserve Currency?” UC, Berkeley, July 25, 2010 http://www.econ.berkeley.edu/~eichengr/rise_fall_dollar_temin.pdf - Barry Eichengreen and Andrew Rose, June 2010, “Implications for China of abandoning its dollar peg”, 27 Up, August 20, 2010 - http://www.econ.berkeley.edu/~eichengr/27_up_6-22-10.pdf - Barry Eichengreen, December 2009, “The Dollar dilemma”, Development Outreach, World Bank Institute, August 20, 2010 - http://siteresources.worldbank.org/WBI/Resources/213798-1259968479602/outreach_eichengreen_dec09.pdf 82
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THIRD PRIZE
LIGHTING UP DARK POOLS As Main Street and Wall Street find ways to cohabitate symbiotically in the aftermath of the financial meltdown of 2008, capital markets are poised to witness a slew of changes with the passage of the Dodd-Frank Act into law and given the heightened regulatory focus. This article aims to take a dekko at one of the sure shot targets of future regulation - dark pools of liquidity. We’ll discuss the electronic equities trading business, evolution of these dark pools and their journey in Asia.
the author —
Dushyant Sahgal a first year MBA student at Olin Business School, Washington University in St. Louis. Prior to joining Olin, he was working at Goldman Sachs in the Equities Technology division. He is reachable via email at dsahgal@wustl.edu
introduction —
With the advent of computers and big money technology investment by broker-dealers and stock exchanges alike, especially in the last decade, equity trading of the yore stands completely revolutionized. What was once a painstakingly manual and a relatively slow process involving open out-cry in trading pits has transformed into a technology intensive process with computer systems matching trades electronically in a fraction of a second.
in trading venues, evolution of Direct Market Access systems, complex trading strategies and a lot more. Somewhere along the way, informal electronic trade matching and settlement systems, called the ‘dark pools’ of today sprung up. Dark pools of liquidity are alternate trading systems (ATS) maintained by broker-dealers that match buyers and sellers within their private system without displaying the quotations to the public.
Online trading brought about much-desired transparency, as trading activities became visible through real-time price dissemination. The capital markets witnessed a massive increase
An Alternative Trading System (ATS) is a trading system that is not regulated as an exchange, but is a venue for matching the buy and sell orders of its subscribers. Money Manager / January 2011
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a typical equities trade flow —
There are many ways in which an order might originate – either by a buy-side OMS/EMS, a sell side trader or an automated algorithmic engine that forks orders based upon trading goals. When captured by the broker’s trading system, the order normally undergoes an array of enrichments, toxic checks and messaging protocol conversions after which it enters the order routing engine. An order originating in Financial Information Exchange (FIX) protocol will need conversion into the in-house messaging protocol that is compatible with the brokers trading system. An Order Management System (OMS) is an electronic system developed to execute securities orders in an efficient and cost-effective manner. The order would then move to the order routing engine which oftentimes has the capability to connect to multiple dark pools of liquidity, stock exchanges and ECNs. This routing engine is loaded with a plethora of complex algorithms and trading logic that enables it to work on the order based upon the trading strategy. Figure 1 below illustrates a generic equities order flow. GENERIC EQUITIES ORDER FLOW BUY-SIDE OMS/EMS
SELL-SIDE TRADER
ALGO ENGINE
ORDER GATEWAY PROTOCOL CONVERSION, ENRICHMENT, VALIDATION SMART ORDER ROUTER
DARK POOL
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Regulations like Reg NMS in US and MiFID in Europe led to greater emphasis on smart order routing in order to meet the requirement of best execution . To be smart, the order routing engine needs an active market data feed from the various trading venues it connects to. As best execution is not just capturing the best price, the broker has to factor in the trading costs, volume available, likelihood of order fulfilment without significant market impact, trading limits imposed for that venue etc. Based upon the price and liquidity available at the trading venues, the order router will split the parent order into one or more child orders and route them to the destination which has the most favourable quote available. As the process of seeking price and liquidity is electronic, the impact on costs and order latency is reduced. Best Execution refers to the responsibility of brokers to provide the most advantageous or best price, order execution for customers. With some dark pools, investors can signal their interest in buying or selling a stock but that indication of interest is communicated only to a group of market participants. Smart routing also involves posting or shadow posting a child order to the dark pool first as an Immediate or Cancel (IOC) order to seek favourable execution. If matching prospects are available, the order gets partially or fully executed in the dark pool. Else, it gets cancelled. A feedback loop into the trade flow ensures that the OMS/EMS is aware of the fate of the child order and does the trade management accordingly.
MARKET DATA
STOCK EXCHANGE/ECNs
ORDER MATCHED?
dark pools and smart order routing —
EXECUTION ORDER CANCELLED
the growth story —
According to the Securities and Exchange Commission, the number of active dark pools dealing in stocks on major US stock markets trebled to 29 in 2009 from about 10 in 2002. Dark pools accounted for 15% of all US equities executions in August 2010 . Given that dark pools accounted for only 1% of the trading volume in 2003, the industry has witnessed tremendous growth as far as the evolution of dark pools goes. There are at least two dozen brokers that operate dark pools today. Figure 3 shows the major dark pools in the US and their execution volume for August 2010. Each of these pools are open to a mix of users, some are open only to institutional investment managers whereas some cater to both the buy and the sell side.
