Foreign Investment: Direct versus Portfolio

Ever since the Asian crisis, there has been a sort of consensus
that foreign direct investment (FDI) is the best and most stable form
of capital inflows while foreign portfolio flows (FII in Indian
parlance) are more volatile and therefore less desirable.

Ever since the global crisis began, I have been reading a lot of
financial history (starting with the last 500 years and slowly going
further back). It now appears to me that the aversion to the
volatility induced by portfolio flows is extremely short sighted.

In the long run, the volatility gets washed out and what counts is
the average growth rate of the economy. The short term (high
frequency) is all noise (volatility) while the signal (mean) is
apparent only in long time series (low frequency). Lessons drawn from
short time series of data are probably wrong.

Looking back at some of the major emerging markets of the
nineteenth century (US, Canada, Australia and Argentina) puts things
in a totally different perspective. I particularly enjoyed the
discussion about nineteenth century US in Chapters 7 and 8 of Atack
and Neal, (The Origin and Development of Financial Markets and
Institutions; From the Seventeenth Century to the Present,
Cambridge University Press, 2009).

Of all the big emerging markets of the nineteenth century, the US
relied most on portfolio flows and Argentina relied the most on
foreign direct investment. By 1890, the results of the different
trajectories were quite apparent.

In the long run, the volatility of the growth rate is largely
irrelevant; it is the average that counts. Despite frequent financial
crises and corporate bankruptcies, the US grew faster. More
importantly, it was also able (despite the damage inflicted by
populist politicians like Andrew Jackson) to build a domestic
financial system that ultimately made it less dependent on foreign
markets and institutions.

Applying that historical lesson would suggest that India should
remain friendly to foreign portfolio flows while developing domestic
financial markets. We must simply learn to live with the volatility
and occasional crises that come in their wake.

 

Indian coupling with global risk aversion in 2009

I wrote a column
in the Financial Express today about why Indian markets
were swayed by global developments in 2009.

Indian markets in 2009 appeared to dance almost completely to the tune
of global developments, reminding us of how strongly integrated we are
with world financial markets.

Unlike China, the Indian economy does not depend so much on exports
for its growth. Collapse of global trade in 2008 and early 2009 did
impact sectors like textiles, diamonds and software services, but
collapsing exports did not crush the whole economy because many other
sectors thrived on domestic demand.

India’s tight coupling with global markets was not due to trade
linkages, but to its dependence on foreign portfolio flows for risk
capital. Over the last few years, more and more Indian investors have
sold their shares in Indian companies largely to foreign investors
(but also partly to Indian promoter groups seeking to increase their
stakes).

Foreigners might have bought because they are more bullish about our
country than we are, or because their global diversification makes
them less concerned about India-specific risks. What is important is
that Indian asset prices are now increasingly determined by foreign
investors.

This dependence has three implications. First, when foreign portfolio
flows reversed, as in late 2008 and early 2009, risk capital
disappeared completely. A few companies with strong balance sheets
were able to raise modest amounts of debt locally, but those with
weaker balance sheets found that they could not raise money at all.

When the corporate sector talked about a liquidity crunch in early
2009, it was really bemoaning the lack of risk capital. Banking system
liquidity was probably adequate by early 2009, but this liquidity was
not risk capital that could meet the needs of cash-strapped
businesses. It was the return of foreign risk capital in mid-2009 that
saved the day for these companies.

The second implication of India’s dependence on foreign risk capital
is that asset prices in India depend on global risk aversion as much
or even more than on domestic sentiment. Capital inflows can ignite
asset-price bubbles and outflows can prick the bubbles.

Many of us worried about asset-price bubbles in India in 2007,
particularly in the stock markets and in real estate. This view can be
debated, but if it is accepted, some of the air went out of these
bubbles in 2008 and early 2009, and the bubbles might have been
inflated again in the second half of 2009. They could deflate again if
global risk appetite reverses in 2010.

The third implication of reliance on foreign risk capital is that
equity portfolio flows have a strong effect on the exchange
rate. Reserve accumulation by the central bank dampens currency
appreciation but does not eliminate it completely. A regime of managed
exchange rates creates difficulties for the conduct of monetary
policy.

Despite all these problems, foreign risk capital (unlike debt capital
inflows) brings huge benefits to the economy. Even in the extreme
scenario where all inflows are sterilised in the form of reserves,
capital inflows provide dramatic risk reduction for the economy as a
whole.

