Wednesday, May 19, 2010

Is the world headed for Inflation or Deflation?

This is a tough one. Ever since central banks started creating money from nothing, Austrian school economists have been crying themselves hoarse about potential inflation. And yet it hasn’t been that much of an issue since Paul Volcker supposedly tamed the beast. Theory supports these economists, but experience doesn’t. So what’s really going on?

For one, theory often makes assumptions which don’t hold true in reality. “Ceteris Paribus”, a Latin phrase meaning “ other things remaining constant” is often used in economic theory but doesn’t really work in real life because almost nothing remains constant.

So when central banks started conjuring money, they not only added to the amount available for consumption, but also to the amount available for lending. This in turn led to the creation of capacities, which are now far in excess of consumption demand. Consumption demand should have risen as well, and it did, but looking at the scale of unemployment in all major economies, not enough to offset increased capacity.

This should ideally result in deflation and if one were to look at core inflation numbers (excluding food & energy) across the world, it has. On the other hand, sectors in which capacities haven’t really kept pace like food-grains, and those where natural limitations exist, like minerals, oil, metals etc., prices have been rising all through this period.

Rising prices of necessities, when coupled with falling prices for almost all other items, does not impact all nations equally. This differential impact is really a function of  the consumption pattern in these nations, which in turn is a function of their average per capita income. In high income nations, a lower proportion of income is spent on necessities when compared to low income nations. So increasing prices of necessities are more than balanced by deflation in other items as far as consumers in high income nations are concerned. On the other hand, in low income nations, necessities form a large part of the consumption basket and despite deflation in other items, perceived and experienced inflation remains high.

Average global inflation is, per force, GDP weighted while actual inflation is ‘per capita GDP’ weighted. This implies that while average global inflation will remain low and inflation experienced by consumers in high income nations will be slightly below this average, inflation experienced by consumers in low income nations will be significantly higher. Looks like the rich are getting richer and the poor, poorer.

Food for thought?

A version of this post appeared on my Business Standard Blog on May 18, 2010

Is the US like Greece?

This question has become one of pretty intense discussion between economists across the world recently. Paul Krugman declared that it isn’t and created some graphs to prove his point. Others declared he misinterpreted the data used for the graphs and used it to prove the opposite case. While Prof Krugman used data to try and prove that the US deficit is reducing and Greek deficit is growing in the coming years, his detractors used the same data to show that despite lower deficits, US Debt/GDP ratio in 2020 will be close to Greece’s today.

The funny thing about numbers is, if one’s smart enough, one can prove almost anything with them. Sadly, the core of the problem isn’t about numbers, its about monetary theory. And by ignoring this, both sides are missing the plot completely.

When Greece adopted the Euro, it chose to give up control of it’s currency. The Euro is now it’s home currency and legal tender for all financial transactions within it’s borders. This includes it’s borrowings. But Greece doesn’t control the quantity of Euro in circulation and cannot create it out of thin air, a privilege reserved only for the European Central Bank. So when it comes to repaying its debt, Greece needs to ensure that it either earns the required amount or borrows it. This was not the case when Greece had its own currency when they could just create it to repay their debt.

The core differentiator between domestic and foreign currency, especially when it comes to borrowings, is the government’s control over the quantity of that currency and not it’s use as legal tender in the country. The test for this differentiator is simple. One only needs to ask whether the government can, even if only as a last resort, create the currency required to repay it’s debt. If it can, all borrowings denominated in that currency are domestic borrowings. Conversely, if it can’t, all borrowings denominated in this currency are external borrowings.

When it comes to choosing between domestic and external borrowing, if such a choice exists, government’s will try and keep external borrowings to a bare minimum to minimize their foreign exchange commitments. But there are nations which either don’t have this choice or don’t need to make it. In the former group are nations which adopted the Euro. They do not have any control over the Euro individually, but have to denominate their borrowings either in Euro or in some foreign currency. In essence. all borrowings for these nations are akin to external borrowings since they cannot unilaterally create the currency needed to repay this debt.

Membership of the latter group; nations which don’t have to make this choice, is restricted to nations having the ability to borrow in their domestic currency from foreigners. Nations like the US do not need to undertake any foreign exchange debt commitments. All their borrowings are denominated in a currency they control completely, and can create and destroy at will. For them all borrowings are akin to domestic borrowings regardless of the nationality of their lenders.

