Illusion and reality

Hedge funds trade in stocks, the rupee and offshore rupee bonds. Actions in one market affect prices in others

One of the big lessons of 2007 is that new financial products and the strategies to trade in them can sometimes be bewilderingly complex. And that troubles in financial markets that have gorged on complexity can quickly ripple out into the rest of the economy. Credit markets in the US and Europe are still trying to make sense of the smorgasbord of derivatives and other securities that lie in bank balance sheets. That is why they seize up with fright every now and then.

Regulators have two options: to demand more clarity on what is going on or to clamp down on financial innovation. The former is quite clearly the more sensible option. Bans never help, although there are the inevitable calls for them whenever there are problems in the financial markets. Usually, crises in the real economy bring with them calls for further deregulation while crises in the financial economy come with calls for tighter regulation: That’s a big paradox in the annals of contemporary policy debate.

All this is of relevance to India. The domestic financial markets are still repressed. Local investors have access to a limited range of securities to buy and sell. But the same cannot be said of offshore investors who are taking positions on the Indian economy—either directly or indirectly. Many of them are hedge funds who use a range of trading strategies. They buy into the India story through participatory notes (PNs), which are offshore instruments backed by Indian equities and derivatives and whose proliferation has kept troubling the Reserve Bank of India and the Securities And Exchange Board of India (Sebi).

This column has argued earlier that a lot of the Indian debate on hedge funds does not take into account the fact that their India strategies could be far more complex than just buying certain shares. It is safe to assume that many hedge funds trade across various Indian assets—individual stocks, indexes, currency and offshore debt. Thus, for example, a violent sell-off in the stock market may unsettle the rupee and interest rates as they are all linked through hedge funds’ trading strategies. No wonder regulators want to know what’s going on in the PN market. It’s systemic risk they are worried about.

A new International Monetary Fund (IMF) working paper by Manmohan Singh, an economist in the Fund’s monetary and capital markets department, throws some light on the types of positions that hedge funds could be taking in India. The main intent of this paper is to assess the probable impact of Sebi’s new regulations on the PN market. But right through the research paper, Singh mentions various investment strategies that PN investors could be using.

Here are some examples.

The most common one is to go long on select shares and hedge by shorting the Nifty index in the futures and options market. Sebi has said that of the $90 billion of money that has come in through PNs, $60 billion has come into the cash market and $30 billion in the derivatives market. Much of the latter could be to take short positions on the Nifty.

These short positions will lose money in a bull market such as ours. Singh then presents an interesting possibility. “Market sources in Hong Kong, Singapore and London suggest that margins (i.e., down payments on futures positions) are roughly 25-30%. Although counter-intuitive, $7.5-$9 billion…has come into India from such margin accounts due to losses on futures positions, without the initial transaction being closed, yet. These inflows have placed an additional upward pressure on the rupee, over and above the pressures from onshore FII (foreign institutional investors) accounts.” This means that even short positions push up the rupee.

In fact, stock prices and the rupee have been positively correlated in recent years. Both move in tandem. So every FII buying stocks is also buying the rupee. In fact, says Singh, it is possible for offshore to take a bet on the rupee through the stock market: go long on Security A in the cash market and short the same security using a PN. Going long in the cash market means that rupees are paid upfront. The short position using a PN derivative means that the investor receives dollars when his trade is closed. In effect, this investor has no net exposure to equity but has taken a bet on the dollar-rupee exchange rate.

I am sure there will be many, many more mixed strategies out there—and why not? That’s the whole point of being hedged.

Hedge funds take simultaneous positions in various markets, be it cash stocks, stock options, the rupee or even offshore rupee bonds. Their actions in one will affect prices in the other. There is nothing wrong in all this. It’s just that the public debate should take into account that hedge funds could be doing far more than buying individual stocks and pushing up the market to new highs—and accept that regulators have good reason to worry.

Our superstar cities

Will rising real estate prices crowd out the middle class, which cannot afford a new house?

Does the real estate listing in your newspaper make your heart sink? It now costs around Rs50 lakh to buy a small flat in most parts of Mumbai. Let’s assume—unrealistically, I admit—that a family that wants to buy a one-bedroom house in the city gets a loan for the entire amount. This family will have to shell out Rs50,000 or so every month to service the loan. It will also need at least another Rs20,000 to meet its monthly household budget. This means that any family earning less that Rs70,000 a month is unlikely to afford buying even a tiny flat in the city.