This benefit was clearly visible in late 2008 and early 2009 when
foreign investors sold shares at prices well below what they had paid
only months earlier and converted the rupee proceeds into dollars at
exchange rates much higher than the rate at which they had bought
rupees when they came in.

Whenever foreign investors sell cheap after buying dear, they make a
loss and India as a nation makes a profit. More importantly, we as a
country make a profit precisely when the economy is not doing too
well. This is a wonderful risk hedge that is worth all the costs that
come with it.

Looking forward to 2010, it is quite likely that the ups and downs of
global markets will be felt in India as well. Major downside risks
remain in the global economy and the question is how well positioned
we are to cope with their impact on India.

The Indian corporate sector has used the recovery of 2009 to repair
balance sheets in a variety of ways. A lot of the rebuilding of
balance sheets has been made possible by foreign risk capital.

Some companies have raised new equity in 2009 largely in the form of
private placements and sales to strategic investors. Many companies
that found themselves struggling to roll over short-term debt in 2008
have taken advantage of benign conditions in 2009 to refinance
short-term debt with longer-term debt.

A few companies have also addressed the problem of busted
convertibles. The recovery of 2009 enabled them to successfully
exchange old convertibles that had uncomfortably high conversion
prices for more viable instruments. The re-emergence of mergers and
acquisitions activity also allowed some companies to carry out asset
sales to rebuild their balance sheet strength.

As a result of all this, the Indian corporate sector is better
positioned to face new challenges in 2010.

 

Letting large banks fail

I wrote a column
in the Financial Express today about the reform
legislation winding its way through the US Congress. I argue that the
regulatory goal of making large banks failure proof will not be
realized and that it is better to have a policy of letting even large
banks fail.

Towards the end of 2008, US policymakers halted the panic phase of the
global financial crisis with three simple words: “No more
Lehmans.” In the short run, this statement could mean that there
would be no more bankruptcies like Lehman – any large financial
entity on the verge of failure would be simply bailed out. AIG was the
first beneficiary of the new policy.

However, in the long run, the ‘No more Lehmans’ policy can
only mean that there would be no more failures like Lehman. Either
financial entities should be unimportant enough to be safely left to
the bankruptcy courts when they fail, or they should be robust enough
to make their failure extremely unlikely.

In this context, the US House of Representatives has passed a
comprehensive 1,279-page Financial Reform Bill, but the Bill could
change significantly before it is passed by the Senate and becomes
law. How effective would this law be in eliminating Lehman-like
failures?

First, the new US provisions (as well as the recent Basel proposals at
the global level) impose higher capital requirements on financial
institutions. While higher capital would reduce the chances of
failure, it would not make failures so unlikely that governments can
safely promise to bail out any large bank that slips through the
cracks. Other elements of the new legislation are, therefore, designed
to make it easier to let large institutions fail.

A second key part of the legislation extends the existing resolution
mechanism for failed banks to systemically important non-banks and
bank holding companies. Under the old law, Lehman could not have been
resolved in this manner and while the banking part of Citigroup could
have been resolved, the holding company itself (which owned many of
the foreign subsidiaries) could not have been.

The new resolution mechanism makes it easier for the regulator to
contemplate the failure of a large entity because the messy bankruptcy
is replaced by a more orderly resolution process. There is also a
provision for a bailout fund (Systemic Dissolution Fund) to facilitate
the resolution process, but this fund is to be financed by
contributions from the financial industry itself.

The problem with this proposal is that while it avoids bailing out
shareholders of a large entity, it actually formalises the bail-out of
their creditors through the systemic dissolution fund. It would,
therefore, have the perverse effect of encouraging banks to become
even larger to exploit this implicit guarantee from the government.

A third key element in the legislation is the reform of the OTC
(over-the-counter) derivatives market. Lehman was not spectacularly
large in terms of assets and liabilities. The systemic importance of
Lehman (and even more so of AIG) came from OTC derivatives.

Lehman was a large dealer in OTC derivatives and AIG was a large
counterparty for subprime-related credit default swaps. They were not
too large to fail, but were described as too interconnected to
fail. Reform of OTC derivatives is intended to prevent this kind of a
situation from arising.

The straightforward solution to the OTC derivative problem is to move
these derivatives to the exchanges where a central counterparty (the
clearing house) collects margins from all participants and assumes
responsibility for all trades. Lehman did have a portfolio of 66,000
contracts totalling $9 trillion of interest rate swaps cleared by
LCH.Clearnet in London. LCH not only resolved the Lehman default
without any loss, but also returned a large part of the margins that
it had collected from Lehman.

