Movie Review: Too Big to Fail

Main Characters

1. US treasury Secretary - Henry Paulson
2. CEO Lehman Brothers - Dick Fuld
3. President federal reserve bank of New York - Timothy Geithner
4. Chairman of federal reserve system - Ben Bernanke

Law:

1. Emergency economic stabilization Act of 2008
2. Troubled Assets Relief Program (TRIP)

Lehman Brothers was in deep trouble on account of excessive exposure to toxic housing assets. Its CEO Dick Fuld tried to contain the problem by bringing in external investment but he got no success.

Henry Paulson, in order to mitigate the financial crisis, which already started with the Bankruptcy of Bear Stearns, tried to arrange investors for Lehman Brothers. He convinced BOA and Barclays to buy Lehman's good assets but, eventually BOA purchased Merrill Lynch. Barclays expressed interest but British Banking Regulators pulled it back by refusing to give a go to the deal.

It was quickly understood that Lehman Brothers problem was not individual. It got spread to entire financial market, which lead to free fall in Dow Jones. Another crisis started with AIG about to default on their loans. AIG was the largest insurer for Mortgage based securities of that time. If it was allowed to collapse, all the companies which have MBO's secured by AIG would collapse. In short, whole financial market would collapse.

Treasury had no option but to take control over AIG. Ben Bernanke forced congress to pass the legislation to authorize any continued intervention by Fed or Treasury. Timothy Geithner planned to end the crisis by planning mergers between Investment bank and Consumer bank, but he failed to do so. Paulson received call from Jeffrey Immelt of GE, who tells Paulson that he is not getting credit for financing day to day business operation. If company like GE is not getting credit, what would be the credit condition for a normal business?

Paulson realised that the crisis has spread to the main street. Ben and Paulson made clear to congress that lack of credit resulted in great depression of 1929. And if congress doesn't act now, it will lead to a situation which is even worse than the great depression. Congress passed the Legislation although in its second attempt.

Now that Ben and Paulson had the cash to make injections in the system, they pressurized the group of banks for mandatory capital injections and use this money to get the credit moving. Banks were running in highly protective format, and were wary of giving loans, but to bring the system to normal state, credit has to start revolving.

Although markets did stabilize and banks repaid their Troubled Assets Relief Programs Funds, credit standards continued to tighten resulting in wide spread closure of businesses which in turn resulted in very high unemployment level in Country.

Finally, to define the crisis in three keywords:

1. Lack of Prudence  - Which resulted in Excessive Leverage

2. Lack of Simplicity - Complex financial products

3. Lack of Humility   - Bankers believing they are the master of Universe 

- By Uday Kotak, Executive Vice Chairman and Managing Director, Kotak Mahindra Group

WPI or CPI, which is better measure of Inflation

WPI (Wholesale Price Index)

WPI is considered as the headline inflation indicator of India. It is defined as the average increase in price of basket of 676 items. It is used by government, banks, and industry and business circles for their decision making. Also, important monetary and fiscal policy changes are linked to WPI movements. At present it is measured with  2004-05 as the base year which earlier was 1993-94.

Working group for the revision of base year was formed on December 26, 2003 under the Chairmanship of Abhijeet Sen, Member, Planning Commission. As per the working committee, base year chosen should be a normal year and for which reliable price and other data are available. This committee proposed 2004-05 as the new base year. The Weightage assigned to various commodities that forms WPI is given below

Weight of Different commodities in WPI

Some countries that use WPI are India, Japan, Greece, Norway and Turkey

CPI (Consumer Price Index)

CPI is defined as the change in price level of basket of goods and services as purchased by households/retail buyers. It is the index for common people because it properly captures the effect of rising prices with respect to common man.

CPI at present is compiled separately for

1. Entire Urban Population
2. Entire Rural Population
3. Consolidated CPI for Urban and Rural – Computed based on the above two CPI’s

Earlier CPI was calculated with four different categories. Base year has been changed to 2010. Total number of elementary items considered is 200.

According to the Ex-Governor D Subbarao, “Conceptually, the CPI is a better indicator of demand side pressures than the WPI... and there is no denying that consumer prices better reflect demand side pressures than wholesale prices”.

In case of weak demand from consumers, retailers will be forced to partly absorb the wholesale price increase and therefore wholesale price increase is passed to customers only when there is strong demand for the goods and services.