THIRD PRIZE US EQUIY EXECUTION VENUE SPLIT AUG 2010 15% DARK POOLS
85% EXCHANGES/ECNs
BROKER
DARK POOL
CREDIT SUSSIE
CROSSFINDER
GOLDMAN SACHS
SIGMA-X
KHIGHT
KNIGHT LINK
GETCO
EXECUTION SERVICES
LEVEL
LEVEL ATS
MORGAN STANLEY
MS POOL
BARCLAYS
LX
INSTINET
INSTINET CROSSING
CITI
CITI MATCH
LIQUIDNET
LIQUIDNET
BIDS TRADING
BIDS
MATCHED SINGLE COUNTED
MATCHED SINGLE COUNTED(millions) 151 112 100 92 68 56 46 34 28 24 22
ONE SHARE BOUGHT AND ONE SHARE SOLD EQUALS ONE M,ATCHED
Some pools allow orders to rest for any amount of time till they find a match. A majority of large dark pools also operate in Europe and Asia, such as CrossFinder by Credit Sussise and SIGMA X operated by Goldman Sachs.
who benefits and who doesn’t —
Dark pools aren’t without their detractors though. Some market participants believe that when trades are executed anonymously, the price listed on the exchange may become skewed, leading to incorrect pricing and ultimately inefficient markets. Participants contend that dark liquidity simply clouds the marketplace and makes it harder for traders to tell what’s happening. At times, users have to “ping” numerous pools with small chunks of shares, which still can result in failing to make a trade at all due to the increased fragmentation of the market. As dark pool trade matching happens within the broker-dealers private system, stock exchanges are beginning to lose substantial transaction volume to dark pools. The London Stock Exchange has lost more than a quarter of the market to alternative platforms, in particular Chi-X. In response, NYSE, LSE and many western exchanges have since set up their own dark pools to fend off competition.
Without dark pools, big institutional traders would have to route their orders directly to the floor of the exchange, exposing their intentions to the market and thereby causing considerable price impact. Traders seek the advantage of anonymity which allows them to complete their transaction out of the public eye. Enter dark pools. Institutional investors like hedge funds, pension funds and other investment management companies are extremely concerned about the impact cost of execution of large orders at the exchanges. For them, dark pools act as a preferred alternative trading venue that addresses these concerns. While the clients of broker-dealers offering dark pools enjoy the benefits of having their execution out of the public gaze, the broker-dealers gain a two pronged advantage – collecting transaction fees from clients and simultaneously saving on exchange membership costs as the execution essentially took place within the confines of the broker-dealer.
regulation and critique —
Post the financial crisis triggered by the subprime crisis of 2008, the Securities and Exchange Commission has often expressed displeasure at the “darkness” of dark pools and has called for increased regulation. According to the Securities and Exchange Commission, the characteristic lack of transparency in dark pools could create a two-tiered market that deprives the public of information about stock prices and liquidity. On October 21 2009, the SEC put forth several proposals for comment that would among other things, treat actionable indications of interest (IOIs) as actual quotes and be therefore subject to the same market disclosure as public quotes. The SEC also wants the dark pools to trade report real time and include the name of the dark pool that handled a given stock trade. It believes that Alternate Trading Systems should be subjected to the same post-trade information disclosure requirements as exchanges by amending existing rules to require real-time disclosure of the identity of a non-displayed venue that executed a trade. Some industry participants believe that the modified post trade reporting requirement might actually harm the investment management funds as they would get worse prices while buying or selling large amounts of stock should dark pools be forced to identify themselves real time. The SEC hasn’t ruled on the matter yet. As it ploughs through the massive workload of converting legislation into rule making with the passage of the Dodd-Frank Act in July 2010, it has also resolved to make progress on issues affecting equities markets. The buy side and the sell side are not too enthusiastic about releasing too much information too soon and as various industry participants debate on this issue, time will only tell what compromise formula actually gets arrived at. Money Manager / January 2011
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asia focus —
Dark pools, alternative trading systems, hidden liquidity etc are still relatively new to the emerging markets in Asia. As opposed to the US and Europe, Asia is a market presenting unique challenges to dark pools operators. It has a large number of countries, each operating its own set of exchanges and associated regulatory and clearance bodies. Each of these 12-13 countries has their own currency, different set of rules and regulations. Moreover, stock exchanges are perceived as national assets and change is relatively more gradual. The depository and clearing bodies are often owned by exchanges, implying that the dark pools operators can earn fees for matching trades but they wouldn’t be able to make money from clearing and settling trades. While broker-dealers operating dark pools acknowledge that penetrating the Asian markets would be a challenge, they are committed to expanding the footprint of dark liquidity in the trading landscape here. At the moment, dark pools operators command an approximate 1 to 3 percent share of equity execution in Asia on the larger exchanges and close to zero on the smaller ones. The Hong Kong and Japan market currently commands the biggest slice of the pie in terms of dark pool presence.
