Prof. Jayanth R. Varma's Financial Markets Blog

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Prof. Jayanth R. Varma's Financial Markets Blog, A Blog on Financial Markets and Their Regulation

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Thu, 29 Aug 2013

Why India's crisis could be a good thing

I recall telling some Indian policy makers in the late 1990s that it was unfortunate that India had not fallen victim to the Asian Crisis. I need hardly add that the rest of the conversation was not very pleasant. However, one of the great privileges of living in a democracy is that one get away with saying such things – policy makers do not have firing squads at their disposal (at least not yet).

Now we seem to be getting a crisis of the kind which I have been expecting for several months now (see my blog posts here, here and here). This is a good time to reflect on the aftermath of the Asian Crisis to understand how (under the right conditions) a lot of good can come out of our crisis.

Like in East Asia of 1997, the Indian corporate sector has come to be dominated by a rent seeking kleptocracy that resembles the Russian oligarchs. Unlike the businesses that came to prominence in the first decade after the 1991 reforms, many of the business group that have emerged in the last decade have been tainted by all kinds of unsavoury conduct. For the country to reestablish itself on the path of high growth and economic transformation, many of these unproductive businesses have to be swept away. In 1997, the bankruptcy of the Daewoo Group was important in reforming the Chaebol and getting Korea back on the track again. We need to see something similar happen in India. A useful analogy is that of a forest fire that clears all the deadwood and allows fresh shoots to grow and rejuvenate the forest.

One of the wonderful things about a financial crisis is that the capital allocation function shifts decisively from those who think like short term lenders to those who think like owners. In a debt restructuring for example, erstwhile lenders are forced to think like equity holders, and they end up allocating capital much better that they did when they were just chasing yields while floating on the high tide of liquidity. They have to stop worrying about sunk costs and focus more on future prospects.

A very good example is what the Asian Crisis did to Samsung. At the time of the crisis, Samsung was an also-ran Chaebol whose head was obsessed with building a car business like Daewoo or Hyundai. In the consumer electronics business, it was well behind Sony. The crisis forced Samsung to abandon its car making dreams under enormous pressure from the financial markets. As it focused on what it knew better, Samsung has created a world beating business while Sony ensconced in its cosy world in a country which largely escaped the Asian Crisis has simply gone downhill.

Even at the level of countries, one can see how a country like Malaysia that changed least in response to the crisis has been in relative decline as compared to its peers. I cannot help speculating that in the emerging crisis, China’s large reserves will allow that country the luxury of behaving like the Malaysia of 1997. If by chance, India responds like the Korea of 1997, Asia’s economic landscape in the next decade will be very interesting.

Another interesting parallel is that in 1997/1998, several of the crisis affected countries faced elections at the height of the crisis or had a change of government by other means (Indonesia). Far from leading to political confusion, these elections helped to legitimize decisive action at the political level. Nothing concentrates a politician’s mind more than a bankrupt treasury. We saw that in 1991 (another case of an election at the time of crisis). We could see that once again in 2014.

Of course, nothing is preordained. We can blow our chances. But to those who think that 1991 was the best thing that ever happened to this country, there is at last reason to hope that we will get another 1991. In these bleak times, all that one can do is to be optimistic in a pragmatic way.

Posted at 21:49 on Thu, 29 Aug 2013     View/Post Comments (5)     permanent link

Wed, 21 Aug 2013

Casualties of credit

I just finished reading Carl Wennerlind’s book Casualties of Credit about the English financial revolution in the late seventeenth century. Much has been written about this period including of course the seminal paper by Douglas North and Barry Weingast on “Constitutions and commitment” (Journal of Economic History, 1989). Yet, I found a lot of material in the book new and highly illuminating.

Especially interesting was the description of the crisis of 1710 – which I think was the first instance in history of the bond market trying to arm twist the government to change its policies. I was also fascinated by the discussion about how Isaac Newton used his vast talents to hunt down coin clippers and counterfeiters, and then ruthlessly sent them to the gallows. I knew that apart from inventing calculus and much of physics, Newton had time to dabble in alchemy, but I had thought that his position as Master of the Mint was a sinecure. Well Newton chose not to treat it as a sinecure.

Posted at 10:11 on Wed, 21 Aug 2013     View/Post Comments (1)     permanent link

Sun, 18 Aug 2013

Quadrillion mantle passes from Italy to Japan after a decade

In the 1990s, we used to joke that the word quadrillion was invented to measure the Italian pubic debt. The introduction of the euro put an end to this joke. Italy’s public debt is currently “only” around two trillion euros, but it would be around four quadrillion lire at 1999 exchange rates. After a gap of more than a decade, the mantle has passed to Japan whose public debt crossed the quadrillion yen mark recently.

The only other important monetary amount that I am aware of that could be in the quadrillion range is the total outstanding notional value of all financial derivatives in the world. The BIS estimate (which is perhaps conservative) for this is only around $600 trillion, but some other estimates (which are perhaps exaggerated) put it in the range of $1,200 – $1,500 trillion.

Posted at 08:08 on Sun, 18 Aug 2013     View/Post Comments (0)     permanent link

Sun, 04 Aug 2013

Do regulators understand countervailing power in markets?

Practitioners understand the importance of countervailing power in keeping markets clean. The biggest obstacle that a would-be manipulator faces is a big player on the opposite side with the incentives and ability to block the attempted manipulation. Without that countervailing power, the regulator would be stretched very thin trying to combat the myriad games that are being played out in the market at any point of time. But regulators seem to be oblivious of this completely and often step in to curb the countervailing power without realizing that they are allowing people on the other side a free run.

This was highlighted yet again by a recent order of the UK Financial Conduct Authority (FCA), the successor to the Financial Services Authority (FSA). The FCA fined Michael Coscia for a trading strategy that made money at the cost of high frequency traders (HFTs).

HFTs often try to trade in front of other people. When the HFT suspects that a large trader is trying to buy (sell), the HFT tries to buy (sell) immediately before the price has gone up (down), and then tries to turn around to sell to (buy from) the large trader at an inflated (depressed) price. Michael Coscia created a trading strategy designed to give the HFTs a taste of their own medicine in the crude oil market. He placed a set of large orders designed to fool the HFTs into thinking that he was trying to sell a big block. When the HFTs began front running his purported large sell order, Coscia turned around and bought some crude from them at below market prices. He then performed the whole operation in reverse, fooling the HFTs into thinking that there was a large buy order in the market. When they tried to front run that buy order, Coscia sold the crude (that he had bought in the previous cycle) back to the HFTs.

The FCA thinks that Corcia violated the exchange rules which provided that “it shall be an offence for a trader or Member to engage in disorderly trading whether by high or low ticking, aggressive bidding or offering or otherwise.” From a legal point of view, the FCA is probably quite correct. But the net effect of the action is to neutralize the kind of trading strategies that would have held the HFTs in check. The FCA of course thinks that they are acting against HFTs because Corcia’s trading strategy also involved high frequency trading.

Posted at 14:29 on Sun, 04 Aug 2013     View/Post Comments (4)     permanent link