So Greece will default, either now or in some time, because it cannot create Euros out of thin air.  But with a similar Debt/GDP ratio, all the US has to do is to create the money required to repay its debt. Whether that’s sensible is another discussion altogether, but in the end, the US has a choice and Greece doesn’t.

And that’s what makes them different, not their numbers.

A version of this post appeared on my Business Standard Blog on May 18, 2010

Saturday, May 15, 2010

Quantitative Easing in Europe - what's the real point?

It seems like the European Bailout package isn't the complete bailout that banks were hoping for. At least, not yet. But that doesn't mean banks have given up trying to make it one.

After the 'almost $1 trillion' bailout package announced on Sunday, pressure is building on the European Central Bank to support it by buying government debt of the peripheral European nations. The ECB has already agreed to buy Greek, Portuguese & Spanish government debt along with private sector debt but, to keep these purchases liquidity neutral, it plans to sell an equal amount of German and French government debt. But the amounts the ECB is willing to commit to this endeavor are relatively small and limited by their holdings of, and ability to sell, German and French debt. In a bid to increase this amount, financial market analysts are trying to get the ECB to delink sales from purchases. The reason being offered, of course, is very different from the real one. Analysts are trying to make the ECB believe that it needs to undertake quantitative easing to 'unfreeze' Europe's slowly freezing credit market. But before we go deeper into the real reason, let's look at some numbers.

The EU has already pledged to set aside over $75 bln to manage balance of payment issues. In addition EU nations will set up a Special Purpose Vehicle (SPV) which will underwrite/guarantee upto $560 bln of weaker members' Government debt. The IMF will contribute close to $320 bln to this effort through either of the channels in addition to the EU commitments bringing the total to a whopping $955 bln.

However, financial analysts will have the world believe that despite the 'ginormous' size, this isn't enough and suggest the ECB step in and buy close to $400 bln of government debt issued by these close-to-failed states as well. To make their 'unfreezing' premise believable and to free these purchases from restrictive limits, they also suggest that the ECB should not sterilize the liquidity. They propose that since this liquidity will go to the banks already holding this government debt, this will allow them to continue functioning normally.

It seems, having analyzed the bailout package, banks and financial institutions have realized that it doesn't give them a way out of their current holdings of debt issued by these weak nations. Debt which matures in the next 3 years will be rolled over with guarantees by the SPV or underwritten by it, but banks have no way out of their holdings of longer term debt issued by these nations.

Analysis of the bailout package also suggests that it will do nothing to stop Greece from defaulting eventually. Similarly, it doesn't really help other peripheral countries like Portugal, Spain etc. This is because the package concentrates it's efforts on improving liquidity for their debt, but doesn't address their solvency. This solvency issue can only be corrected by a partial default, also called debt renegotiation. But, debt renegotiation will involve write-downs in the value of this debt and a direct loss to the holders of this debt.

Worried about these losses, and not knowing which bank will suffer more, banks have virtually stopped lending to each other, preferring instead to deposit funds with the ECB. As of Monday, bank surpluses deposited with the ECB totaled just under $400 bln, the highest since July 2009. This suggests two things.

1) There is no shortage of liquidity with the banks and the demand for additional liquidity is completely unjustified.

2) Banks are seriously concerned about their own solvency if one or more of these countries were to default and don't trust each other to survive. Hence the reluctance to lend.

But in doing so, they are also making it clear that they will continue to hold the financial markets to ransom till their demand to be insulated from these losses is met.

The ECB has called their bluff to some extent by addressing their fear of frozen markets and re-introducing a facility under which it lends to banks for slightly longer periods, similar to what it did in 2007/2008. But this has only changed their argument. There are now suggestions that inflation caused by quantitative easing is desirable as it will allow the fiscally weak nations to recover easily, given that inflation reduces the real value of debt. That rising inflation would go against the only task the ECB has been entrusted with is, of course, of no consequence to these self serving advisors.

Hopefully, it's still of consequence to the ECB.

Thursday, May 13, 2010

The European Crisis - some good graphs

Der Spiegel has some really great graphs on the Euro Nations' financials

Did Banks dupe Rating Agencies?