As the markets in Asia start seeing an expansion of the capital base pooled into the markets, new trading venues will spring up to tap them. Goldman Sachs launched the SIGMA-X dark pool in Hong Kong in March 2009 which allows for trading of the stocks listed on the Hong Kong Stock Exchange. Chi-East, the joint venture between Chi-X Global and the Singapore Exchange (SGX), has recently received regulatory approval from the Monetary Authority of Singapore (MAS) to operate a dark pool trading platform. Dark pools haven’t found home in India yet. At the moment, brokers are not allowed to square trades within their private network. It’s a market where Direct Market Access and algorithmic trading itself were a relatively recent phenomenon and as these further develop and spread in the marketplace, the needs for dark pools will hopefully become apparent. India and other Asian countries have a great opportunity to learn from the experiences (both good and bad) of the US and European markets and work towards well thought of liberalization of their capital markets as far as the expansion of alternate trading systems goes.Notwithstanding how the dark pools of tomorrow shape up, dark pools of today – downright opaque or bright enough? It is your call.
references - Md Julfikar Rahaman,2009: Journal Article on Smart Order Routing: What it Brings to the Table - Tabb Forum Liquidity Matrix August 2010 - http://www.tabbforum.com - Jason Shough August 2010: Chicago investor groups and traders debate the benefit of ‘dark pools’ - Scott Patterson and Aaron Lucchetti, May 2008 WSJ: Dark Pools Drain Liquidity - Kevin Lim and Adrian Bathgate: ANALYSIS-Regulation may dim growth of ‘dark pools’ in Asia -Financial Regulatory Forum August 2010 - Kevin Lim and Adrian Bathgate: ANALYSIS-Regulation may dim growth of ‘dark pools’ in Asia -Financial Regulatory Forum August 2010 - Securities and Exchange Commission: Statement on Dark Pool Regulation Oct 21 2009 http://www.sec.gov - Matthew Samelson, Oct 2010 - Early thoughts on SEC Dark Pool Regulation: Advanced Trading http:// www.advancedtrading.com - Peter Chapman, Sep 2010: Traders Magazine - Dodd-Frank Won’t Derail SEC’s Market Structure Work http://www.tradersmagazine.com - Kevin Lim and Adrian Bathgate: ANALYSIS-Regulation may dim growth of ‘dark pools’ in Asia -Financial Regulatory Forum August 2010 - Goldman Sachs Electronic Trading, March 2009 http://gset.gs.com - Chi-East Press Release, Oct 4 2010: Chi-East Receives Regulatory Approval to Launch - Independent, Pan-Asian, Non-Displayed Trading Venue http://www.chi-east.com - Other General References - http://www.investopedia.com http://www.marketswiki.com 86
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STUDENT ARTICLE
REGULATION IN INDIAN SECURITIZATION MARKET prudent or punitive? Regulators – Omnipotent Watchdogs or Liberal Bystanders?
the authors — Sharanjit Singh The author is a second year student of Post Graduate Program in Management at Indian Institute of Management, Bangalore. He can be reached at sharanjit.singh09@iimb.ernet.in
Souvik Sen The author is a second year student of Post Graduate Program in Management at Indian Institute of Management, Bangalore. He can be reached at souvik.sen09@iimb.ernet.in
Abstract Following the global financial crisis, RBI has proposed quite a few significant changes in the Indian securitization framework. While most of these changes are balanced and sensible reflection of important lessons learnt from the disaster, some of these might also choke the flow of funds in the economy. The proposal in its current form can potentially put an end to a few emerging asset classes like microfinance loans. In this article, some of the major proposed changes and their impact in the Indian securitization market have been highlighted. Money Manager / January 2011
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asset backed regulatory framework securitization in india — — Throughout the nineties auto loans have been the mainstay of securitization in India. From 2000 onwards, growth of securitization has been observed in Mortgage Backed Securities (MBS), the infrastructure sector and other Asset Backed Securities (ABS). However, the US housing bubble burst followed by the collapse of global financial market severely hindered this growth. Globally, securitization has been attributed as one of the primary causes of the financial disaster. However, the default rate in Indian securitization market has been significantly low, thanks to the conservative approach of RBI and the rating agencies. SECURITY ISSUANCE IN INDIA AS AT END
Data Source: http://www.mof.go.jp/jouhou/kokkin/ tyousa/ 0603indiabond_9.pdf
OF FY2009
FYO2
FYO2
FYO2
FYO2
FYO2
FYO2
FYO2
FYO2
ASSET BACKED SECURITIES MORTAGE BACKED SECURITIES COLLATERALIZED DEBT OBLIGATION PARTIAL GUARANTEE OTHERS
what hinders the growth of abs in india? — Though, the stringent securitization guideline ensures a robust system, it also reduces attractiveness of the same. Traditionally, the activity in Indian securitization market has been low. The total volume of securitization transaction in USA is almost 150 times India’s market . Some of the reasons for this are - Liquidity is substantially limited in the secondary market. - Number of participants is very low. - Investor base is not large as NBFCs, PEs and VCs are not allowed to invest in these securities. - FIIs are not allowed to participate. - Lack of investor appetite for long term and lower than AAA rated papers. 88
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In February 2006, RBI released its guidelines governing the asset securitization in India. The aim was to develop a vibrant and robust securitization market in India. Thereafter no change has been done in this guideline. However, post financial crisis, RBI took a more conservative stand and proposed quite a few amendments in this guideline. While most of these changes are balanced and sensible reflection of important lessons learnt from the disaster, some of these might also choke the flow of funds in the economy. Some of the significant changes are discussed here.