Three major reasons why central government uses WPI over CPI

In the same article, honourable D Subbarao cited the reasons for using WPI over CPI. They are : -

1.     WPI is computed on an all India basis, while CPI are constructed for specific centers and aggregated to an all-India index.
2.        WPI is available with a shorter lag than CPI
3.     WPI has a broader coverage (676 items) as compare to CPI (200 items)

Producer Price Index:

It measures the average change in selling price of goods and services with reference to the Producer. The prices included in PPI are from the first commercial transaction for many products and services. Most of the OECD countries uses PPI as a measure of inflation.

Data Source and Articles covered:

http://dbie.rbi.org.in/DBIE/dbie.rbi?site=home

http://articles.economictimes.indiatimes.com/2011-07-05/news/29738756_1_wpi-wholesale-prices-inflation-forecast

http://www.allbankingsolutions.com/Banking-Tutor/WPI-CPI-How-inflation-is-measured.htm

http://en.wikipedia.org/wiki/Consumer_price_index

http://www.thehindu.com/business/Economy/new-cpi-series-to-reflect-prices-at-microlevel/article1467984.ece

Problems with Japanese Economy

Year 1990 started with the collapse of Japanese stock market. It was the result of asset price bubble that took real estate prices to rock bottom. Nikkei average dropped from around 40,000 to 14,000 in just a year. Japans high growth economy suddenly stopped and shrunk. Before the crisis, it was believed that Japan, if it grows with the same pace, will surpass the economy of the USA by 2010. But since the crisis started, their economy didn’t move at all.

Japan got itself into decade long recession. To further aggravate the situation, macroeconomic parameter like deflation started corroding the economy. Prices of goods and services died down every day. Manufacturing capacity of plants was reduced. This lead to large scale layoff and reduced the personal disposable income of people of Japan.  There was no money left in the system. Most of the banks had properties as collateral for the loans they have given. Banks were reluctant to call in the loans because these properties have lost their values and there were no buyers even at reduced price. Competitor nation like South Korea and China were taking over the position of Japanese manufacturers.

In the year 1999, unemployment rate exceeded 4%. From the graph it can be observed that starting 1991 till late 2003, there was no improvement in unemployment and it went to touch 5.8% before showing a sign of recovery thereafter. Massive layoff’s further resulted in default on bank loans and increase in suicide rate across the country. Post bubble financial crisis started with the collapse of Sanyo Securities and Yamaichi Securities which are compared to Bear Stearns and Lehman Brothers of the USA.

Government tried to control the situation by reducing interest rate. It reduced it to give a boost to economy. But because of high NPA’s which banks were carrying on their balance sheet, they were reluctant to give loan. In the year 2000, Interest rates bottomed to nearly zero level. There was very little sign of recovery. This forced government to start the quantitative easing, to pump more liquidity in the system.

In the year 1998, government established a 60 trillion yen funding to promote economic recovery. The national budget of 1999 included a large increase in public project spending and increased measures like increase in tax credits for a new home purchase.

In 1998, Diet passed a series of financial reforms. Diet consists of House of Representatives and House of Councillors, to whom Legislative power is vested. One of the major acts was Financial reconstruction law, which authorizes use of $515 billion to acquire failed financial institutions. The institution soon took control of Long Term Credit Bank of Japan and Nippon Credit Bank. Further 17 major Japanese banks were merged to make 4 megabank groups. 

Deflation was another problem which started creeping in the economy. As it can be seen from the  

Graph that inflation bottomed to sub-zero level in the late 90’s. Property prices were declining, companies were not investing in plants and machineries. The idea that price will be cheaper in future was driving them away from spending and blocking the liquidity of system. New York times reported “Deflation has left a deep imprint on the Japanese, breeding generational tensions and culture of pessimism, fatalism and reduced expectations.

Deflation and its impact on economy

Deflation refers to an increase in the value of money. In layman's language, with the same amount of money you would be able to purchase more goods. Let’s not confuse it with Disinflation, which mean decrease in rate of inflation.

Is deflation good or bad for economy?

The good side of it is my money increases in real terms. Even if I don’t invest, my money can buy more goods today than it would have bought yesterday. Let’s understand what is the bad side of it.

If there is deflation, consumers would like to postpone their purchases because with less spending they would get more goods the very next day. This will reduce the total consumption in economy. If consumption decreases, industries would not be utilizing their maximum efficiency. And therefore they will produce less and as a result will have a hit on their bottom line (profit). If industries produce less, there will be less demand of workers, and so the total money in hands of people will also reduce. This will lead to a deflationary spiral, which will reduce the overall economic activity and push the country towards recession.