Hence the question: Will the relentless rise in house prices in our cities crowd out the middle class, which cannot afford to buy a house and which will refuse to stay in a slum?

Many other cities around the world have to struggle with the same question thanks to the global boom in real estate. New York mayor Michael Bloomberg said in 2003: “If New York City is a business, it isn’t Wal-Mart—it isn’t trying to be the lowest-priced product in the market. It’s a high-end product, may be even a luxury product. New York offers tremendous value, but only for those companies able to capitalize on it.”

Three professors from the Wharton School of Business—Joseph Gyourko, Christopher Mayer and Todd Sinai— have come up with the concept of superstar cities, in an academic paper published in June 2006. Their thesis is a simple one. Certain cities in the US have seen sharper increases in real estate prices than regular cities. Why? Gyourko, Mayer and Sinai believe this is because of two reasons. First, these cities have a disproportionate amount of rich people compared with other cities. Two, the supply of housing in superstar cities cannot be increased easily when prices rise; it is relatively inelastic. Also, there are few alternatives to these glamorous cities. They have unique attractions for the affluent and successful.

It’s not just a rich-world occurrence. In a new working paper for the World Bank, Robert M. Buckley and Ashna S. Mathema ask: Is Accra a superstar city? The capital of Ghana is experiencing the same sort of problems that our own cities are. Buckley and Mathema write about how “housing in Accra has become more expensive, and appears to be increasingly pricing middle- and lower-income groups out of the housing market, resulting in substandard and congested living conditions for a large majority of the city’s residents.” Sounds like our own cities, doesn’t it?

It is easy to work yourself into a moralistic fervour about this. And demand price controls on housing or the creation of subsidized housing stock. But these will lead to rent seeking and corruption rather than equity, as the few who get hold of subsidized housing are likely to trade it in the market for a profit sooner or later.

And that’s why I feel there is some truth in Bloomberg’s arrogant-sounding statement. Some cities will eventually support only high-value economic activity. We already see this happening in many cities around the world, as manufacturing has been replaced by financial services, tourism, education and other such activities as their main business.

High real estate prices should thus be an incentive for cities to change their own business models. But how does that fit into the other great Indian reality—urbanization? Millions move into the cities every year. Will ever-higher land prices condemn them to life in filthy and crowded slums?

Not necessarily. Robert Shiller of Yale University and one of the finest minds to write on real estate and housing economics doesn’t quite buy the superstar city idea.

One of his objections is to the assumption that land supply cannot be increased. “While there is only so much land in any one of the existing superstar cities, in every case, there are vast amounts of land where a new city could be started. And new cities are started, taking away from the “uniqueness” of existing cities. The best-known examples of such grand new cities are planned capitals… These include Brasilia (1950s), Canberra (1910s), Islamabad (1960s), New Delhi (1910s) and Washington, DC (1790s).”

I’m not sure that showpiece cities to house the nation’s bureaucrats are necessarily the correct examples. However, Shiller’s larger point is worth taking seriously. The way cities can be made more affordable for all is to increase the effective supply of urban land. And one way to do this is to build new cities.

It is unfortunate that so much of the urban debate is consumed in fiery anger against builder lobbies and redevelopment controversies. The really interesting long-term solution is for India to build a hundred new cities with public-private partnership.

It would be a good idea to start discussing how we can go about it.

Good news for farmers

Higher global cotton prices could help distressed farmers far more than a budgetary relief package

The news from the farm has been almost uniformly bleak over these past few years. Agricultural growth has been anaemic, food prices have been sluggish and we have been inundated with horrific stories about mounting rural debt and farmer suicides.

Will the situation finally start improving this year, as production and prices of farm produce rise?

Let’s consider cotton, the one crop that has led to so much farmer grief. In its new report released this month, the Prime Minister’s Economic Advisory Council says the ministry of agriculture expects cotton production to increase by a modest 1% in 2007-08. But then it adds: “However, estimates of the Cotton Advisory Board, which are considered to be more accurate by trade and industry, had placed this year’s output at nearly 31 million bales, an increase of 9% over the last year.”

The more recent estimates of a domestic cotton crop are only slightly lower—30 million bales. Of course, this jump in production alone will not help distressed farmers if prices stagnate or fall. Sugar farmers are in precisely this sort of mess—surplus production and weak prices. But there could be better news for India’s cotton farmers. Global prices of cotton are close to their four-year highs.