revolving securitization —
Revolving structure is an innovative way of securitizing asset classes with short term tenure. This structure is widely used in developed countries to securitize credit card receivables, trade bills etc. The structure has two major cash flow periods. a) Revolving Period: During this period, only the interest component of the payment from borrower is passed to the investors and the principal component is reinvested. b) Amortization Period: During this period, the entire cash flow received from the borrowers is passed to the investors. This transaction allows extending the tenure of the issued Passed Through Certificates (PTCs) when the underlying asset has a short tenure. There are various risks associated with revolving structure. - As the asset pool is replenished frequently with new assets, the asset quality may change over a period of time. - Though it does not directly go against the “true-sale” criteria of securitization, it requires a commitment from the originator to do new “true-sale” later. - In case the originator cannot generate new portfolio to replenish the asset pool, early amortization is kicked off. This involves reinvestment risk for the investor. RBI draft guideline dated 19th April, 2010, paragraph 7.3 explicitly prohibits revolving structure in India1. But, this clause lacks clarity. The point indicates that revolving structure is used for un-amortizing assets and this structure will not be permitted. However, revolving structure can potentially be done also for amortizing assets with short tenure like micro finance loans. Traditionally revolving structure is done for credit card receivables, trade receivables which are non-amortizing in nature. It means the payoff to the investors may be highly irregular during the tenure of the PTCs. For example, investors will be paid only when the credit card borrower will pay the amount (which does not have any payment schedule).
STUDENT ARTICLE A blanket ban on the structure means even amortizing asset class with shorter duration cannot be securitized. As long as the asset class is amortizing asset, payment irregularity does not exist even if the asset tenure is short term. Also, many of the other issues can be resolved by ensuring frequent portfolio rating by the rating agencies, increasing credit enhancement requirement etc. A blanket ban on the structure prevents institutions to raise medium to long term capital when their asset is of shorter duration. Therefore, even if the institution has good quality portfolio, this restriction will not allow them to raise funding.
to Distribute” model.1 Also, 5% of the portfolio should be held on the book of the originator to ensure quality of the portfolio. While this move is a clear reflection of the lesson learnt from the financial calamity, this will potentially put an end for securitization of short term assets like microfinance loans. Therefore, this requirement in its current form will severely hit the securitization market in India. The seasoning requirement should be different for different asset classes depending on its tenure.
monoline insurance
re-securitization and synthetic securitization — —
As per RBI definition “A re-securitisation exposure is a securitisation exposure in which the risk associated with an underlying pool of exposures is tranched and at least one of the underlying exposures is a securitisation exposure. In addition, an exposure to one or more re-securitisation exposures is a re-securitisation exposure.” The draft guideline clarifies that resecuritization will not be allowed in India. This prohibits issuing collateralized debt obligations where the underlying asset pool consists of asset backed securities. While this restriction will hinder the growth of CDO market, it ensures that the investors of securitized PTCs know what they are buying. As the risk cannot later be transferred to another set of investors through re-securitization, the investor and the underwriter are incentivized to do proper due diligence of the portfolio. Credit derivatives and synthetic securitization are deemed as complex and risky by RBI. Therefore, RBI does not allow these structures at the moment. RBI draft guideline dated 19th April, 2010, paragraph 7.2 clarifies this point. However, RBI indicated that the structure could be allowed in future if found appropriate.
minimum holding period and retention requirement —
Perhaps the most contentious change in the recent regulation is the minimum holding period and retention requirement. RBI has proposed to impose a seasoning requirement of 9 months for loans with tenure up to 24 months to discourage the “Originate
Financial guaranty is one of the most popular forms of credit enhancements in the developed countries like USA, Australia. This is also popularly called monoline insurance. Recently, Tata Motors came up with an innovative NCD structure guaranteed by SBI. Following this transaction, RBI came up with a circular indicating that banks cannot provide guaranty on bonds or any debt instruments . Therefore, monoline insurance as a credit enhancement method does not exist in India. The monoline insurance industry globally was severely hit by the recent credit crisis. Top global insurers like Ambac, MBIA, and CIFG are now in a suspended state of operations. Under these circumstances, RBI put the blanket ban on financial guaranty by the banks in India. As the financial institutions are not allowed to provide guaranty with a leveraged position, this mitigates the risk for the investor to a great extent. While this is a good step in preventing such disasters, it disallows small firm to take the benefit of securitization. Currently, the most popular method of credit enhancement in India is cash collateral. But, this increases the cost of capital and reduces the attractiveness of securitization.
conclusion While it is important to ensure a robust and institutional framework for securitization in India, it is also important to keep the securitization attractive. Otherwise, the economy could be starved of capital and recovery imperilled. Though, the new guidelines have been developed to ensure enhanced investor protection, the same guideline for all asset classes may not be relevant and prevent the growth of many emerging asset classes. Lack of asset class diversification can severely impede the growth of a vibrant securitization market. Therefore, the new guideline requires further elaboration and differential treatment for some of the emerging asset classes.
references - Source: http://www.mof.go.jp/jouhou/kokkin/ tyousa/ 0603in diabond_9.pdf - RBI Draft proposal for securitization, 19th April, 2010 - http://www.rbi.org.in/scripts/BS_SpeechesView.aspx?Id=402 - RBI master circular on guarantees and co-acceptances dated July 1, 2009 – paragraph 2.4.2.3.a.vii Money Manager / January 2011
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DOLLAR CRISIS REAL OR IMAGINARY Sustainability of the global financial system has been questioned since its inception. Still the dollar is likely to survive because of lack of alternatives and ‘network externalities’ associated with it. Evidence suggest that China is trying to shift away from dollar and leading initiatives for internalization of RMB in east Asia though ASEAN members are ‘hedging’ their position within existing power structures. Long term sustainability of system will require reinvestment of developing countrys’ savings back into their own country. “Insurance needs” of developing countries will have to be addressed through pooling of reserves.