US Federal Prosecutors are investigating 8 Banks to determine whether they lied to Rating Agencies and manipulated the underlying asset pools to get the highest possible ratings for their mortgage backed instruments.

This leaves only two possibilities regarding the role of Rating Agencies.

1) They are innocent and got duped: This would mean that they didn't understand the instruments very well and were fooled by representations made by the banks. This also means that they had no business assigning any ratings to these instruments since they didn't understand them well.

2) They understood the instruments and worked along with the Banks to fudge the ratings: Well, in this case, they have no business rating any instrument and should be barred from doing so.

Either way, it doesn't look good for the rating agencies.

The European Bailout - Shucks and Woe!

Late Sunday night, European leaders announced they had reached an understanding on stabilizing their currency and debt markets. It was a "shock and awe" bailout package of close to USD 1 trillion... It's amazing how easily the number rolls off the tongue now. The trillion is now the new billion.

The markets have reacted exceedingly well for now, but who actually benefits from this bailout? Is it Greece, or are they too far gone? Is it Spain, Portugal, Ireland and Italy because they still have some time? Or is it the bankers who lent to these countries, knowing their credit quality was suspect, but secure in the belief they could coerce government(s) into underwriting their losses? Following the money is always an easy way to figure this out...

As far as Greece is concerned, very little changes. The newly created multinational agency will underwrite Greece's future debt obligations. This will include new debt issued to finance it's fiscal deficit and refinancing of old debt which is due to mature in the near future. For Greece, this means lower interest rates on their borrowings which will help. What this will not do for Greece is help reduce their debt burden. It will not penalize it's lenders even though they lent to Greece knowing it's fiscal position. Greece's Debt-GDP ratio will continue to remain unsustainably high in the near future. And even though it looks as if it can be reduced by going thru an extremely painful deflationary process to improve it's finances, it's just not that simple.

Balancing the budget is not good enough anymore. Greece has to start generating primary surpluses of a magnitude greater than the deflationary impact of the austerity required to do so AND 1.25 times its average interest rate (currently 8%) for it to reduce it's debt-GDP ratio. The math isn't simple because it's iterative in nature but just as an example, Greece will have to turn from a primary deficit of 8.6% of GDP to a primary surplus of 10% of GDP while ensuring that its GDP does not shrink to maintain it's Debt-GDP ratio. It'll need to do more to reduce it. So Greece will remain where it is, with default being it's best option, either now or sometime in the future.

Spain, Portugal, Ireland and Italy aren't that badly off yet. Their Debt-GDP ratio is better than that of Greece and all they have to ensure is that it doesn't grow. Given the above example, once  again, it's not as simple as it sounds. They may not be candidates for default just yet, but one needs to bear in mind that they are just a few percentage points of GDP away.

The European Bailout package has fallen into a classic trap. It mistakes a solvency crisis to be a liquidity crisis. Yes, it can ensure that all these countries will get the funds they need to meet their debt obligations, but it doesn't address why they couldn't raise the money without help. While Greece is already insolvent, most of the others are on the brink and giving them access to cheap funds only delays the inevitable.

And it ensures that banks get paid in full. Since all maturing debt will either be underwritten, or provided, by the new entity created for this purpose, the burden of eventual default will be borne by those financing this entity, the European taxpayers. As far as the IMF's contribution is concerned, the burden of it's losses will be borne by each and every IMF shareholder, including India. So banks walk away unhurt while taxpayers across the world assume unnecessary risk. Doesn't that make you wonder who we're ruled by?

The only "hope" the package holds out is that of monetary expansion. If the ECB were to start expanding money supply by unsterilized purchases of bad Euro government debt and sparks off inflation in the process, Greece and the other countries may not have to worry about deflation as much. But if the ECB were to do so, not only would it be going against it's anti inflation mandate, it would end up weakening the Euro. This could result in developing countries devaluing their currencies to retain competitiveness in Europe. With the US still struggling for competitiveness, prospects of a sustainable recovery would all but vanish and the world will be back to 2007.

Except, this time around, it won't be financial sector bankruptcy we will be dealing with. It will be sovereign default.

This note was posted on my Business Standard Blog on May 11, 2010.

