Is a large current account deficit sustainable?

Is current account deficit a bad economic signal?

A country faces a trade deficit when its imports exceed its exports. As long as foreign investors are willing to finance this difference by net capital flows into the country, the situation poses no economic problem. The depreciation pressures from current account are balanced by appreciation pressures from financial account. A current account deficit is sometimes caused by economic growth – faster growth – more imports than exports. Higher economic growth also gives attractive returns to invested capital and attracts foreign investment. These capital flows provide natural financing for current account deficit. 

Is a large current account deficit sustainable?

Normally in a developing economy a deficit ranging from 2-8% of GDP is observed. At the higher end – it’s a concern particularly when the foreign investment comes from debt investments rather than foreign private investors. In India the Current Account Deficit is hovering around 4-4.5% of GDP. 

A large current account deficit is sustainable if non residents are willing to finance it continuously. As soon as foreign investors reduce their financial flows, or seek to repatriate their invested capital, the financing of the current account deficit will disappear and adjustments will need to take place, usually in the form of the currency depreciation. Recall also that income payments are part of current account, so too large a foreign debt burden can exacerbate current account deficits.

Currently the Current Account Deficit in India is around the danger mark and that explains the government’s urgency in taking steps that send positive signal to foreign investors and the capital inflows improve. Mamta and company please pay heed – the situation is not that comfortable. 

Give me a quote on LIBOR

How LIBOR / EURIBOR is getting rigged?

Each morning at 1100 in London, submitters at panels of some of the world’s biggest banks send their estimates of borrowing costs in various currencies and for various terms. A few minutes later the benchmark figures flash to life on tens to thousands of traders’ machines around the world and ripple out into the pricing of loans, derivatives and other financial instruments. Even if  markets were functioning properly some of the banks submitting estimates would struggle to borrow at any interest rate – let alone the rate they have been submitting. The problem is starkest for EURIBOR – where individual banks have been submitting rates that are likely to be a good deal lower than the rates they would have to pay in actual transactions. The biggest banks in Italy and Spain generally estimate the cost of borrowing Euros for a year at about 1.1%. The rate is much lower than the 4-5% their governments pay to borrow for the same period. Solution – banks that claim one price but actually pay another when they borrow should face a hefty fine. 

Central Bank's Toolbox

What are the policy tools available with the Central Bank in a bear zero interest rate environment?

Normally a Central Bank’s preferred choice of policy tool for inflation is short term interest rate. But when happens when the interest rate drops to zero and the central banks commits to keep interest rates are near zero in the near future? What are the policy tools available with the Central Bank in such a low interest rate scenario?

QE or quantitative easing is the answer. QE, a form of asset purchase has now come to refer to several flavours of asset purchase programme. It is generally used when the traditional measures/ tools like lowering interest rates are exhausted. One version of QE is credit easing in which the aim is to support the economy by boosting liquidity and reducing interest rates when credit channels are clogged. Fed’s purchase of MBS demand for which has weakened sharply during the financial crisis fall into this category. Another type of asset purchase aims to boost the economy without creating new money. An example of this is the Fed’s ongoing Operation twist in which Fed sells short term debt and uses the proceeds to buy long term debt giving investors cash for long term debt prompting them to invest more money in other assets. QE proper is a third type – the most straightforward way is portfolio rebalancing – the investors who sell the securities to the central bank then take the proceeds and buy other assets raising their prices. Lower bond yields encourage borrowing, higher equity prices raise consumption, and both help investment and boost demand.

Why is infaltion sticky in India?

 

 

 

 

Monetary policy and fiscal policy are in contradiction. Monetary policy is tight whereas fiscal policy is loose which has resulted in a flat yield curve. Inflation remains high as the output gap is still not negative - demand has gone down but investment has dropped more than demand and thus there is no situation of an excess capacity in the system. Thus the prices are sticky. In sectors, such as auto, where there is excess capacity, prices have come down. Solution - Prop up demand, slashing interest rates will not solve the problem as capex cycle is very low and investment is not forthcoming. 

 

 

Decoding the Liquidity Conundrum of 2008: How the events played out.