And there is a story here. US farmers have been cutting back on cotton production and moving to more lucrative crops such as corn and soya bean. Demand for both has been very strong and their prices have soared skywards over the past three years. In a bid to cut dependence on imported oil, the US government has lavished subsidies on corn-based ethanol and helped push up corn prices. Growing demand for meat, especially in China, has pushed up the prices of soya beans, which are fed to cattle and pigs.

The result: Acreage under cotton has shrunk in the US by almost 30%, according to trade journal Farm News, as farmers there have used their land to grow crops such as corn and soya bean. According to another estimate, the US will plant 9.9 million acres of cotton this year, the lowest in more than two decades. Global cotton supply is likely to grow by a very modest 1% this year. Thus, demand for cotton from textile mills is likely to be more than this year’s global output. Prices could head further northwards.

All this could help distressed cotton farmers in the killing fields of Maharashtra’s Vidarbha region and elsewhere. Here’s a quick back-of-the-envelope calculation. Cotton output increases by 10% this year. Prices too are up 10%. The income of the average cotton farmer could thus rise by one-fifth this year. The relief provided by higher cotton prices could be far larger than anything the government can come up with through a budgetary relief package.

There could be repeats of this story in other crops as well. Overall, this is expected to be a far better year for farm output. The agriculture sector is expected to grow at 3.6% this year, compared with the initial estimate of 2.5% and the actual growth of 2.7% in the previous year. While this is still far less than the 6% growth we saw in 2005-06, let’s not forget that the jump in farm output that year was from the low drought-ridden base of 2004-05, when agriculture did not grow at all.

At the same time, prices of various grains and food items have been soaring globally. The Indian government has also increased support prices for grain. Once again, higher production and prices could help farmers. A new research report by investment bank Credit Suisse says that investors can benefit from this trend. “The current situation is an unprecedented one for Indian farmers. With global prices soaring, due partly to cyclical and partly to secular factors, free market forces are forcing the procurement prices of key crops to rise by a hitherto unforeseen…30%-plus year on year in India as well.”

But it’s not good news all around in the villages. Only around one-third of the rural population produces surplus food. The other 70% has to buy food to meet its needs.

This majority could feel the pinch. India does control prices of food items that are sold to the poor through the public distribution system, but the poor still have to buy their vegetables and milk from the open market. The consumer price index for agricultural labourers, which is heavily weighted with food items, has been growing at close to double-digit levels this year. It is unlikely that rural wage rates have grown at the same pace, which means that real incomes of the rural poor could be under immense pressure.

These are policy tangles that governments all around the world will have to deal with in the coming years. The food price shock will affect different parts of the population differently, depending on whether a family buys or sells food. But there is little doubt that higher farm output and prices could do a lot to assuage farmer distress in India—and perhaps lead to a long overdue revival in rural demand in the coming quarters.

Games hedge funds play

India has a lot to learn from the double play that hedge funds used in 1998 to attack Hong Kong’s economy

Have you heard of the infamous double play that hedge funds used to bring Hong Kong’s economy to its knees in 1998? India, as it tries to understand the games hedge funds play, could learn from that episode.

The Asian economic crisis started in July 1997. Hong Kong had initially done far better than Thailand, South Korea, Indonesia and Malaysia. Till it was attacked using what has come to be called the double play.

Here’s how it went. Hong Kong was committed to a fixed exchange rate against the US dollar through a currency board. By the end of 1997, a group of hedge funds thought that they could make a killing by forcing Hong Kong to devalue its currency. That’s what they had done successfully in many Asian countries in the preceding months.

What they did in Hong Kong was more complicated. In early 1998, the hedge funds built up their armoury by swapping US dollars for Hong Kong dollars. They then shorted the stock market in a sudden coordinated attack, both in the cash and futures segments. They followed it up by shorting the Hong Kong dollar as well.

The Hong Kong Monetary Authority (HKMA) was forced to increase interest rates all the way up to 280% to defend the fixed exchange rate. That brought down the stock market. The short sellers made a killing. Meanwhile, the Hong Kong dollars that the hedge funds had collected in the swap market started earning them usurious rates of interest.