Greece – Is it a failure of the Euro?

With the US markets suddenly losing ground on Greek fears, and for some time now, analyses connecting Greece’s woes to its decision to join the Euro are everywhere. Some suggest that Greece may not be able to find its way out of its problems without leaving the Euro. They suggest that Greece return to a national currency system and devalue it’s way out of debt.

While it’s true that for Greece to recover, leaving the Euro seems to be a solution, it is clearly not a very plausible one. Another solution is being tried out under which Greece would take the tough decisions required to improve its fiscal health, which would result in the other Euro countries and the IMF bailing it out. This solution has found support in Greek Parliament but has been greeted by riots and mayhem on the streets. The idea of living with lower government expenditure somehow seems abhorrent to the Greek as it would necessarily result in changes in Greece’s social security structure and public sector salaries.

The cause of Greece’s woes is not its membership of the Euro. Being a part of a monetary union where monetary policy is independent of the state is as close as a country can get to monetary utopia under the current system of fiat currencies and monetary monopoly. But when a nation undertakes to live with a currency outside its control, a lot of things change. For starters, all borrowings of the state and it’s citizens become the equivalent of external borrowings. This is because once the state loses its power to create currency or manipulate its price, it’s ability to repay becomes directly dependent on its capability to earn the currency required to repay it’s debt. In this situation, it is incumbent on the state not only to ensure that it’s revenues are maintained at the required level, it is also it’s responsibility to ensure that borrowings are made only as a last resort.

Countercyclical fiscal policy, which is recommended for all countries regardless of currency system, becomes a necessity in a currency system where the state has no control. And not only in the traditional sense of a balance being maintained in good years and deficits undertaken in bad years. When the state does not have control over currency, it is imperative that deficits of tough years are balanced by surpluses in good years to ensure that over a business cycle or two, government debt tends to zero.

Greece’s troubles today are not a result of their joining the Euro, and they will not be solved by them leaving it. Greece’s problems are fiscal in nature and have been brought upon themselves by irresponsible spending. The only sustainable course of action is to make genuine attempts to improve their fiscal position. And improvements not only to the extent of reduced fiscal deficits, which will only reduce the pace of increase in their debt burden. Greece has to chart a path towards fiscal surpluses which will result in a reduction of total debt.

Leaving the Euro now may not help them to the extent envisaged by various commentators. Yes, it will give them control over their currency which they can merrily devalue to increase exports and become more competitive. But since all their debt will still be in foreign currencies, devaluation will increase the value of their debt in terms of their new currency. With the total stock of debt exceeding GDP by 1.7 times (including private debt but not including interest payments), devaluation would only work if nominal GDP growth were to outstrip the extent of devaluation itself by a factor of 1.7. This may take some time and in the initial stages, the balance will not be in it’s favor. This will result in Greece borrowing to meet it’s obligations at an interest rate which will be worse than it’s existing rate. Since the starting point is one where bondholders are demanding over 15% for 2 year debt, one can only shudder to think what worsening would mean.

And interest rates add their own twist to the math. As long as average interest cost on outstanding debt remains above nominal GDP growth in the currency of obligation, the debt burden will keep on growing. Till as recently as December 2009, Greece was borrowing one year money at an interest rate lower than inflation. This has changed in 2010. Rates now are sky high pricing in a significant probability of default. To make matter worse, close to half of Greece’s outstanding debt matures in the next 5 years, which will have to be refinanced at rates which are far higher than that on the maturing debt.

All in all, Greece’s debt problems cannot be solved by either staying with or leaving the Euro. It’s problems are fiscal in nature and can be solved only through fiscal measures. Given public reaction to this path, there is a distinct possibility that this will not happen.

And the only option left will be default.

This note was posted on my Business Standard Blog on May 7, 2010.

Tuesday, May 11, 2010

Audit the Fed becomes reality!

The US Senate agreed to a landmark provision on the Financial Reform Bill this Monday. In a step that returns power to the people, the Senate proposes a one time audit of the Federal Reserve which will include complete disclosure of who the $ 2 trillion rescue amount was lent to.

This just reinforces the belief that in a democracy, all government institutions have to be accountable to the people through their elected representatives. No government institution should be permitted to operate in secrecy unless disclosure is a threat to the state. No aspect of central bank functioning qualifies for secrecy.