The basic principal of finance says that risk and returns are directly related. Like if you invest in most secured ‘AAA’ rated US treasury, you would get the least interest rate. And if you invest in ‘AA’ or ‘A’ or ‘B’ rated bonds, you have a chance to earn more returns. In case of deflation an investor earns more returns with virtually no risk at all. So he starts hording money and therefore reduces the liquidity in the system.

Other big impact of deflation is it affects the total borrowing of a country. Take for example, if I have borrowed $100 from you and promise to return it after a month, with an interest of 2% ($2). If my country is running Deflation of 2% a month, I would effectively pay you $104. So the interest rate effectively increases to 4% (approx.).

How might have deflation came in the first place

Suppose there were 100 people living in a country and there $1000 bills circulated. Suddenly the number of people increases and equivalently if the amount of money does not increase, than dollar will become dearer and its value will increases. Result is Deflation

Another scenario is if the overall efficiency of manufacturing plants increases, than the total goods produced by them will increase. Also because of mass production the cost of producing goods would decrease and therefore the amount of goods for the same dollar will increase. This will again lead to Deflation.

Another reason for Deflation is the new competition in an industry. Competitors enter into a sector which is profitable and easy to enter. With competition, competitors would be forced to sell cheap and this would result in purchase of more goods with the same amount of money. Good for buyer but it will again lead to Deflation. 

Interest rates in Japan

The Interest rates in Japan have always been very low. Long term average from 1972 to 2013 stands at 3.2%, while since February 1999, it has been at zero level.  

The reason for keeping such low interest rates is to push growth and turn deflation into inflation. If we see the graph of CPI in Japan, we will hardly find a time (after 1990) when they were above zero level. Result was a deflating economy.

When most of the countries around the world are fighting with high inflation level, developed countries like Japan, America are fighting with low inflation. Starting from the year 2009, CPI started pushing up. But much to the disappointment of Bank of Japan, it fall back to sub zero level in 2012. It again started picking towards the middle of 2012-13. 

Japan's new prime minister, Shinzo Abe assumed office in 26 December, 2012. Abe's major challenge was to boost the growth and control deflation. He started massive quantitative easing, coupled with high growth in infrastructure and the devaluation of Japanese Yen. His economic policies, which was now referred as Abenomics, started showing the result. Japanese Yen devalued approximately 25% with respect to US $. Also the unemployment rate also decreased from 4% to in 2012 to 3.7% in 2013.

Abenomics is a set of steps taken by Shinzo Abe to control the macroeconomic condition in Japan. It will have its impact on all the ways economy of a country can be controlled. For example change in Monetary policies like target inflation level of 2%, excessive quantitative easing, investment in infrastructure, correction of appreciating Yen and strategies to promote private investment. Change in Fiscal policies like Fiscal spending increase by 2% of GDP,which will increase the deficit to 11.5% of GDP for the year 2013.

What government is doing is confusing to me. On the one hand they have started QE, and on the other hand they are increasing tax rate. Consumption tax, which currently stands at 5%, is set to increase to 8% by 2014 and 10% by 2015. Increasing monetary base helps increasing demand and supply but what Japan is doing, is setting its path for default. Public debt as a percentage of GDP for Japan stands at 245% in 2013 which is even worse than Greece - 181.8%, Italy 127.3%, Portugal 123.7%. 

Charts to supplement the reading

Monetary base of Japan

GDP growth rate of Japan

Forex Reserve of Japan

Current Account of Japan

Dollar to Yen Exchange rate

MSF and its impact on liquidity Position of India

RBI has reduced MSF by 50 basis points. It has sent clear message that it is no more worried about the volatility of Indian rupee against USD. For past couple of monetary reviews, RBI has tightened the interest rates. The reason was to curb the usage of excess liquidity in the market to fund for dollar based speculations.

Now that Rupee has stabilized in 61-63 level, and CAD has significantly improved, RBI has started loosening its grip on the interest rate. The result is decrease in MSF consecutively for last two revisions. At present it stands at 9%.  

In order to boost growth, interest rates have to be slashed. But because of high inflation and high volatility of Rupee, RBI was forced to keep interest rates high. 

Sales of discretionary items (non essential but luxury items) peak during festive season. Diwali is just a couple of weeks away. To help increase the sales and demand in market, RBI has decided to reduce MSF. The immediate effect of which would be reduced short term borrowing rates. The earlier revision of MSF was on September 20, when RBI reduced interest rate by 75 basis points. 

Liquidity position in market will further improve because of the Rs 52K worth cash management bills which are due to expire between October 14 to October 22. 

Related readings:

MSF:

Under this scheme, Banks are able to borrow 2% of their respective NDTL (Net demand and timed liabilities) outstanding at the end of the second preceding fortnight. 