The plunge in share prices led to a capital outflow and further pressure on HKMA to abandon the fixed exchange rate and sharply devalue the currency. That would have given the hedge funds that had shorted the Hong Kong currency another windfall. It was then that HKMA chose an unusual step. Rather than protecting the currency by selling dollars from its reserves, HKMA went in and supported the stock market. It bought $120 billion of shares in two weeks, because that was where the epicentre of the double play lay. (HKMA sold these shares at a huge profit five years later.)

So, why should India bother about an episode of a daring—and brilliant attack—on an Asian central bank 10 years ago?

I am not suggesting here that India will be in any similar danger any time soon. But there are two lessons worth remembering. One, hedge funds often take complicated positions that straddle the share, bond and currency markets. I am not sure that all the loose talk about hedge funds pouring money into India takes this simple fact into account—they may also be speculating in the offshore market for Indian derivatives and currency. The rupee and the stock indices may be part of coordinated trades that we know little about, or even care to know.

Two, the response in Hong Kong, too, was unconventional. HKMA is, like the other institutions in that great mercantile city, a committed bastion of free-market thought. Yet, it had no qualms about abandoning its standard practice and actually buying in the stock market to prop up its currency. The lesson: a central bank may need to use blunt instruments in special times.

In 1999, when the fires that raged across Asia had been doused, Barry Eichengreen and Donald Mathieson wrote a paper for the International Monetary Fund. It was called Hedge Funds: What Do We Really Know? (It is a question that still evades a clear answer.)

Eichengreen and Mathieson identified three main classes of hedge funds. First: the macro funds, which study a country’s economic fundamentals and take large, unhedged positions (going fully long or short) in that country’s markets. Two: the global funds, which pick stocks across the world based on the prospects of individual companies. Three: the relative value funds, which study correlations between the prices of various securities (emerging market bonds and US bonds, for example) and try to profit when prices deviate from their expected relative paths.

Long Term Capital Management (LTCM), the hedge fund that was set up by some of the most highly regarded traders and financial economists in the world, was a relative value fund that tried to bet on prices that were off the path estimated by the fund’s statistical models. The story of how LTCM blew up in 1998 has been wonderfully retold in Roger Lowenstein’s book, When Genius Failed.

So, the point is a simple one. Hedge funds make complicated bets, often across countries and markets. They often do it with huge leverage. These funds are part and parcel of the modern financial landscape. They cannot be wished away.

India, too, is attracting billions of dollars of hedge fund money. That’s not a bad thing in itself. But there should be more clarity about what this money is all about. Given this fact, the central bank and the stock market regulator are justified in keeping a close eye on their activities.

Beyond gender dystopia

Rapid growth in incomes may help break down traditional Asian societies and their preference for sons

Jim Rogers is trying to bet on the shortage of girls in Asia.

The investor, who once partnered the legendary George Soros in the 1970s and was one of the first to latch on to the incipient commodity boom earlier in this decade, reportedly said in a video interview to Bloomberg: “There’s a huge shortage of women developing right now. In Korea, for every 100 girls, there are 120 sixteen-year-old boys. The same is happening in China, the same is happening in Japan, India. I have not found any good ways to invest in this—it’s going to change education, it’s going to change travel, it’s going to change everything. You should become a divorce lawyer. Divorces are going to skyrocket in Asia as 26-year-old women figure out that they don’t have to be abused by their husbands any more or their employers. The status of women is going to change dramatically and someone is going to make a lot of money off of it.”

Rogers has been saying for some time that a shortage of girls will eventually make our societies value them more. Does he know what he is talking about?

Asian countries have had a long history of female infanticide. Easy access to sex-determination tests has worsened the problem in our patriarchal societies. The number of girls for every hundred boys has been dropping in recent decades across Asia, as female foetuses are aborted. The usual assumption is that this trend could continue, and the gender imbalance will lead to greater violence against women and wars between nations. This vision of a testosterone-ridden dystopia got a fresh airing at the end of October, when the UN Population Fund said in a new report that Asia’s gender imbalance is growing.

But will a society that has a surfeit of single men start respecting women or will it fall back on its unfortunate habits to violate their independence even further? In terms of crude economics, a shortage of girls should ideally increase their value. But then we forget the cultural backdrop against which economies operate. That may actually degrade women further.

There is a glimmer of hope here, however.

