Prof. Jayanth R. Varma's Financial Markets Blog

Photograph About
Prof. Jayanth R. Varma's Financial Markets Blog, A Blog on Financial Markets and Their Regulation. This blog is currently suspended.

© Prof. Jayanth R. Varma

Subscribe to a feed
RSS Feed
Atom Feed
RSS Feed (Comments)

Follow on:

Sun Mon Tue Wed Thu Fri Sat

Powered by Blosxom

Tue, 30 Sep 2008

More on financial crunch potential in India

I received several comments (some by email and some on the Wordpress blog) in response to my post about the possibility of a home grown financial crunch in India. Let me respond to some of them.

Posted at 22:21 on Tue, 30 Sep 2008     View/Post Comments (0)     permanent link

Thu, 25 Sep 2008

Can a US style financial crunch happen in India?

When people ask me what impact the global turmoil would have on India, my response is that the relevant question to ask is whether a similar crunch could happen in India. The first point to emphasize is that the US turmoil has nothing to do with CDOs and securitization and everything to do with the bursting of a real estate bubble (see for example this, this, this and this).

Real estate prices are sticky (particularly downward) and therefore the bursting of the bubble is a very slow process – it is more like a leaking balloon than a bursting balloon. On the other hand, a liquid financial asset whose value is linked to real estate prices will decline sharply reflecting not merely the current fall in real estate prices but also the entire anticipated fall in real estate prices. This is why the first signal of problems in the US real estate came in the derivative markets (the ABX Index contracts). From there, the problems spread to the mortgage securities and CDO tranches that were most sensitive to real estate prices. To blame CDOs for this crisis is really no different from blaming the messengers for the bad news that they bring. I am fond of saying that the deadliest financial innovation that brought about the global turmoil is a millenia-old innovation called the mortgage loan. We have had plenty of that in India.

In India, the only liquid financial market related to real estate is the stock market. If we want to throw light on the boom and bust in real estate prices, it is to the stock market that we must turn. The stocks comprising the BSE Realty Index lost over 65% of their value between December 2007 and September 2008 while the broader market lost only 35-40% of value. Since the market value based debt-equity ratio of the realty companies was quite small (of the order of 10%), and the realty companies were valued in the stock market on the basis of the estimated value of their land bank, it is clear that the implied drop in nation-wide land prices is very steep. The implied drop is much higher than the 20% drop in selected pockets that is often mentioned anecdotally.

Just as the ABX Index prices (and housing futures prices at CME) have been the beacon of light in the US market in assessing the true state of US real estate, the realty stock prices are the beacon of light in understanding the true state of Indian real estate. The broad picture that we see is of an ultimate drop in real estate prices that is comparable to what is expected in the US. Since Indian mortgage loans are not marked to market (unlike the US mortgage securities) the impact of the problems in Indian real estate are hidden from the public view and are likely to manifest themselves in financial sector balance sheets only over a period of time.

Another way of looking at the Indian situation comes from reading Ellis’ paper “The housing meltdown: Why did it happen in the United States?”, BIS Working Paper 259. Many of the factors mentioned by Ellis are equally applicable to India:

All this implies that the housing price correction and associated mortgage defaults could be a serious problem in India. The key imponderable is the trajectory of monetary policy as well as GDP growth in India.

What is worse is that unlike in the United States, commercial real estate (CRE) is probably as badly (or even more badly) affected than residential real estate. There is of course a lag between dropping footfalls in malls to rising vacancy rates and falling CRE prices, but the trends are clearly in evidence.

Problems in commercial real estate are a serious problem for the banking system because a great deal of the improvement in non performing assets in recent years has been due to rising real estate prices. Many corporate defaulters queued up for settling the defaulted loans because the real estate value exceeded the value of the debt.

Moreover, the entire infrastructure sector which has received a lot of bank credit in recent years is largely a real estate play. If commercial real estate collapses, the viability of many of these projects would be seriously in doubt.

In a modern economy, lending of 80% of the value of real estate is a prescription for disaster when real estate prices come down. Real estate finance globally is in serious need for reform as I argued in a blog post several months ago. Real estate leverage ratios need to be brought down to more realistic “corporate finance” levels. (It is possible to achieve 80% or higher debt levels in repo markets and margin trading, but that requires the discipline of daily mark to market which is impossible in illiquid assets like real estate.)

Posted at 20:36 on Thu, 25 Sep 2008     View/Post Comments (1)     permanent link

Tue, 23 Sep 2008

More on market for buyers only

Ankit Sharma sent me detailed short selling restrictions from various countries around the world. I have summarized the picture as follows:

Needless to say, this is a crude summary which glosses over exemptions and a lot of fine print.