If passed into law, this will usher in a paradigm shift in central bank functioning. For the better.




Friday, May 7, 2010

An Exchange Rate Policy for India

After many attempts at trying to convince the RBI to elucidate the exchange rate policy for India, Mr. A V Rajwade, a noted and respected foreign exchange expert, decided to do it himself. As mentioned in the second of his series (Exchange Rate Policy – II , Business Standard, May 3 2010) this was more of an attempt to describe what the exchange rate policy “should be” rather than what it actually was.

The series, though highly enlightening, falls prey to the same  fallacious beliefs that may have driven India’s exchange rate policy in the years past. I have attempted to address these individually.

1) “In many ways, a carefully constructed Real Effective Exchange Rate (REER) is a reasonable measure of the direction of movement of an exchange rate, and also of its deviation from fair value. (The REER index has some weaknesses but so do all indices used for policy-making — the wholesale price index, the consumer price index, the index for industrial production, etc.)”

The problems with using the REER index as policy input has been discussed at length in an earlier note (Is the REER model of any use?, Business Standard, April 28 2010). In summary, the REER index does not just suffer from normal mathematical & statistical flaws like the other indices mentioned above. It suffers from two fatal flaws which make its output virtually meaningless from a policy making perspective. It can at best be a guidepost, but one which is questioned intensely regarding the impact of its known flaws.

2) “Believers in market efficiency would argue that market prices are self-correcting and that, therefore, the central bank should leave the exchange rate to the market, an argument that is rarely made in relation to the domestic value of money.”

The market is self correcting and the same argument is actually made very often in relation to the domestic value of money. For this to happen, however, there has to be a free market for money, not the current system of fiat currencies with one sole issuer. These arguments are seldom acknowledged by central bankers, past and present, arguably because of the fear of redundancy. Anyway, given the system that exists, since the central bank is the sole issuer of currency, a task that it carries out in a reckless manner sometimes, it is the responsibility of the central bank to manage the consequences of these actions. Also, as an issuer of a currency, it is the central bank’s responsibility to protect its value both internally and externally, a fact that does not seem to figure in any argument put forth in support of a weak currency policy.

3) “Arguably, the exchange rate would be self-correcting if the foreign exchange market were to consist primarily of current account transactions”

“Capital account flows are often cyclical. For example, capital inflows in the equity market would tend to appreciate both share prices and the exchange rate which, in turn, attract more investors thus continuing the cycle, carrying the exchange rate significantly away from fair value.”

The exchange rate would be self correcting regardless of the nature of the flows. In any cross – currency investment transaction, two risks are analyzed. The first risk and one that is given significantly higher weight is currency risk. The second risk is the risk of the asset sought to be purchased, whether Equity, Real Estate or Debt. If the target currency appreciates sharply as a result of capital flows and moves significantly away from its fundamental value, the currency risk for investors would increase significantly, which would lead to an outflow. This would apply the requisite pressure on the currency, which would then depreciate to a level thought to be fundamentally sound. When the RBI intervenes in the market, supposedly to reduce volatility, it insulates foreign investors against their primary risk, which actually leads to an increase in the volume of capital inflows. In one of the few “Growth Oases” left in the world today, insulating foreign investors from exchange rate risk will only increase their willingness to invest, not reduce it. In short, if the aim of our currency policy is to reduce volatility, the outcome will often be the polar opposite. We will have extended periods of calm followed by bouts of extreme volatility due to the build-up of capital inflows and the RBI’s limits in absorbing and sterilizing them.

4) “It is sometimes argued that sterilisation of the excess money supply can lead to an increase in domestic interest rates, which would be detrimental to growth.”

Not only “sometimes argued” but “actually experienced”. The events of 2007 & 2008 bear testimony to the damaging effect of reckless attempts at sterilization in 2008 of an equally, if not more, reckless increase in money supply due to FX intervention in 2007 ( Total FX Reserve increase of approx. USD 95 Bln. through 2007 or close to 10% of GDP). In this case, the manner in which sterilization was sought to be undertaken not only contributed to a severe domestic slowdown, but caused unprecedented volatility in the domestic money market. For close to 2 weeks in October 2008, overnight rates experienced by market participants moved between 0-100%. Volatility of any magnitude in the risk-free rate leads to imperfect pricing of term assets. Volatility of the magnitude experienced then virtually prevented the pricing of term assets. How would the market price a 5 year bond, or even a 3 month commercial paper, if the risk free rate could be anywhere between 0-100%?