Related news article:

http://articles.economictimes.indiatimes.com/2013-10-08/news/42829516_1_yield-curve-msf-rate-50-basis-points

US Shutdown

Starting this month, US government has closed all non-essential government offices, after Congress failed to strike a deal on US government spending on Obamacare and increase in debt ceiling.

US congress has entered into a deadlock where the republican senate is not approving the increase in debt ceiling from its current $16.7 Trillion. US government is set on the path of default on its bond on 17th October. If it happens, financial market will collapse. We can see recession of 2008 or even worse.

US government bond is considered risk free. Not for a single time in its history, have they defaulted on it. It being so risk less gives them the power to pay less interest as compared to other options available for investment in market. With the upcoming default, investors will ask for more interest from government. As a result of which government will come under a lot of debt.

Deadlock is because republicans are asking to remove spending on Obamacare. Obamacare is nation wide medical insurance policy started by President Obama three years ago. He believes that it's important for country, as it is benefiting a lot of people for whom medical facilities were out of reach before.

Impact of Shutdown on Indian Economy  

US Shutdown is not an independent event. It brings with itself a lot of connected issues. Countries which are doing trade with US will directly get impacted because of it. We Live in a globalized economy where our own economy is not only a function of our activities, but is equally dependent on things happening outside our world. US economy being the most powerful, controls most of the economic activity happening in the world.

As stated in Indian Express, commercial ports do not come in emergency service category, so there will be delays in port services like clearing of goods from port due to staff shortage. This will have a bad impact on Indian exporters who at present send out almost $ 36 Billion worth of goods and services to USA. Also Exporters are not able to benefit from current depreciation of INR.

US shutdown would also result in slow visa processing by immigration department. This would pose threat for IT companies which sends out a lot of employee to work on onsite 

Direct financial impact of US shutdown would be the sudden rise in interest rates of US government bond. This will result in flow of money out from EM (Emerging Markets) into the developed market. The trailer of which was observed when US treasury announced tapering in bond purchase. The result was sudden jump of 200 basis points in short term interest rates in US. A result of which was a huge outflow of money from EM's. This resulted in catastrophic depreciation of currencies of EM's with Indian currency the most affected.

Quantitative Easing

To make this term more clear to the reader, I would be taking up some questions, and the answers to which will help in understanding the term better.

Very often we hear this term coming up in news papers. But what exactly it means?.

This term has been around in finance news for couple of years since recession kicked in on global markets. It started when central bank of US had no other avenues left to increase the inflation which was touching abyss. Let's first understand how central bank control inflation.

What are the options available to Central bank for controlling Inflation?

In order to control inflation, central bank changes interest rate. If interest rate increases, people want to borrow less, as it becomes costlier for them to borrow from market.

Industries scrape project because, what we typically call in Finance World, "The Net present value of project" becomes negative. As a result of which, supply and demand both decreases, which in turn reduces inflation.

Central bank was trying to boost growth in country. Declining inflation suggested that there was decrease in manufacturing activity happening. Also consumption was low. To tackle this situation, government reduced the interest rate. It helped still demand was not pushing.

As we can see that around 2009, interest rates bottomed to almost zero level.

Now what? Government cannot reduce it any further. It cannot make interest rate negative. No one will keep their money with government in that case.

So, in order to pump liquidity into the system, Fed increased the monetary base. Monetary base is the total amount of money which is rotating in the country. Like if central bank issues a $100 note, and if statuary requirements requires banks to have 10% in bank vaults, the total money in circulation would be 100/0.1=1000. This is called the money multiplier effect.

So government stated pushing money into the system. But how? Can it distribute money like leaflets. The obvious answer is no. So how did they pump more money in the system.

They purchased the CMO's which banks at that time were loaded with. All good for nothing. But that helped banks to manage their debt and bring them back in liquid state.

What  did central bank do with them?

They kept it with the faith that these banks will start walking, without any support, and buy back these CMO's.

Lets look at this phenomenal increase in monetary base with the help of data.

As we can see that around 2009, monetary base started increasing. That is QE1. Government pushed in a hell lot of money in the system. More money that it had pushed in last 50 years. Result was an increase in inflation, which government wanted.

Lets see the impact of QE on inflation by a graph

QE helped in boosting growth and as a result inflation started to increase. Effect of QE on inflation was lagged. And therefore, impact on inflation was seen starting from 2009, but QE stated in around Oct 2008.

With this small article I tried to establish relationship between interest rate, QE and Inflation.