Two researchers from the World Bank, Woojin Chung and Monica Das Gupta, have said in a policy paper published in October that son preference is declining in South Korea. That makes South Korea the first Asian country to reverse a tragic trend, even though its gender ratio is still one of the worst in the world. Chung and Das Gupta also ask what India and China can learn from the South Korean experience.

They say that the primary reason why South Korean parents are less obsessed with having sons is that industrialization and urbanization have helped break down traditional society and its mores. This is despite the fact that successive South Korean governments, especially those controlled by the military, tried to promote strict adherence to Confucian values.

Chung and Das Gupta say that India and China may not have to wait till they are as developed as South Korea is, before their gender ratios too move towards balance. “The spread of non-farm employment diversifies sources of livelihood, making people more independent of familial pressures and traditions, and higher levels of circular migration spread urban ways to thinking,” they say. Also, the governments of India and China are more sensitive to gender equality than South Korea’s generals were.

Or take the latest World Development Indicators published every year by the World Bank. “The gaps between the sexes are going through a major shift worldwide,” writes Harvard economist Ricardo Hausmann in a blog. “In 2006, literacy ratios of young women between the ages of 15 and 25 were higher than young men’s in 54 out of 123 countries. If we look at secondary school enrolment, in 2004, there were 84 out of 171 countries in which girls outnumbered boys. At college level, this is also true of 83 of 141 reporting countries.”

This by no stretch of imagination means that women are anywhere close to equality in our societies. There is a long way to go.

The point here is a more limited one. The dark prophecy of hyper-aggressive societies dominated by single men may turn out to be true after all. But there is another possibility beyond this brave new world of violence and indignity. Rapid growth in incomes may help break down traditional society and parents will start getting over their obsessive preference for male offspring. This is what has started to happen in South Korea. Or the shortage of girls will force societies to value them more, lavishing them with care and not denying them their core human rights.

It’s a tough call to make. But perhaps, to answer the question raised earlier in this article, Jim Rogers does know what he is talking about. There could be a whole new investment opportunity out there as we learn to respect our little princesses.

The economics of Bangalore

Coase’s insights on transaction costs help us understand why Bangalore became an outsourcing boomtown

Cities have patron saints and deities, not patron economists. But every now and then we come across cases of urban success that are deeply linked with how a particular economist viewed the world.

Haseeb A. Drabu, now the chairman of Jammu & Kashmir Bank and once a fellow journalist, wrote an article comparing Mumbai and New Delhi a few years ago. He concluded that piece with a memorable line: “Delhi is Keynesian while Bombay is Schumpeterian.” One city gets its importance from being the heart of government, while the other thrives on entrepreneurial energy.

I would like to extend the thought experiment. Bangalore is Coasian.
Ronald Coase won the Nobel Prize in economics in 1991. As a young economist in the 1930s, Coase tried to solve a puzzle that had escaped others. The traditional economics of the time assumed that the market coordinated all economic activity. Replacing it with a plan was inefficient.

Coase has studied business administration before he turned to economics, so he could not ignore the fact that a lot of economic coordination was done outside the market, in firms. There must be a reason why these firms exist. At the same time, the Soviet dream of running the entire economy like one big factory, as Lenin had put it, was not successful either. So the question was: why are some things done better in the market and some within a firm?

Coase asked himself: why did firms exist at all? All around him, he saw how company managements, outside the open market, coordinated the use of capital and labour. They had corporate plans to do so, many of which worked quite well. Why?

Coase’s answer was strikingly original. He wrote in a groundbreaking article almost exactly 60 years ago that firms exist because there are costs involved in market transactions. When these costs are too high, it makes sense to coordinate certain activities within the boundaries of a firm. “Whether a transaction would be organized within a firm or whether it would be carried out on the market depended on a comparison of the costs of organizing such a transaction within a firm with the costs of a market transaction that would accomplish the same result,” Coase said in a speech that he gave in 1994.

In a very crude sense, a company employs workers on a long-term basis because the costs involved in finding skilled workers every morning would be too high to make the attempt efficient. If by some wave of the magic wand or stunning innovation, it would be possible for a company to locate just the sort of talent it needs for the day, then we would all be freelancers. There are several other transactions besides employing labour every day that are better done outside the purview of the market. Transaction costs became the centrepiece of Coase’s economics.

