Sunday, November 28, 2010

Too big to fail - a revisit

The troubles facing Ireland have brough to fore yet again an uneasy compromise policymakers and the populace had come to live with. This concerns the issue of private profits, public losses that emerged in the financial crisis. The main theme underlying the issue is the bailing out of several errant financial institutions by their respective governments during the crisis, using tax-payer's money. By not allowing these institutions to fail, the governments essentially let the owners of these companies keep the profits they made while committing the follies which drove them to the failure in the first place. The argument for doing this was that these institutions were too big to fail and letting them go through the well deserved failure would have undermined the stability of the entire financial system - with very dire repurcussions for the real economy as well. The failure of Lehman Brothers is often cited as the case in point for this. I believe part of this argument is indeed valid. I have so described in my book as well - in a box on "The Logic of Too Big to Fail".

In the short term this argument is quite acceptable. While firefighting, one does not look to punish the errant who started the fire immediately. However, this need not become the norm in the modern financial world. If financial institutions realize that they have a free hand to engage in any risk taking as long as they remain big enough (or interrelated to the rest of the financial system in complex enough ways) they will be bailed out, one does not need a crystal ball to guess what path they will choose.

In India in particular, we have the luxury of time and learning from the west's regulatory and policy mistakes. It would be a terrible waste if we ignore this phenomenon of too big to fail till a similar crisis hits us. There are various mechanisms to prevent individual companies from becoming systemically important enough to warrant a bail-out with public money. This need not smack of the relic of "Prevention of Monopolies Act". At the heart of the too big to fail argument lies the interconnections of various firms in finance. This is unlike other sectors. In finance competitors deal with each other lot more than those in any other sector. Hence any large enough firm tends to become too big to fail. The correct policy intervention here would be to make sure that the ways in which financial institutions do business with each other is adequately secure. One example is the regulation of OTC derivatives. While in theory one can argue that two firms can decide the risks they would like to take on their own books, in practice this is a sure-shot mechanism of transmitting a bankruptcy of one firm to another. More needs to be researched on this front. In general though, transperancy, promoting centralized clearing of transactions and keeping an eye on finanical sector innovations should be the general intent of policy making.

Saturday, November 20, 2010

G20, Currency Wars, Economic Imbalances and the general mess that goes with the present International Monetary System

Last three decades have not been very forgiving for the global monetary system. There have been numerous sovereign defaults, many large bank failures, several local currency and banking crises and then one mega-crisis along with the deepest recession in last 70 years. When did life become so complicated?

At the risk of oversimplification I am going to suggest a date! 15th August 1971. That was the date on which President Nixon of US announced the abolishing of Gold Standard under the Bretton Woods system. This day onwards, currencies started floating freely against each other. The initial reaction of most countries was one of the two. Large economies were fine with letting their currencies float since the volatility in the exchange rate was not significant - this included Germany, UK, Japan etc. Smaller countries chose to peg their currency to one of the major currencies - mostly driven by the currency of choice for their largest trading partners. Majority chose USD, some went with Pound Sterling.

Over a period of time, the policy makers in the emerging economies discovered the strategy of currency management for export promotion. A very interesting analysis of this strategy has been done in a paper by Prof. Sebastian Morris of IIM Ahmedabad. Parallely, as capital became more mobile globally in the 80s and 90s, many emerging economies started seeing significant movement of capital in and out. Some discovered to their peril the footloose character of large part of these flows - also termed "hot money". The Asian Financial Crisis of 1997 was a testimony to this. Coupled with the cheap currency led export promotion and the need to have large forex reserves in the wake of the crisis, most Asian economies built massive piles of reserves (now running into trillions of dollars).

The world is now divided into three camps - monetarily speaking! Many of the advanced economies which run current account deficits and capital account surpluses in one camp, some advanced economies and many large economies which run currency account surplus and capital account deficits and the rest of the world. US and UK lead the first camp, Germany/Japan amongst advanced economies and China/East Asia amongst emerging economies lead the second camp. The second camp accumulates reserves or has depreciating currencies. The first camp has an ever increasing issuance of government debt to the reserve accumulators. (India belongs to the third camp - it accumulates reserves only when there is massive capital account surplus, else the moderate capital surplus typically balances out its almost always positive current account deficit.)

The funny (or tragic depending on your beliefs in fairness, human nature and geopolitics!) thing is that this state of affairs is thoroughly unstable. Whatever equillibrium the global financial system achieves is always likely to be very fragile since the actors in the above state of affairs are soveriegn states with very limited influence on each other! Consider the US-China exchange on the currency management by China and loose monetary policy of US Fed. Neither can directly control what the other is going to do to its internal monetary policy but both are likely to be strongly affected by it. It almost seems like one needs to coin a new phrase to describe this phenomenon of politics getting intertwined with monetary policy - "moneto-politics" maybe (along the lines of "geopolitics").

There is no easy way out of this. Central banks and governments across the world will keep managing their monetary policies and currencies independently. That may not always be the optimal outcome for everyone concerned. However, till most of the participants see more benefits of coordinated action than the to-each-his-own policies, the instability remains an inherent feature of the modern monetary system. Maybe one should do a game-theory analysis of monetary policy conduct of major economies!

Friday, November 12, 2010

Dealing with FPOs

There is a spate of follow-on public offerings in the offing - Power Grid is already behind us, SAIL, ONGC and some other PSUs are to follow. FPOs are an interesting animal. Unlike IPOs, FPOs already have a traded security in the market. The price discovery hence is already done. Unlike the IPO the issue price can be benchmarked to something real. For investors this is a good indicator of whether they should buy in the follow on issue or simply from the secondary markets - something dependent on the degree of the discount offered in the issue.

Since the issuer would want investors to subscribe to the issue despite the availability of the same shares in the secondary markets, it is understandable that FPOs would typically happen at a discount to the prevailing market price. While this is a small positive for the long term investor, it is potentially a very interesting opportunity for the short term investor. Inherent to the discount is an arbitrage opportunity. Since the FPO is likely to be in discount to the open market price, one can short the futures of the underlying security in the secondary markets and bid for the issue. When the allocation happens, one can square off the futures position as well as sell the alloted shares. This would lock in the price differential. Of course one needs to estimate the allocation amount. Given this, one can even use leverage to further boost the returns - especially since this strategy is relatively free of market risk.