To understand the liquidity conundrum of 2008, we need to understand the difference between banks and non banks. In U.S. banks are highly regulated and have to maintain capital requirements and adhere to reserve ratios. The deposits of banks are insured by FDIC, which means that depositors are not concerned what the bank is doing with the money as the deposit is secured by the government. Another features that distinguishes banks from non banks is that the banks can discount their assets with the central bank to repay the depositor when required be. On the flip side non banks or the shadow banking system consist of conduits like REIT, CLO, CDO etc. These are levered institutions which take a lot of risk and are loosely regulated. they don’t have access to fed Discount window and deposits are not secured by FDIC. Therefore non banks are more susceptible to change in the risk appetite of their deposit base. Two primary funding sources of their deposit base – reverse repo and asset backed commercial paper. When the market’s risk appetite is strong, the liabilities of shadow banking system look stable. Brokers MTM investor’s collateral at face value, requiring reasonable margins and never hassle the non banks for more collateral and the asset backed commercial paper is picking up 2-3 bps versus conventional commercial paper. Everything looks fine, every 45-90 days bankers roll over the asset backed commercial paper and effectively the shadow banks have the same stability in their liabilities as the traditional banks. Rating agencies act as quasi regulators in case of shadow banks. However the shadow banks are able to get better of credit rating agencies by securing desired rating for their products through external and internal credit enhancements.

Non banks were able to hold an asset at a tighter spread than the regular banking system because leverage allows a non bank to hold an asset at a tighter spread relative to its funding cost and still generate an acceptable return on equity. For example if one broker has levered 12 times and another has levered 50 times and they have the same return on equity objective , then the broker who is levered 50 times will buy all the assets. This was the reality at the beginning of 2007. Those who questioned the reasonableness of the spreads were told that it was all a result of an enormous pool of liquidity. But the game was coming to an end. The liquidity was in fact was leverage and non transparent pool of money. The first sign was that when structured investment began to issue asset backed commercial paper, which gave the issuer the option to extend the maturity for a fixed period of time. This made the buyer the lender of last resort for a mere 2 bps. In Feb 2007, a Bear Sterns HF revealed that its reverse repo lenders had asked for more collateral to ensure that it does not lose money on the investment. When Bear Sterns conceded that it did not have more collateral, the lenders decided to sell off the collateral that they had. This was a wakeup call that initiated a run on the shadow banking system and the disappearance of liquidity. Traditional banks could not experience bank runs because FDIC insurance makes the govt the lender of last resort. Shadow banks however did experience the modern day version of bank run in 2007. The combination of not having the protections of FDIC, being under pressure from reverse repo brokers to put up more collateral, and facing an asset backed commercial paper market that refused to refinance took the market from unlimited liquidity to liquidity crunch. The non banks could not sell their assets fast enough to satisfy the increased risk aversion of their lenders. The liquidity dissipated and volatility returned to the market because investors state of mind changed their risk appetite. Financial instability hypothesis – This hypothesis states that stability is inherently destabilizing because stability leads to the extrapolation of stability into infinity, which encourage more risk seeking financial structures, particularly with debt. Therefore the more stability a marker has and the longer it lasts, the more unstable the foundation of the stability becomes. Stability is destabilizing because it begets more unstable debt structures.

Problem with the housing market

In this situation a borrower who buys an asset, the income generated by the asset plus other income is insufficient for amortizing the principal or even playing all of the interest. At the maturity the borrower has a balloon payment bigger than the original loan as the interest was not paid. The borrower is betting that the value of the collateral will go up. Borrowers who take on a Ponzi debt are betting that if they can buy an overvalued asset, when the balloon payment comes due, another borrower will pay a higher overvalued price for the collateral. The collateral cannot just hold its value, it has to go up.

By 2006 the preponderance of debt creation at the margin was Ponzi unit finance. A classic example is the 2/28 subprime adjustable rate mortgage in which borrowers put no money down, get a teaser rate for two years, and can opt to pay less than the full amount of interest. The borrowers choose how much interest to pay, and the rest is put towards principal. After two years the interest rate goes up by 5%. The majority of the marginal borrowers for the year 2004-2006 made use of this mortgage structure.

No one defaulted as the property prices were going up and there was no gain in defaulting on the balloon payments. But by the first quarter of 2007, the subprime mortgages issued in 2006 had a surge of early payment defaults. The percentage of borrowers not making the first payment on their mortgages rose quickly which signalled that the property market had reached the ponzi stage. The value of the property was less than the value of the loan due, so there was no gain in paying up the loans hence the defaults.