“So what does all this have to do with Bangalore and its success as a global outsourcing hub?” you might ask. Bangalore’s astonishing boom over the past 15 years can best be explained by using Coase’s insights into the nature of the firm. Bangalore had most of the ingredients on its later success in previous decades—including a skilled workforce that could be employed at a fraction of the wages paid for similar work in Europe and the US. Yet the outsourcing wave did not gain power till the mid 1990s.

Coase’s insights on transaction costs help us understand why Bangalore eventually became an outsourcing boomtown. As firms in the rich countries grew in size and became large and tangled conglomerates, the cost of carrying out certain activities within these firms went up. It made economic sense for them to focus on their “core” activities. Meanwhile, the drop in international telecom costs helped slash transaction costs in the outside market.

Internal transaction costs went up while market transaction costs fell after the mid-1990s. That was the economic cue for outsourcing to take off, as companies found it cheaper to get certain things done outside rather than from within the boundaries of the firm. This is straight out of Coase.

A lot of attention is paid to the famous rule-of-the-thumb laws in the world of technology. Take Moore’s Law, which says that the power of microprocessors would double every year without a similar increase in costs; or Grosch’s law, which states that computing power grows as a square function of its costs.

It would be good if Coase’s simple rule that stuff gets outsourced when external transaction costs dip below internal transaction costs, gets wider recognition as the core rule explaining Bangalore’s rise as a tech hotspot.

It is now 60 years since Coase wrote about the nature of the firm, a paper that led to the rise of an entire discipline known as transaction cost economics. The young techies who gather in Bangalore’s buzzing pubs should perhaps raise a glass of cold beer to salute the man whose work so neatly explains why their city is such a success today.

Life beyond the dollar

When a mighty currency falls, it is only natural that the earth around it shakes a little

The dollar is our currency, but your problem,” US treasury secretary John Connolly had told his European counterparts in 1971.

This was when the US was mired in an expensive foreign war in Vietnam; its fiscal and external deficits were high; and there was growing international uneasiness about the dollar. It was a situation quite like the one we see today.

The dollar, then as now, was the cornerstone of the global economy. Though most major currencies then were valued in terms of a fixed weight in gold, there was not enough yellow metal in the non-US central bank vaults to back the paper. These central banks pegged their currencies to the US dollar, and the US government promised to redeem these dollars with gold whenever required. Banks outside the US held dollars because they could be exchanged for gold.
But as the pressure to convert dollar holdings into gold grew, the US government decided to close this option in 1971. The dollar fell in value. The world economy went into a bout of turmoil.
While inflation and slow growth were already on the horizon, the dollar crisis in the early 1970s pushed the world economy towards stagflation— the then-unexpected combination of stagnant growth and high inflation.

Cut to 1985. Once again, it was the same basic problem: high US deficits. Officials from five countries—the US, Japan, Germany, France and the UK—met at the Plaza Hotel in the September of that year. There was wide agreement that the dollar was overvalued and had to fall against the major currencies. The Plaza deal was a comprehensive plan for price-fixing. The dollar would be eased down against the other major currencies, and especially the Japanese yen.
That is precisely what happened, but with unintended consequences. The rising yen threw sand in Japan’s export engine and threatened growth there. Japan’s finance ministry was forced to react because of the outcry from domestic lobbies. It asked the central bank to slash interest rates to negate the effects of a strong yen.

Japan’s central bank released a flood of yen into its domestic economy, lifting equity and real estate prices to unheard-of highs. It was the Japanese bubble. When it eventually burst in 1990, the banking system was nearly wrecked and the economy went into a deflationary spiral.

Another unintended consequence of the rising yen: Japanese manufacturers had to tweak their strategies. A lot of work could be done offshore in cheaper countries in Asia. So, to cut costs, Japanese investments flowed into places such as Malaysia, Thailand and the Philippines. This movement of money fed the bubble in these countries. It popped in 1997, to devastating effect.
There is a point to this little excursion into financial history. Connolly was right in 1971: the dollar may be the US currency but it is our problem. The greenback has been so central to the world economy that its gyrations can rock economies in the most unlikely corners of the earth.
Look at the line-up of challenges the US has today: high deficits, an expensive foreign war and a weak currency (among other things). These are creating problems in other countries. In India, exporters are under huge pressure. In China, there are worries that its trillion dollar plus foreign exchange hoard will lose value. In West Asia, where currencies are pegged to the US dollar and, hence, independent monetary policy has been abandoned, the falling dollar has pushed up inflation and sparked off labour protests.