The recent demand for interest rate hikes in response to prevailing inflation is another case in point. Thankfully, the RBI has tempered it’s approach, learning no doubt, from its mistakes in 2007/8.

5) “For one thing, if the currency is allowed to appreciate to avoid intervention and sterilisation, this too is a deflationary factor for the economy.”

It would, and in this environment of runaway international commodity prices, thank god! In any case, a deflationary exchange rate policy which precludes the use of domestic monetary policy measures would be a much better way of managing inflation than the current system of inflationary exchange rate policy combined with disinflationary interest rate policy. Monetary policy, which includes the management of exchange rate and interest rate, cannot be conducted in a vacuum. In the current environment of high commodity prices, the conduct of monetary policy has to change from that in the past when the environment was different. While one can argue for a completely free market exchange rate, if the exchange rate has to be managed, it must be done with an eye on the environment. Our existing monetary policy approach seems to be a one-size fits-all approach insomuch as we use similar tactics in a global inflationary environment and a global deflationary environment.

6) “On the other hand, if sterilisation is done through increasing the cash reserve requirement, there are no costs to the central bank — or even to the banking system since the central bank is impounding only the money it had created through intervention.”

This statement is partly correct. There is no cost to the central bank and if one were to take a composite view of the market, the overall cost would be zero as well. However, the market is not one large entity. It is made up of several categories of participants, and even if one were to restrict the scope to banks, several types of banks. When the RBI intervenes in the currency market, it does not buy foreign exchange from all banks in the ratio of their Net Demand and Time Liabilities (NDTL). It buys foreign exchange from banks which have active international banking activities as these are the banks which hold foreign exchange surpluses. And these are the banks which get the injected liquidity. However, when it sterilizes this excess liquidity through a CRR increase, the impact of this is distributed across all banks in the ratio of their NDTL. Obviously there are banks who incur significant costs as a result, but this is balanced by gains made by other banks resulting in zero net cost for the banking system as a whole.

This was also borne out in the liquidity crisis created by this mode of sterilization in 2008, when a couple of disadvantaged banks were driven to the brink of regulatory default, an outcome that would have caused a crisis of confidence in the system as a whole. This would qualify as a low cost option only if we believe in the possibility of “immaculate transfer” of liquidity within the banking system where surplus liquidity would mysteriously flow from a surplus bank to a deficient bank without any cost. Unfortunately, it does not exist and the consequences of such measures are far too frightening to be quantified in terms of cost.

7) “if capital flows continue to surge as many analysts and the International Monetary Fund are expecting, in an extreme situation, one of the three may have to be given up, and it should be the liberal capital account — in other words, resorting to capital controls particularly on portfolio inflows. This is the least costly measure in terms of growth and investment as there is no empirical evidence suggesting that a liberal capital account helps growth.”

By all means! But capital controls on inflows should be accompanied by capital controls on outflows including controls on the import of capital equipment, not just capital outflows in the traditional sense if a repeat of the 1991 crisis is to be avoided. At the root of that crisis was the freedom to import capital goods after 1984 without freeing up of inflows. This led to a situation where negative capital flows added to a negative current account balance, resulting in increased sovereign foreign exchange indebtedness. When this indebtedness reached a point where international investors lost faith in our ability to generate the requisite foreign exchange for debt service payments, they refused further lending.

And if we were to impose these controls on outflows, we would be denying domestic industry the very tools they need to be internationally competitive or the opportunity to buy foreign companies along with their intellectual property, an outcome which cannot be desirable from any perspective.

The one striking aspect of most arguments in favor of the existing interventionist exchange rate policy is the extent to which these are willing to go to preserve status quo or strengthen it. The detrimental impact of attempted sterilization, which has had severe consequences in the not-too-recent past, seems like a minor issue. Capital controls as stated by Mr. Rajwade, or export restrictions and the misuse of our legal system to “arm twist” commodity suppliers as mentioned by Dr. Ajit Ranade (Dancing with the Dragon, Business Standard, April 27 2010), it seems we are now limited only by our imagination.