To understand the difference with the OTC market, suppose that Lehman
had sold $100 billion of a certain OTC swap to some parties and bought
$90 billion of the same OTC swap from others. Its failure would force
all its counterparties to terminate their $190 billion of Lehman deals
and establish new contracts with other counterparties. When all these
trades are done through an exchange, the clearing house would have to
liquidate only the net position of $10 billion, and this is easier
because of the margins that the clearing house has collected.

The US law tries to mandate clearing of standardised OTC derivatives,
but the proposals are riddled with loopholes that threaten to make
them ineffective. First, it does not mandate exchange trading; it only
mandates clearing and that too if a clearing house accepts the
concerned derivative for clearing. Second, many OTC derivatives lack
price transparency and are therefore illiquid. Without a push towards
transparency, many derivatives will simply be unacceptable for
clearing. Third, minor changes in terms may make a derivative
non-standardised and therefore not subject to clearing.

All in all, the 1,000-odd pages of complex provisions riddled with
loopholes in this legislation will not make Lehmans sufficiently
unlikely in future. I would suggest that ‘No more Lehmans’
is not the correct policy after all. True capitalism is about letting
insolvent banks fail, however painful that might be.

 

How broken are the OTC markets?

The SEC has filed a complaint
against the world’s largest inter dealer broker ICAP which
dominates trading in US government securities and many other OTC
markets. ICAP has settled the charges for $25 million and an
undertaking to implement remedial action to be suggested by an
independent consultant.

The charges are very serious:

• ICAP displayed thousands of fictitious trades designed to mislead
  other traders about the true state of the market; and
• ICAP brokers executed thousands of trades to liquidate
  ICAP’s positions against customer orders in violation of the
  stated workup protocol.

It is depressing that charges of such seriousness are settled
without an admission of guilt. The alleged actions shake the very
foundations of market integrity and make one wonder whether OTC
markets can be trusted at all.

Around the same time that I was reading this complaint, Rortybomb
alerted me to a Bloomberg
story of a few months ago about an investigation against
Markit. The charges here are of a very different nature but they are
disturbing in their own way. It is alleged that Markit agreed to
provide price information to a clearinghouse only if the latter agreed
to clear only trades that involved a dealer.

The question in my mind now is how badly broken are the OTC
markets. Whenever, people describe the stock exchanges as casinos, my
response is that even if many of the participants are only gambling,
the stock exchange still performs the socially useful purpose of price
discovery. OTC markets that do not provide transparent price discovery
do not perform this function and are much closer to pure
casinos. Those that distort the price discovery are worse than
casinos.

 

Getting rid of cheques

The UK Payment Council this week announced a plan
to abolish cheques in less than a decade. Actually, it is the clearing
of cheques that would be closed on October 31, 2018, but that is as
good as abolishing cheques themselves.

The report points out that “A number of countries including
The Netherlands and Sweden have already largely or totally eliminated
cheques. However volumes of paper credit payments in these countries
remain significant. The cheque replacement programme in the UK would
be going beyond these countries in aiming to modernise the payment
system …”

The usage of cheques in the UK peaked nearly two decades ago in
1990 and has been falling relentlessly since then. “Cheque use
is in long-term, terminal decline.” The UK therefore proposes to
shift remaining users of cheques to paperless channels (ATMs, mobile
banking, internet banking and stored value cards) over the next decade
and then get rid of cheques completely.

The report has a section on “cheque dependent
consumers.” This group consists mainly of individuals with
degenerative conditions and individuals living in care homes or with
mobility problems. The main advantage of cheques is that they allow
third parties to assist the user by filling up the cheque before the
user signs the cheque. My own sense is that biometrics would be safer
than reliance on a third party in such situations.

Interestingly, the report also discusses a few UK statutes which do
not allow any alternative to paper payment – these include
penalties for dog fouling, litter, releasing greenhouse gases and
cigarette smoke.

 

Samuelson and finance theory

I found it surprising that most of the Samuelson obituaries do not
refer to the impact that he had on finance theory. Along with
Modigliani and Arrow, Samuelson was among the few mainstream
economists who had an enduring impact on finance theory.

Indeed it appears odd that while modern finance theory is often
regarded as the bastion of free market economics, it owes so much to
Samuelson who was the dominant left wing economist of his era. By
contrast, Samuelson’s great right wing rival, Milton Friedman,
contributed very little to modern finance theory apart from his famous
pronouncements on destabilizing speculation.