What happened in 1971 and 1985 shows that these tremors are not unexpected. To paraphrase Rajiv Gandhi’s unfortunate statement in 1984, after his mother’s assassination: when a mighty currency falls, it is only natural that the earth around it shakes a little.

Is there a way out? Should a world economy that is now less dependent on the US than before be so hopelessly dependent on the dollar to conduct its trade and hold its foreign assets?

These are not new questions. In 1945, as the world came out of World War II, John Maynard Keynes had vehemently argued for a new global currency to displace the British pound. It would be managed by a global central bank. Keynes called this currency the bancor. Others such as the great monetary economist Robert Mundell, have been passionate supporters of a single international currency because, as former US Federal Reserve chairman Paul Volcker once said, a global economy needs a global currency.

On the other hand, Austrian economists such as F.A. Hayek have backed a free-market plan to have private currencies that will compete against one another, free of central bank intervention. Money would be denationalized. And then there are the more immediate possibilities, such as the euro replacing the dollar as the world’s reserve currency.
The debates could resurface if the dollar’s decline is not a smooth one.

Bubbles: good and bad

Some bubbles actually do long-term good. The recent housing bubble has no such redeeming feature

Housing prices in some parts of the world have finally fallen prey to gravity. In London, they dropped by 6.8% between mid-November and mid-December, according to a UK property website. Ouch! An average house in upmarket Kensington and Chelsea has become cheaper by around £20,000 over the past few weeks. Home prices in the rest of the UK fell a more modest, but still sharp, 3.2%.


Meanwhile, the US property market continues to slump. In a television interview this week, former US Federal Reserve chairman Alan Greenspan said the government should provide “disaster relief” to US home owners. He seems to be suggesting that the US housing shock is an economic version of Hurricane Katrina.

These are perhaps early signs that the housing bubble has popped—and high time, too. Many expect prices in the US and parts of Europe (and perhaps China) to continue to fall in 2008. In an article in the Financial Times this week, commentator Wolfgang Munchau said: “In the UK the latest upward movement has lasted 10 years and on my calculation prices started to rise above the trend line somewhere between 2000 and 2002. That would suggest that the downturn phase is going to last as long—possibly longer since downward moves often undershoot the trend line. Unless there has been some structural shift, there is going to be one of the most serious housing downturns ever.”

There is inevitable and immediate pain when a bubble goes pop. The journey back to normalcy usually carries with it the extra load of economic slowdown, loss of confidence and a tattered banking system. That’s what the aftermath of several episodes of irrational exuberance in recent years shows—Japan in 1990, Asia in 1997, technology companies in 2001 and the current housing meltdown in the US and Europe. But with the very obvious bad and the ugly, there is also some long-term good that comes out of bubbles. Well, at least some of them.

Take the Internet bubble of the late 1990s. Like all bubbles, it was fed by cheap money. Investors were paying a king’s ransom to buy online companies. Online grocers boasted of higher valuations than large auto companies. A share often cost more than a hundred times a company’s current earnings, which was way above any traditional norm of good investment sense. Some of these online companies had no hope in hell of earning any profits at all. So, they were valued on the basis of wacky parameters such as eyeballs and hits.

As is well known, thousands of Internet and technology companies were charred in the subsequent flame-out. But a lot of good was also left behind. If you are one of those who sifts through the Internet using Google’s search engine, buys air tickets online and downloads music to your iPod, you have to thank not only the scientists and entrepreneurs who were behind these ventures but also the investors who were silly enough to suspend their judgement and fund new ventures, both those that were successful and those that failed.

Or consider the telecom infrastructure mania of those years. What we remember today is the crooked companies such as WorldCom that misled investors. But the $200 billion that was spent in laying cables and other stuff to connect the four corners of the world pushed down telecom costs in the late 1990s. Didn’t that help the Indian outsourcing industry, by making it cheaper to send data across the oceans? The technology bubble had some positive consequences, some intended and some unintended.

In his own work on business cycles, Joseph Schumpeter, the patron economist of Silicon Valley, mentioned the importance of sudden bursts of what he called “wildcat or reckless finance” in fostering innovation. The boom-and-bust cycle in technology in the late 1990s left us with some long-term advantages, both as producers and consumers. In a provocative article in Wired magazine in February 2006, the writer Daniel Gross praises bubbles: “People focus on the sob stories (think of the grandmothers who invested in Pets.com) and the tales of financial chicanery (think WorldCom). But bubbles—those sudden, excessive, and seemingly irrational investment stampedes—aren’t all bad. Sure, they tend to follow a painful cycle of boom, bust, hand wringing, and abject humiliation. But there’s often another step at the end: innovation. Over the past 150 years, many bursting bubbles have paved the way for economic and cultural progress.”