And all this because we believe that the RBI has a monopoly on the wisdom required to price the rupee.

Wednesday, May 5, 2010

Just what is our currency worth?

In the broadest sense of the word, it was possible to ascribe an absolute value to currencies as recently as 1971. However, it was only till the Great Depression of 1929 that this valuation was at it’s purest.

In the pre-1929 era, the obligation of the Government, as issuer of currency, and holders of the currency was in the nature of a Trustee obligation. Governments were obligated to hold an amount equal to the value of their outstanding currency in Gold and this asset could not be co-mingled with the other assets of the Government. This meant that the Gold was exclusively used to back the issuance of currency, and was not available for any other governmental obligation. Not only this, but it was also obligatory for the Government to maintain a steady value for it’s currency vis-a-vis Gold. Till this point, in corporate credit terms, the holders of a currency were secured creditors of the Government, who were assured of a value in terms of another commodity, namely Gold. This is akin to a Corporate entity assuring a Bondholder who holds a Rs. 100 bond, that it not only holds the Rs. 100 in a separate account but promises to pay the Bondholder Rs. 100 on demand. Till this point in time, the tenure of outstanding currency came to an end when a holder returned it to the Government in exchange for Gold.

While asset exclusivity and the nature of the relationship was maintained after the Great Depression as well, the emergence of the Purchasing Power Parity model allowed Governments to change the value of their currencies vis-a-vis Gold and, as a result, vis-a-vis other currencies as well. With this freedom in hand, almost all countries devalued their currency to gain an advantage in markets other than their own, through cheaper exports. This led to the first spree of Competitive Devaluation in the world, resulting in significant unrest. Till this point as well, countries were obligated to hold reserves in Gold to underpin the value of their currency, but they were at liberty to decide this value. This meant that a currency holder was only entitled to receive its worth in terms of the currency itself, and nothing more. In corporate credit terms, this is like a Corporate entity assuring a Rs. 100 Bondholder, that it would hold some part of the Rs. 100 in a separate account, and would not retire its obligation directly. Rather it was required that the Bondholder sell the bond in the market to retrieve its worth. There was no longer an obligation that the sum retrieved would amount to Rs. 100. It would be the prevailing rate for a Rs. 100 bond at that time and nothing more.  It was expected that the markets would assign a fair value to the currency given the quantum of reserves held and the prevailing peg of the currency to Gold. From this point onwards, currency acquired immortality. It could be passed from one holder to another, but never returned to the borrower for value to be delivered.

But it was only after World War II, that the US and Allied nations got together to declare a monetary truce, which resulted in the Bretton Woods Agreement. Returning to a Quasi-Gold Standard, most currencies were linked to the US Dollar and the US Dollar itself was convertible to Gold at the rate of USD 35/ounce. While nations were not obligated to maintain distinct reserves anymore, they were obligated to maintain the international value of their currencies, which should have ideally resulted in adequate reserves being maintained at all times. There were strict valuation covenants specified for nations to adhere to and a change in a nation’s currency value, beyond the flexibility built into the system,  required agreement from the group. While currency devaluation did happen in the time this agreement was in force, they were few and far between and due to the process, the possibility of resultant unrest was minimized. At this point, the obligation would be described as a Corporate Entity advising a Rs. 100 Bondholder that a) The borrower was not obligated to hold any asset in a distinct account, b) Even if it held an asset, it would not be in Rupees, but another currency which could be converted to Rupees, c) It would not hand over this asset to the bondholder in settlement of its claim, d) The borrower would not repay the money on demand, but d) try its best to ensure that the bond was worth Rs. 100 in the market. If it wasn’t there would be no obligation to compensate the Bondholder for the loss. In effect the Bondholder now ranked equally along with all other government obligations and was just another unsecured creditor. All currencies remained perpetual in nature, with the exception of the US Dollar, which could be returned to the Federal Reserve against value delivered in Gold. 