Samuelson more or less established the modern
“martingale” concept of market efficiency (as opposed to
the now largely discredited random walk model) in his landmark paper
entitled “Proof that Properly Anticipated Prices Fluctuate
Randomly.”

Samuelson also had a strong influence on option pricing through
his doctoral student Robert Merton though Samuelson’s own work
in this area is completely obsolete.

Above all, I think the mathematical approaches that Samuelson brought to
economics were necessary prerequisites for modern financial economics
to develop.

 

Principles based securities regulation

Cristie Ford has posted on SSRN an interesting paper on
“Principles-Based Securities Regulation in the Wake of the
Global Financial Crisis.” The paper argues that the Global
Financial Crisis has not discredited principles based regulation.

According to Ford, what the crisis has done is to demonstrate that
principles based regulation requires as much (and sometimes more)
regulatory resources and trained staff as any other form of
regulation. Principles based regulation “requires greater
regulatory capacity in terms of numbers, resources, and expertise than
has been allocated to it in some of the infamous examples of
regulatory failure in the past two years – the failure of
Northern Rock in the UK, and of the the SEC’s CSE
Program”.

Principles based regulators also must have the ability to obtain
transparent and reliable data directly, for otherwise, they
effectively cede the field to the regulatees.

Ford also argues that regulators’ hiring decisions must be
based not only on applicants’ relevant industry and legal
expertise, but also with a view to whether applicants seem to have
sufficient confidence and independence of mind.

Ford’s paper is an insightful analysis of the issues involved
and is definitely worth reading.

 

Pirate stock exchanges and the origin of stock exchanges

Reuters has an interesting report
on the stock exchange set up by Somali pirates to fund their
activities. It is a fascinating story of how a stock exchange is
operating in a near-barter economy. One of the shareholders got her
“dividend” for contributing a grenade launcher which she
received as alimony from her ex-husband.

The interesting thing is that this is exactly how finance
began. Meir Kohn provides the following interesting description
of the capital market before 1600 (page 13-14):

While landowners and governments could finance themselves with
long-term debt, this option was generally not available to business:
it lacked the security and the reliable cash flow required for a debt
issue. On the other hand, business could promise substantial gains if
things went well to compensate for the possibility of loss if things
went badly. This potential for extraordinary returns did provide a
basis for equity finance.

The fundamental problem of equity finance is to ensure
equity-holders a fair return on their investment. Today, there
exists a complex of institutional mechanisms to address this
problem – accounting procedures and an accounting profession, legal
protections, extensive reporting and analysis of financial
information. Since none of these existed before 1600, equity finance
had to rely on a simpler mechanism: wind up the business periodically,
and divide up the proceeds among the shareholders. This procedure was
possible, because business was largely commercial and did not require
any substantial investment in fixed capital.

A few months ago, I wrote a post
on ultra-simplified finance which revolved around equity markets. To
see how powerful equity markets can be even when there is almost
nothing else by way of a financial system, one has three choices:

1. read Kenneth Arrow’s classic paper (“The role of securities in the optimal allocation of
   risk-bearing”);
2. go back in time to the pre-industrial era;
3. take a trip to Somalia.

 

Payment and Settlement Systems

I wrote a column in today’s Financial Express
about payment and settlement systems in India in the context of the
vision statement released by the Reserve bank of India

RBI recently released a vision statement for the payment systems in
India for the next three years. The mission is “to ensure that
all the payment and settlement systems operating in the country are
safe, secure, sound, efficient, accessible and authorised.”

It is true that the payment system in India has made considerable
progress in the last few years with the emergence of Real Time Gross
Settlement (RTGS) system, National Electronic Fund Transfer (NEFT)
system, implementation of core banking software in most large banks
and rapid spread of the ATM network. With these developments, India is
gradually moving away from antiquated paper-based payments to a modern
payment system. The progress is slower than one would like, but it is
progress all the same.

However, the global financial crisis in 2007 and 2008 has changed
the way we look at the safety and soundness of payment systems, and
the RBI vision statement does not reflect these new concerns and
priorities at all. In fact, the document is characterised by a
pre-crisis world view that makes it largely complacent about
settlement system risks.

The first lesson from the crisis is that any payment or settlement
system that settles in commercial bank money is simply unacceptable as
a ‘safe, secure and sound’ system. During the crisis,
credit default swap spreads on some of the largest banks in the
developed world as well as in India rose to levels indicating serious
concerns about their solvency.