the author —
Nirmal Sharda a second year student at IIM Ahmedabad. He has completed his graduation in commerce from Shri Ram College of Commerce and can be reached at 9nirmals@iimahd.ernet.in.
abstract The recent financial crisis has again raised questions over fundamentals of present global monetary system. Triffin saw paradox in current global system back in 1960s-creation of international liquidity through creation of debt over issuing country. Surprisingly the same questions about the sustainability of global imbalances are raised every time a crisis strikes but each time global financial system appears to be much more resilient. Nicholas Kaldor in 1971 predicted “… transforming a nation (US) of creative producers into a community of rentiers” with an observation by commentator that the prediction looks equally true even 40 years after. 90
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Data prove that dollar is the pivot of the modern financial system. Most global commodities– including oil and gold – are priced in dollars. In 2008, 45% of international debt securities were denominated in dollars, and only 32% in Euros. 66 countries used dollar as an anchor against 27 who used Euro. (IMF April 2008). Furthermore 86% of international transactions were invoiced in dollars. (BIS 2007) This suggests that US is the center of the world financial system. At the same time, US is absorbing 70 percent of world’s surplus savings. (wolf 2008 p. 76) . According to the bank of international settlements two-thirds of reserves (excluding China) were in Dollars-not too short against 70 percent reported in 2001, despite a fall of Dollar against Euro and Pound-Sterling. Standard economic theory suggests that surplus capital will move towards capital-poor regions (where capital-to labor ratio is relatively low) but globally, capital runs uphill: from the high-risk-
STUDENT ARTICLE reward-capital-poor countries to the low-risk-reward-capital-rich countries. The trend seems to have become more prominent over years. Studies show that the result holds even when controlling for variables which reduces investors’ risk-adjusted returns, in developing countries like political instability, poor infrastructure, corruption, etc. (Prasad et al.,2007) Clearly developing countries seems to be paying premium for liquidity of dollar assets what Keynes (1936) had referred to as “anti-social fetish of liquidity”. But the buck does not stop here. Some part of that capital invested into developed countries is ‘recycled back’ into developing countries in the form of FDI and portfolio investment. But these investments often don’t reflect investment priorities of developing countries and often cause volatility and distortion of relative prices.
causes of current global imbalances —
There are several competing theories to explain current global imbalances. ‘Savings glut hypothesis’ states that the primary reason for these imbalances is higher currency reserve accumulation by developing countries either to promote exports-led growth or as a “self insurance” against sudden flight of capital. Several emerging countries have been doing systematic intervention in exchange markets to keep value of their currency low. China’s exchange rate policies have been severely criticized under the format bracket. Aizenman and Lee (2005) report that insurance factors like-openness and exposure to financial crisis-are better able to explain rise in emerging countries’ reserves than exports and deviations from purchasing power parity. (argument in favor of self insurance hypothesis). ” Self insurance theory” gains its material empirical evidence from the fact that emerging countries had major increases in their reserves during post East Asian and Mexican crisis period. Dani Rodik mentions that prior to 2008, reserves as percentage of GDP had risen to about 30 percent of GDP from about 6-8 percent during 1970s and 1980s. The trend towards excess self insurance is ubiquitous. African reserves grew to a level of nine month of import equivalent (against benchmark 3 month). Another theory attributes cause of global imbalances to US monetary excesses which resulted in lower interest rates and substantial rise in consumer credit and consequently their consumption and residential investment spending. This excess spending spilled over abroad causing substantial rise in their current account surpluses and consequently their reserves. But considering monetary growth rate during this period, it looks unlikely. Also inflation expectations were largely subdued during this period.
Costable (2007) points out that both “savings glut hypothesis” and “profligacy argument” points to the same underlying phenomenon of international monetary system- trade-off between liquidity in the global monetary system and persistent current account deficits of central country.
what is the distribution of global current account balances? — East Asia as a whole accounts for more than 60 percent of world’s current account surpluses. (Wolf 2008 p 78) China alone accounts for around half of that. China is playing a unique dual role both as a capital exporter and fastest growing emerging giant (played by UK and US respectively in late 19th century.(Wolf 2008 p 81) Oil countries surpluses accounted for 12 percent of their total GDP. This was primarily due to rise in oil prices. But unlike 1970s this time they have been cautious in spending their oil revenues. These countries have been somewhat reluctant to park their savings into US dollars. European Union had more or less balanced current account. Japan historically had large savings though due to structural changes that is expected to come down in future. Clearly all major blocs in the world are either generating current account surpluses or are balanced.
comparison with gold-dollar standard —
The equation that must hold true for reserve currency in the previous standard is: (X-M+R)=G+STC+LTC Where X is exports, M denotes imports, R denotes balance in the service account, G stands for gold, STC is short term borrowings and LTC denotes long term borrowings. For a given current account deficit, movement of gold reserve can be avoided by central country only if short term debt (lent to central country) is higher than long term investments (by central country) abroad (STC>LTC). Chronic current account deficits will necessarily trigger shortfall in short term borrowing of reserve currency country and hence cause movement of gold reserves outside central country. But under present monetary system G ceases to exist and all excesses of STC over LTC imply an increase in other country’s reserves. US don’t have to vary its interest rates to keep STC and LTC in tandem-to attract gold. Also there are no restrictions on its external account. (Serrano, 2003) Money Manager / January 2011
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the current scenario —
In the aftermath of crisis there were several rumblings about the inherent flaws in the present global financial system and need to move away from it. Joseph Stiglitz proposed a new global reserve system (UN Commission of Experts, 2009). Zhou, the Governor of the People’s Bank of China, called for an international reserve currency that delinked it from sovereign nations. During the same year, John Lipsky, Director of IMF, assessed possibility of SDRs to replace Dollar as reserve currency as “entirely conceivable”. Russian President Dmitry Medvedev, at the G8 meeting in Italy, paraded a sample minted coin of a new world currency to the press. UNCTAD’s Trade and Development Report 2009 also backed the idea of using SDR as a form of liquidity against dollar.