Posted at 20:04 on Tue, 23 Sep 2008     View/Post Comments (0)     permanent link

Fri, 19 Sep 2008

Towards a market only for buyers

The current state of progress towards a market where only buying is permitted is as follows:

Posted at 13:30 on Fri, 19 Sep 2008     View/Post Comments (0)     permanent link

Mon, 15 Sep 2008

New blog feeds

I have been receiving several complaints about problems with my blog feeds particularly in Bloglines. People have also complained about the accessibility of my blog itself in terms of the uptime of the server on which it is hosted. I have done two things to make things better.

  1. I have started an atom feed in addition to the RSS feed. So if you have a problem reading my blog in Bloglines, you could unsubcribe from the old RSS feed and subscribe to the new atom feed:
  2. I have also begun mirroring my blog at Wordpress. The blog address is and the RSS feed is My reason for choosing Wordpress rather than Blogspot is that Wordpress allowed me to import all my old blog posts while Blogspot does not allow me to do so. As of now, I first post on my regular blog and then cross-post on Wordpress as soon as possible.

Posted at 17:47 on Mon, 15 Sep 2008     View/Post Comments (0)     permanent link

Sun, 14 Sep 2008

Visible benefits of margining FIIs

Foreign Institutional Investors (FIIs) resisted being margined in the Indian stock market, but the benefits of margining are now quite visible. Today, the Wall Street Journal reports that “Lehman has hired law firm Weil, Gotshal & Manges LLP to prepare a potential bankruptcy filing, according to a person familiar with the situation. The New York-based Weil has a leading bankruptcy practice and advised Drexel Burnham Lambert on its 1990 bankruptcy filing.” Lehman may yet be rescued, but the report serves to remind all of us that a bankruptcy of a US firm leaves non US creditors totally in the lurch as explained by the London Banker in the Finance and Markets Monitor at RGE Monitor.

The basic premise is that each jurisdiction buries its own dead and keeps whatever treasure or garbage it finds with the corpse. Local creditors get to recover their claims out of the locally available assets. ...

The key to having a happy insolvency, if such a thing exists, lies in ensuring that when a globalised bank goes bust, all the best assets are inside your borders and subject to seizure by your liquidators on behalf of your creditors. Everyone else outside your borders is on their own.

The margining system ensures that there are enough assets within Indian borders to satisfy the needs of Indian counterparties. In this context, the unmargined OTC inter bank market leaves Indian counterparties at risk when foreign entities go bankrupt. That is an additional reason why the RBI should abandon its bias in favour of OTC markets and move more and more markets to an exchange traded and novated platform.

Posted at 12:02 on Sun, 14 Sep 2008     View/Post Comments (0)     permanent link

Tue, 09 Sep 2008

Governments can keep secrets if they want

Writing about the takeover of Fannie and Freddie in his Infectious Greed blog, Paul Kedrosky says: “Apparently the government is better at keeping secrets than anyone else in the capital markets. I’m not sure if that’s reassuring, or frightening.”

Kedrosky has a point. If the stories in the New York Times (“As Crisis Grew, a Few Options Shrank to One”, September 8, 2008) and the Wall Street Journal (“Mounting Woes Left Officials With Little Room to Maneuver”, September 8, 2008) are right, the decision to take a drastic action was taken more than a week before the announcement. The New York Times says that Treasury Secretary Paulson briefed President Bush over secure video on August 26, while the Wall Street Journal reports that the decision on conservatorship was taken on August 30/31 (the Labor day weekend). Yet, the markets did not get even a whiff about it until the government informed Fannie and Freddie about the decision on Friday, September 5 and asked them to get their boards to accept the terms of the rescue. From that point onwards, the media knew the broad contours of the rescue package and the announcement on Sunday morning was largely a formality.

In India also, we observe that the government is able to keep secrets if it wants to. Budget proposals are a wonderful example. Sometimes, the budget speech reserves its sting for the tail and then one an observe that until the closing minutes of the speech, the market has no clue about what is to come. And then within seconds, the market tanks as the finance minister reads out the nasty proposal.

The private sector by contrast finds it very difficult to keep secrets. It is very difficult anywhere in the world to even begin a merger discussion without the news leaking to the media.

Evidently, the incentive structures that the government can bring to bear are far more severe than anything that the private sector can muster. To answer Kedrosky’s question, I personally find it more frightening than reassuring – it suggests that governments simply cannot be trusted because their secrecy processes allow them to get away with blatant lying if they choose.

Posted at 14:51 on Tue, 09 Sep 2008     View/Post Comments (0)     permanent link

Mon, 08 Sep 2008

More on currency futures

I received some offline comments on my earlier blog post on currency futures in India and would therefore like to elaborate on my views.