This immediately brings up the horror scenario of every payment or
settlement system: pay-ins take place into the settlement banks of
these systems just before the settlement bank fails. In other words,
the settlement bank fails after receiving the pay-in but before making
the pay-outs.

Since the major securities and derivative settlement systems in
India settle in commercial bank money, this horror scenario should be
giving sleepless nights to the securities regulator and to the central
bank. Unfortunately, the vision statement does not betray any such
concern.

I think urgent steps should be taken to allow major settlement
agencies like the clearing corporations of the stock exchanges,
derivative exchanges, commodity exchanges, the Clearing Corporation of
India and similar entities to make settlements in central bank
money. Whether this takes the form of giving them a limited banking
licence or of opening up the RBI’s payment system to
systemically important non-bank entities is a matter of detail that
need not bother us here.

The point is that we do not have a true delivery-versus-payment
(DVP) system unless the payment happens irrevocably in central bank
money. Before the crisis, it was possible to pretend that large banks
are safe enough to allow settlement to happen in their books. After
the crisis, the regulators would be irresponsible and delusional to
accept this idea.

An even bigger problem exists in the settlement of foreign currency
transactions where time zone differences preclude any true
payment-versus-payment (PVP) settlement of these
transactions. Herstatt Risk has really not been solved several decades
after Herstatt Bank in Germany failed after receiving payments in its
currency but before making payments in foreign currency.

The international community has come up with the idea of having a
private bank (CLS Bank) handle the global settlement of foreign
currency trades. This avoids banks having to take exposure on each
other, but requires them to take exposure on CLS Bank and sometimes on
a participant bank that provides access to CLS Bank.

The thinking was that a settlement and custody bank like CLS Bank
cannot fail, but this is a delusion. During the 2008 global crisis,
questions were raised about some US banks that were largely settlement
and custody banks rather than lending banks. Moreover, even settlement
and custody banks can suffer from acute operational risk as was
demonstrated in a famous episode two decades ago in the US. As a
member of the G20, India has an opportunity to argue for putting
foreign exchange settlement on a sounder footing.

Many alternatives can be thought of. First is that the IMF could
take on the responsibility of running foreign currency settlement not
only because it holds all the currencies of the world, but also
because it enjoys multilateral guarantees that would make settlement
in IMF books a true PVP. The second possibility is that the
world’s major reserve currencies (and currencies of invoicing)
can be persuaded to run a 24/7 RTGS that eliminates the time zone
problem.

The third solution, closer in line with the post-crisis philosophy
of each country taking responsibility for risks within its territory,
is for RBI to run a US dollar RTGS in Mumbai by taking advantage of
its huge dollar reserves. In short, a lot needs to happen before we
can say that “all the payment and settlement systems operating
in the country are safe, secure and sound.”

 

Dubai World brings Islamic finance down to earth

Back in 2007 and 2008, people were fond of arguing that the crisis
was due to highly complex financial instruments and that if finance
became boring, it would be a good thing. People even argued that
Islamic finance would be a good idea.

This week Dubai put an end to this talk by making it clear
that Dubai World would default on debt issued by its subsidiary Nakheel
Development Limited. The debt falls due in the middle of December, but
Dubai wants creditors to agree on a standstill till May while a
restructuring is worked out.

The interesting thing is that the instrument in question is an
Islamic bond – a Sukuk. The prospectus (available in the FT
Alphaville Long
Room) proudly refers to the “pronouncement dated 11 December
2006 issued on behalf of the Sharia Supervision Board of Dubai Islamic
Bank PJSC confirming that, in their view, the proposed issue of the
Certificates and the related structure and mechanism described in the
Transaction Documents are in compliance with Sharia principles.”
(page 34)

Of course, one can argue that there is really nothing Islamic about
modern Islamic bonds other than an opportunity for some religious
scholars to earn a living by issuing pronouncements on Sharia
compliance. But that itself is a warning that trying to legislate
simplicity in finance is often futile.

Modern corporate finance teaches us that money is made and lost on
the asset side of the balance sheet. To adapt a favourite statement of
the Austrian economists, losses occur when wrong investment decisions
are made. The defaults on the liabilities side of the balance sheet
only serve to announce and crystallize this loss. Last month, I blogged
about how bank losses from loans in the current crisis exceed losses
on securities. The default on the Sukuk reinforces this idea that
mis-allocation of capital produces losses regardless of the composition
of the liability structure.