whether dollar can survive? — Any impact of devaluation of dollar will also have to consider ‘valuation effect’. According to a Mckinsey report even with a balanced current account, US would continue to run an overall trade deficit in 2012. This would be composed of $720 billion deficit in merchandise and $430 billion surplus in service account…. Its net foreign debt position would swing from a projected (-) $8.1 trillion to a positive $4.9 trillion. This is with an additional note that this would be the biggest default in the history of the world and might shift reserves away from dollar assets. This will be primarily due to the valuation effect of dollar devaluation. When dollar falls, US’s liabilities (which are also measured in dollar) also fall. But at the same time its asset (which are denominated in local currencies will rise in Dollar terms) Martin wolf calls this “biggest default in the history”.. Dollar is likely to survive in the near future simply because of lack of alternatives, its deep and liquid financial markets and inertia on the part of players. Flandreau et al suggest that central banks persist to existing reserve currencies despite decline of economic hegemon. Dollar did not become world currency until 1944 Bretton Woods Conference-approximately seven decades aft.er US overtook UK in terms of GDP. Also strong strategic ties of US with East Asia and Japan also provide it a safety net. But position of the dollar is now more vulnerable than before, particularly after the credibility of the US financial market became highly questionable. Thus US now needs to make deliberate efforts to gain trust of global economic players. Dollar in such condition can be called ‘Negotiated Currency’ –“currency 92
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that works as international currency only with support of other major economies that are using it as the main reserve currency.” Hicks states that even a chronic deficit-ridden dollar will continue to hold its reserve currency position because of these reasons: 1) Approximately a third of US current account deficits is due to exports by US corporations from abroad-a permanent source of dollar demand. Also due to military superiority of US, developing countries will continue to supply commodities to US and receive payments in Dollars. Also Dollar is unlikely to be affected by a unilateral action by a country. Rather that will only exacerbate its own foreign position and can even trigger financial crisis. Also other countries are likely to act against it. (Serrano, 2003) But In the event of continued US current account deficit, market could attempt to shift this balance from Dollar to other high income countries’ assets causing major tensions in the Euro Bloc. Maurice Obtsfeld et al show that real exchange rate of European currencies will have to rise by over 50 percent if East Asian countries maintain their dollar peg as Europeans will have to adjust to shrinkage in US deficit and substantial rise in East Asian surplus. Deterioration of external balances due to appreciation of currencies might cause Euro zone to fall apart.
china and east asia —
In the aftermath of crisis, there are signs of major policy shifts in China. It has more or less stopped buying US Treasuries. Also Beijing sold $50-$100 billion of dollar assets every month since late 2008, and invested in natural resources like minerals, energy and European and Asian equity. China is also making loans to oil companies in oil producing countries that will be repaid in oil. (Wade 2009) China accounts for 60 percent China has current account deficits against all major East Asian countries. Hence it has a major interest in internationalization of RMB in the region. China is making several steps in this direction: bilateral foreign currency swap scheme with Korea, Hong Kong, Malaysia, Indonesia and Argentina. Also China is evaluating possibility of in cross border trade settlements in RMB with Hong Kong, Yuman and ASEAN. But major hurdles in internationalization of RMB include lack of capital account convertibility, lack of floating currency (which prevents forward transactions and hence prevent from hedging currency risks) and poor state of domestic financial markets, China has taken several steps in this direction. In June 2010, the People’s Bank of China announced the return to a managed floating exchange rate regime that allows for intraday movements of .5 percent from a central parity. Also there have been several liberalization efforts in fixed income markets including freeing up of rates on interbank transactions, central
STUDENT ARTICLE bank papers and repo transactions. But China still employs nonmarket measures to conduct monetary policy like ceilings on bank deposit rates and determination of quantity of bank lending. Monetary Union in East Asia don’t look feasible as compared with Europe, Asian countries have more marked differences in economic cycles and structures and they suffer from significant conflicts in history, culture, religion and politics, which makes currency and financial cooperation difficult.” (Grimes, 2009) Furthermore ASEAN members want to use initiatives like Chiang mai more to gain better bargaining position within the existing power structure rather than to bring drastic change into it. (Drezner 2009)
Dollar block-
Consisting of countries using dollar as a currency or pegged to itaccounted for three-quarters of total global reserves by the end of 2006. Internal recycling within the block can match net surpluses and deficits within the block and hence no external funding is required. Within the block, peripheral members can hold up dollar. Any shifting of reserves from dollar to other floating currencies will result in simultaneous depreciation of currencies of entire ‘dollar bloc resulting in deterioration in external account of the shifting country itself
SDR as an alternative-
In the aftermath of crisis, both demand for SDR by BRIC countries and its increased supply from fund have increased global reserves held in SDR to 4 percent. (IMF Working Paper May 2009). But for SDRs will require deep and liquid markets to acquire reserve currency status. A critical mass of issuance and trading of SDR denominated assets not just by IMF but by some member countries as well. Such attempts in 1970s failed primarily due to coordination problems. (IMF Working Paper May 2009) Historically, composite currencies traded commercially are not attractive for liquidity-return combination. For this to happen, someone would have to act as market maker and subsidize the operation of the market until it acquired scale and liquidity.