I see this market evolving in three phases:

  1. In phase one, the market is largely retail. Retail traders simply did not have access to the forward market and assuming that they would like to use currency derivatives, the futures market is the only option for them. Some of the retail participation would be purely speculative, but there would be substantial hedging demand as well. The fact is that you can have an exposure to exchange rates even if all your economic transactions are with domestic participants and are denominated in Indian rupees. For example, a small pepper farmer who sells produce in the local market in Indian rupees is exposed to currency risk to the extent to which domestic pepper prices are linked to global prices denominated in dollars or other foreign currency. I believe that retail demand alone would be sufficient to take the market to the point where it has sufficient liquidity and depth for amounts of $50,000 to $200,000.
  2. This would bring the market to phase two where the liquidity and depth is enough to attract small and medium enterprises (SMEs). SMEs do not trade in the interbank market – they do forward contracts with their regular bank and face quite significant transaction costs. It is easy for the futures market to be competitive for this segment in terms of liquidity and depth. The futures market have the advantage of not tying up credit limits, but have the disadvantage of daily mark to market cash flows. Assuming that the broking business in India is more price competitive than the banking business, I expect brokers to find ways of meeting SME hedging demand at a lower all-in-cost than the banks do. Large SME participation would provide the market with good liquidity at a depth of around a million dollars.
  3. At this stage, the market is ready for phase three, where the market starts competing with the inter bank market for the smaller lots traded there. It is at this point (probably a year or more from today) that the restrictions on the futures market in terms of FII participation and client level position limits will start to bite. Assuming that these restrictions are lifted by then, the futures market could provide stiff competition to the inter bank market if the exchanges provide strong support for direct market access (DMA) and algorthmic trading and persuade agencies like Reuters and Bloomberg to give enough visibility to futures market quotes.

Posted at 13:23 on Mon, 08 Sep 2008     View/Post Comments (0)     permanent link

Thu, 04 Sep 2008

Indian Currency Futures

Ajay Shah’s blog post yesterday provides a lot of interesting data about liquidity and trading in India’s nascent currency futures market. The contract is doing quite well for a newly introduced product, but clearly it is miniscule compared to the OTC market. What are the prospects of this market really becoming mainstream?

How does an illiquid market grow and take liquidity away from an established market? One important factor based on lessons from the well known battle for bund futures (see for example Cantillon and Yin) is the ability of the market to attract a different group of traders into the new market. New markets get their initial momentum from new entrants and not from switchers from old markets. This group of new entrants who value the liquidity of the old market less than the other characteristics that the new market offers start trading and gradually build up liquidity in the new market to the point where it can start attracting switchers.

For currency futures in India, there are several such groups available:

The restrictions in the currency futures market (position limit and absence of FIIs) do not bite at this stage because they do not by and large affect this group of new entrants.

The real battle for market share would begin when the market builds up reasonable depth and liquidity to attract participants from the inter-bank market (as opposed to the customer market from which the initial traders would come).

Globally, we know that the currency futures have a role in price discovery that is disproportinate to its share in trading (Rosenberg and Traub) though improved transparency in the OTC market has reduced this role quite sharply between 1996 and 2006. In India, the price discovery role of currency futures is potentially greater because of regulatory restrictions on the OTC market. An additional complication is that since covered interest parity does not yet hold in India, there is information content in the forward/futures market distinct from what is there in the spot market. Globally, one assumes that the information in futures and spot markets is the same.

Posted at 17:49 on Thu, 04 Sep 2008     View/Post Comments (0)     permanent link

Mon, 01 Sep 2008

Indian and Asian Money Markets

The September 2008 issue of the BIS Quarterly Review has an interesting article on Asian money markets by Loretan and Woolridge.

Their Graph 1 shows that as a percentage of GDP, the Indian Treasury Bill market is quite tiny. The Treasury and Central Bank Bill markets in countries like Malaysia, Phillipines, China and Taiwan are much larger as a percentage of GDP. India’s large fiscal deficit ensures that the government securities market as a percentage of GDP is reasonably large and I had not thought of this as a problem area. But Loretan and Woolridge data does suggest that there may be an issue with the maturity composition of the debt. A lot of the Asian T-Bill and CB-Bill market came out of sterilization operations and to my mind this makes sense. If a lot of the reserves are invested in short maturity assets, it makes sense to fund them with short matutirity liabilities as well. The question is why did India use Market Stabilization Bonds instead of Market Stabilization T-Bills.

The second thing that stands out in the paper is the volatility of the interbank interest rate. Indian rates are so volatile that in Graph 3 of the paper, Loretan and Woolridge plot India and Indonesia on a separate graph titled “Higher Volatility Markets”. Even between these two, it is the Indian interest rate that swings more wildly – even in a graph of the two most volatile rates, the Indian rate goes out of the graph. I can understand this happening when the central bank was targetting money supply rather than interest rates – even a monopolist cannot simultaneously control the quantity of money and its price. But this kind of volatility ought not to be present today.

Table 1 about turnover in derivatives market is distressing in terms of what India is missing out on, but at least here most of emerging Asia gives us company.

Posted at 15:53 on Mon, 01 Sep 2008     View/Post Comments (0)     permanent link