If the US had stayed true to it’s implied promise of maintaining Gold Reserves, all currencies would have been backed by Gold through the US Dollar and valued accordingly, even though the possibility of value leakage existed due to the absence of any firm commitment to maintaining reserves. But that didn’t happen. And on August 15 1971, the world changed. When the US unilaterally decided that the US Dollar would not be convertible to Gold anymore, it effectively robbed currencies across the world the luxury of absolute value. By this time, it backed only 22% of it’s outstanding currency in Gold. But even then, it was quite simple to put a value to a nation’s currency in terms of Gold through the Exchange Rate vis-a-vis the US Dollar, the US Dollar’s peg of $35/ ounce of Gold and a coverage ration of 22% in Gold Reserves.

But from then on, all that remained from was value relative to other currencies. This doesn’t mean that currencies have no value, but after 1929 there has been a steady deterioration of the nature of the relationship between Government and the holders of a currency. This has resulted in the process of discovering a value becoming infinitely more complex. Continuing with the bondholder example, the contract would now read something like a) the company is not obligated to hold any asset to back it’s currency, b) If an asset is held, it would be a part of the General Account and be available to all obligations, c) There is no predefined value to the company’s obligation to the bondholder, d) in the absence of this predefined value, obligation having a pre-defined value would outrank this obligation and be settled against assets first which means e) whatever is left after settling all other obligations would be divided amongst the currency holders in the ratio of the currency held and this would amount to a full and final settlement of all obligations of the company towards the Bondholder. And of course, the bond could not be returned to the company till such time the company was in existence.

One would be excused for thinking that this does not sound like a loan or credit obligation. It isn’t. It is now an quasi-equity obligation against the balance sheet of the issuing Government. The change in the nature of the obligation through the years has disadvantaged currency holders from the risk perspective without any form of discussion with them and consent from them. And if this wasn’t bad enough, there is no way for a currency holder to find even a rough estimate of the value of his currency as Governments do not maintain, or publish a Balance Sheet*.

To describe what a Government’s Balance Sheet would look like, one would have to use corporate analogy. For even more relevance, let us try to imagine what the Balance Sheet of the Government of India would look like.

On the asset side of a Government balance sheet are all the assets owned by the Government. As in the case of a corporate entity, these would be divided into Movable & Immovable property, Investments, Cash & Bank Balances and most importantly, Accumulated Losses (or Accumulated Deficit) .

On the liabilities side would be the Debt and Equity Obligations of the Government. Debt would comprise of all outstanding Market debt, Small Savings Obligations, Loans taken (Domestic & Foreign) etc. The balancing figure, Net Assets (Total assets(Excluding Accumulated losses) minus Debt) would be the value of Equity, or the value of currency issued. When divided by the quantity of currency, a per unit value would also be available.

Even if all assets were to be valued in rupee terms, there is a distinct possibility that this value would not be equal to the face value of the currency in existence. This is because of the presence of Accumulated Deficits through the years. It is also possible that the Net Assets, as described above, would be a negative number. Which would essentially mean that the currency that we hold is worthless, or worth just the paper it’s printed on.

No matter how it turns out, currency holders have a right to know what their currency is worth. Its a right they have been denied for over 40 years now.

Along with Right to Education and Right to Food, this is an idea whose time has come.

*While some attempts have been made for Sovereign Balance Sheet disclosures in the past there has been a general lack of interest. A wonderful presentation on the complexity and issues is available on the OECD website here

This article was featured on Business-Standard.com on April 26, 2010.

Monday, May 3, 2010

Inflation yet again…

Once again, it seems that inflationary pressures from the rest of the world will creep into the Indian economy as well (Inflation clouds gather over Indian economy, Business Standard, May 3 2010)

And even though there are voices suggesting increased demand, there are others not so sanguine. More importantly, there’s no one denying the impact of higher international commodity prices, which seems to be the only certainty in an otherwise uncertain environment.

As far as monetary policy goes, it would make immense sense to tackle a certain cause rather than risk targeting the uncertain one.

Hopefully the RBI will agree…

Sunday, May 2, 2010

Statistician or Economist?

If one were to go by public statements, one would be forgiven for assuming that Dr. Pronab Sen is an astute economist. And he is, even though his designation is that of The Chief Statistician of India.

If only the RBI finds it within itself to ignore the designation and listen to the man… And pigs would fly…