The question is: will any such good come out of the housing cycle? I doubt it. There has been enough reckless finance this time around as well, but it was to fund second homes and excess consumption rather than to support Schumpeterian innovation. Nor has it been used to finance an infrastructure build-up, as in the US in the late 19th century or South-East Asia a hundred years later.

And that’s the big difference.

Battling national risks

Though trade-offs in public policy are far more complex than in corporate policy, risks have to be managed in both

Should governments manage risk the way companies do?

This may seem to be the wrong time to ask such a question. After all, these have not been good times for risk managers in the West. Many of them have been rapped on the knuckles for their failure to prevent mounting losses in the trading rooms that they were meant to police. Some have met a worse fate. Banks such as Citigroup, Merrill Lynch and Canadian Imperial Bank of Commerce have asked their chief risk officers to leave because they could not prevent the build-up of bets that eventually backfired.

Yet, central corporate risk offices do help top management get a grip on what the various decisions taken across the company mean for overall corporate resilience. Individual traders and managers usually assess the risk of their individual bets, or at most of the total investment and business portfolios they are managing. They have an incentive to take large risky bets to pull in the mega profits that will ensure a handsome bonus at the end of the year. They have little immediate interest in what this could do to the entire company they work for. Corporate risk officers are in-house regulators: they try to keep the risk faced by the entire organization under control and minimize potential losses.

This edifice has been shaken with the subprime and derivative tremors in the US and elsewhere. So, it is interesting that the World Economic Forum (WEF) has recently reiterated a suggestion it had made a year ago—that national governments should have a country risk officer who would be the “public sector equivalent of corporate risk officers in the private sector.” Why? Because “managing risk on a portfolio basis is as important in government as it is in the private sector,” says WEF in its new Global Risks 2008 report.

So, should governments think in terms of national risk? And try to manage it?

The idea seems alluring. Countries face risks—geopolitical, economic and environmental. Many of these risks are correlated. For example, consider the current rush to give subsidies for ethanol production in a bid to cut dependence on imported oil. Ethanol subsidies try to manage one type of national risk—energy insecurity. But they worsen another. Ethanol subsidies have put food security in some countries at risk, as corn, grain and sugar cane are diverted for fuel.
How should energy security and food security be balanced in public policy? There are two ministries and two sets of stakeholders involved. Is there a useful framework to sort out the tangle?

Then, some are global and outside the control of any single government: avian flu and climate change, for example. How does a government negotiate with others on these issues? These risks should ideally be quantified so that the trade-offs are more transparent.
Could a national risk officer do the job?

However, there are some important differences between risk management at the national and corporate level. The WEF report points to a few. For example, business is all about taking risks while governance is often about avoiding risks. Also, companies have a clear mandate to maximize profits and shareholder returns and their risk management can be designed with these clear goals in view. Governments, however, have to satisfy a far broader group of stakeholders and policy goals. And the trade-offs in public policy are far more complex than in corporate policy.

Britain has already taken a few baby steps towards setting up a national risk management office. It set up the Civil Contingencies Secretariat (CCS) in 2001. It sits at the heart of the British government, in the cabinet office: the stomping ground of the Sir Humphrey Applebys of the world. This group started off trying to improve post-crisis management, but has now taken on a more forward-looking role “in identifying and assessing potential risks to national resilience.” While the CCS website suggests that terrorism is the chief concern, it does mention other threats as well: flooding, outbreak of disease, failure of key utilities such as power and water, industrial accidents and even public protests.

It is not yet clear whether initiatives such as CCS will evolve into Orwellian nightmares. Or what risk management techniques national risk offices would use. Or whether the state will clamp down on private business and individuals in the name of protecting national resilience. It is always preferable if the financial markets evolve further and provide ways to buy insurance against large nationwide shocks. Bonds that insure against natural catastrophes such as floods and earthquakes (the so-called cat bonds) have already become popular.

That said, evaluating public policy from a risk manager’s viewpoint could be a useful route to follow.