Domestic currency denominated bond markets in Developing countries-
There has been a substantial increase in the bond issuance of emerging economies and amounted to $7.2 trillion. Approximately 84 percent was denominated in local currencies; issuance of local currency denominated bonds has been modest though increasing. But a major chunk of the bonds is subscribed by domestic banks. (IMF Working Paper April 2010) Eichengreen et al suggest that international financial institutions could encourage use of assets denominated in inflation-adjustedbasket of emerging market economies by issuing debt denominated in basket of currencies and simultaneously purchasing bonds in those currencies.
Insurance to developing countries against sudden stoppage-
Third-party insurance though efficient, this system has major drawbacks in terms of :the absence of liquid markets, significant upfront costs to underwriters for identifying risks and returns adequately, difficulty in pricing tail events such as financial crises, inability to diversify sovereign risks etc. (Isabelle et al 2009) Pooling of reserves is a better alternative for self-insurance but for that IMF will have to lend relatively freely without policy directives. Currently these countries do not trust IMF primarily because of its role in previous crisis situations and its domination by United States and Europe. Also IMF’s resources are too small for the role. Regional reserve pooling arrangements like Chiang Mai initiatives may provide practical solution in the short term. (Martin Wolf 2008)
Multi currency system-
Euro a possible alternative to dollar suffers from weaknesses like high transaction costs, anti growth bias of European economy, no consolidated sovereign debt market and its fragile governance structure. Also European continental financial markets cannot match the dollar-based market in New York in its depth and efficiency (Tadokoro 2010) Even during the financial crisis, there was no substantial shift in reserves towards Euro. Other high income countries like Australia UK are simply too small to absorb large financial flows. The system will impose discipline on reserve currency issuer as countries may shift to alternative reserve currencies. Also competing stores of value will cause higher exchange rate volatility if reserve holders manage their portfolios. Close policy coordination among key reserve issuers would be necessary avoid exchange rate volatility. But problem is that in previous cases of multiple currencies, reserve holders tend to move towards a single currency for the “network effects” of money. (Tadokoro 2010)
Creating a public investment fund-
The current export led model adopted by developing countries cause capital to be “recycled back” by US back into their own country. But the investment does not reflect investment priorities of that country. Also portfolio investment from these countries often distort relative prices and cause excessive volatility rather than providing any long term financing. What is needed is(are) closed ended fund(s) for making investments in the developing countries. These funds would own assets in these countries and simultaneously issue their liabilities in their local currency. Multilateral nature of these funds would incentivize developing countries to invest their reserves with these funds. (Arista 2009)
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Reforming the international payment system
Current monetary system encourages non reserve countries to keep their currency weak to gain competitive advantage and enhance exports. But for balance in the global system, every country will “have to use its own currency backed by wealth created within its own borders, to participate in the global economy.” Keynes idea of International Clearing Agency (ICA) would solve this problem by clearing transactions in members’ home currency. It would permit changes in exchange rates based upon changes in reserve position. Variations could be introduced in the system to authorize open market operations by an international agency. ICA could govern liquidity by creating/extinguishing international reserves. (Arista 2009)
references - Will currency follow the flag? Drezner Daniel W.,2009, Cambridge Journal of Economics 2009, 33, 633–652, - Jane D’Arista, The evolving international monetary system, ,Cambridge Journal of Economics 2009, 33, 633–652 - Tadokoro Masayuki, After dollar?, International Relations of the Asia-Pacific, Volume 10 (2010) 415–440 - Wade Robert , From global imbalances to global Reorganizations, Cambridge Journal of Economics 2009, 33, 539–562 - Barry Eichengreen1, Out of the Box Thoughts about the International Financial Architecture, IMF Working Paper-Strategy, Policy, and Review Department, , May 2009 - Shanaka J. Peiris ,IMF Foreign Participation in Emerging Markets’ Local Currency Bond Markets, ,IMF Working Paper-Monetary and Capital Markets Department, ,April 2010 - Franklin Serrano, From ‘static’ gold to the floating dollar | Contrib. Pol. Economy | 2003-1122: | 87 - 102 | - Martin Wolf, fixing global finance, Baltimore, Johns Hopkins, 2008 - Zhang Ming, China’s New International Financial Strategy amid the Global Financial Crisis, China & World Economy / 22 – 35, Vol. 17, No. 5, 2009 - Gian Maria Milesi-Ferretti, Fundamentals at Odds? The U.S. Current Account Deficit and The Dollar - Isabelle Mateos y Lago, Rupa Duttagupta, and Rishi Goyal, The Debate on the International Monetary System, Strategy, Policy, and Review Department, International Monetary Fund, 2009 94
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LAST WORD The Money Manager was started with an aim to collect the views of students, practitioners and academicians on the current developments and most relevant issues in finance and bring to students perspectives on pressing issues in the world of finance. Its stated objective was to provide a platform for management students to express their views on all areas of finance from private equity to capital markets, corporate finance to insurance. The Money Manager is not a “research journal�; rather, it is a collection of interesting and current ideas in finance. It is the first of its kind, a joint endeavour of the finance clubs of IIM Ahmedabad, Bangalore and Calcutta. The student articles are then screened for originality and then judged by an elite panel. The winning articles are tested on originality, depth of analysis, relevance of topic and presentation style. Eight editions of the Money Manager have been published before this, but this ninth edition of the Money Manager has broken several stereotypes which Money Manager has become known for. Right from soliciting student entries from international business schools, to expanding the scope of the guest articles, this edition has been revolutionary in more ways than one. Moreover, student articles were for the first time screened by an elite panel comprising both industry persons and professors from IIMA. We hope you have enjoyed reading this edition of Money Manager, and we promise that further editions of Money Manager will continue to establish new ground-breaking norms delivering relevant and thoughtprovoking articles to read for anyone who is interested in finance. To enable the Money Manager to reach an even wider audience, it will be available for download online. All current and past editions are available on our websites, including http://stdwww.iimahd.ernet.in/beta, the website of Beta, the Finance Club of IIM Ahmedabad. These will be updated regularly, so do keep checking in! -The Finance Clubs of IIM - A,B & C
BETA RECOMMENDS
Probably IIMA’s best known and most quoted economist post the crisis, Raghuram Rajan uses this 250-page book to strongly drive home the point he infamously raised during the Fed’s routine Jackson Hole retreat in 2005. The book takes a reader through reasons why he believes economists and politicians should take a greater blame for the financial crisis than the average banker. While he does acknowledge that certain institutions were too keen on making the proverbial quick buck, he cautions against dismissing the financial sector merely as a greedy industry serving to line the pockets of its workers. While building upon the social usefulness of modern day banks, hedge funds and other financial institutions, Rajan proposes some novel methods of regulation. A very interesting distinction that he seeks to draw is between institutions that are too big to fail (under which definition would also fall PIMCO) and ones that are too intricately linked to fail (like Bear Sterns). Besides these chapters on finance and its regulations which occupy the beginning and end of the book, the middle is what I believe the book shall really be remembered for. In these chapters Rajan carries out a detailed and refreshing analysis of why he believes the problems facing the USA are too structural to be resolved even when the financial markets come back to life. From issues relating to a suddenly less flexible workforce to decreasing average years of study and changing demographics, Mr. Rajan cautions that the current downturn might quite become the norm if the American leadership does not take some hard decisions very soon. Easy to understand with a very ambitious scope, that it does full justice to, this book is a must for any aspiring banker. 98
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Niall Ferguson has exhaustively and succinctly covered the evolution of money from its humble origins as cocoa beans used to trade slaves in South America to the plastic money of the present age. Money in its various avatars – be it the rupee, dollar or pound is the fundamental link determines the dynamics between the financial and real economy. In that sense a deeper study of its evolution sheds interesting insights into the state of the current monetary and financial systems and how they will evolve in the years to come. The book is a lot more than just a timeline that traces the roots of money; it delves deep into the men and the society who were intimately involved in its creation. Be it the Medici family who gave us the double entry book keeping system or Nathan Mayer Rothschild who virtually detonated Napoleon through the bond market – the reason for evolution of the fancy stock markets and bond markets have had very little to do with the intent of creating an institution. They were intended to serve the money making ambitions of the holders of the baton of power. Men of power have determined the course that currency and money have taken to reach the present stage. But Ferguson doesn’t stop there in analysis – he takes it a step further by analysing the political underpinnings that went into making money, mankind’s fascination for Gold and how it determined seigniorage. At this point of time post a financial crisis that has worked economists and bankers into overdrive, the author, a historian by profession, provides a refreshing and altogether different insight into the vagaries of the financial markets, globalization and the geopolitical impact on monetary practices. An interesting and absorbing read that deeply analyses from a business and societal stand point the ascent and also possibly the descent of money.
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BETA, THE FINANCE CLUB OF IIM AHMEDABAD
BETA is the most prestigious club of IIM Ahmedabad and has been an integral part of IIMA culture since decades. BETA aims to generate and promote interest in finance among IIMA students. Besides it has organized several national level competitions such as “Exchequer”, trading games and workshops in the past. It has also been associated with distinguished people from academia and industry. Some of BETA’s regular activities are organizing placement oriented sessions, internships experience talks, contests and discussions on current issues. Besides, BETA also releases a plethora of publications, both daily and weekly. For more on BETA, do visit http://beta-iima.com
NETWORTH, THE FINANCE CLUB OF IIM BANGALORE
Networth is ‘Everything Finance’ at IIM Bangalore. Its primary driving force has been to establish a ‘connect’ with the world of finance and develop synergies around the function, both within and outside the campus. Through its broad portfolio of activities, the club encourages students to explore the realm of finance. It conducts workshops and organizes talks wherein students get exposed to the high priests of finance. It also encourages participation from students through its trading events, online quizzes and case contests. At the same time it assists students in their pursuit towards their dream careers in finance through its popular gyaan sessions for placements.
FINANCE & INVESTMENTS CLUB OF IIM CALCUTTA
Finance & Investments Club of IIM Calcutta, popularly known as the Finclub is a student driven initiative that collaborates with both the corporate and academia from the financial sector to provide a platform for students to improve their quantitative and analytical thinking abilities. The club also manages and maintains the IIM Calcutta Finance Laboratory in collaboration with the Department of Finance and Control. The club organizes industry talks, workshops, stock trading and other finance based simulated events.
Please send your feedback and queries to: E-mail: beta@iimahd.ernet.in Website: http://beta-iima.com/
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