Monday, April 27, 2015

The remarkable persistence of the idea of open capital account

It is remarkable that the idea of open capital account as a macroeconomic policy goal, a central pillar of the Washington Consensus and the policy recipe of any multilateral agency, still finds support among influential policy makers in countries like India when the orthodoxy has turned the full circle elsewhere. 
I have blogged extensively on this several occasions. This oped briefly makes the case against rapid capital account liberalization, arguing that markets over-react when countries respond to signs of trouble by reintroducing capital controls and other capital flows management measures, thereby making the original decision on liberalization all the more critical.  

There is nothing profound about this. The contagion from cross-border flows operates through multiple channels. Surging inflows cause exchange rate appreciation, which in turn lowers export competitiveness and generates current account imbalances, apart from unleashing inflationary pressures and adversely affecting local manufacturing and other tradeables. Simultaneously, in the financial markets, it engenders resource mis-allocation manifested in asset bubbles and reckless corporate leveraging. When the tide turns, the risks of over-leveraged corporate balance sheets and aggressive bank lending become evident, with devastating consequences. Sudden stop follows and capital rushes out. Interestingly, and this is important, the trigger for a reversal of capital flows, can happen due to exogenous events which have little to do with the host country. This is a reflection of the deep global financial linkages and necessitated by liquidity and portfolio rebalancing among global financial market participants. Unfortunately, by this time, the country's current account imbalances would have approached unsustainable levels, thereby amplifying the country risk perceptions and hastening the capital flight. De-leveraging and banking crisis invariably follow, accompanied by recession and prolonged slowdown. A decade or so is lost. And it is no different this time.    

In fact, in a landmark confession (the Economist said that "it was as if the Vatican had given its blessing to birth control!"), after rigorous examination of the evidence, the IMF, no less, argued that 'capital controls are part of the toolkit' and admitted to this,
Capital flows can have substantial benefits for countries. At the same time, they also carry risks, even for countries that have long been open and drawn benefits from them... They are volatile and can be large relative to the size of a country's financial markets or economy. This can lead to booms and busts in credit or asset prices, and makes countries more vulnerable to contagion from global instability... Global financial market volatility... has significant spillovers to emerging market economies... Countries with extensive and long-standing measures to limit capital flows are likely to benefit from further liberalization in an orderly manner. There is, however, no presumption that full liberalization is an appropriate goal for all countries at all times... For countries that have to manage the risks associated with inflow surges or disruptive outflows, a key role needs to be played by macroeconomic policies, as well as by sound financial supervision and regulation, and strong institutions. In certain circumstances, capital flow management measures can be useful. They should not, however, substitute for warranted macroeconomic adjustment. 
The IMF's latest country report on India, which examined the impact of global financial market volatility on India, has more to say,
A surge in global financial market volatility is transmitted very strongly to key macroeconomic and financial variables of emerging markets, and the extent of its pass-through increases with the depth of external balance-sheet linkages between advanced countries and emerging markets... We argue that strong fundamentals and sound policy frameworks per se are not enough to isolate countries from an increase in global financial market volatility. This is particularly the case where there is a sudden adjustment of expectations triggered by monetary policy normalization uncertainty in advanced economies... no country (neither advanced markets nor emerging markets) appears immune from the impact of a surge in global financial market volatility. 
In a speech in 2013 at the central banker's retreat at Jackson Hole, Helene Rey (pdf from here) of the London Business School went so far as to claim that "independent monetary policies are possible if and only if thee capital account is managed directly or indirectly". In fact, she describes monetary policy autonomy and free capital flows as an "irreconcilable duo". 

There has been an explosion of research and publications on this issue in recent years. Barry Eichengreen and Poonam Gupta used evidence from the Fed's 2013 tapering talk to show that capital flows volatility spares none,
Better fundamentals (the budget deficit, the public debt, the level of reserves, the rate of economic growth) did not provide insulation. A more important determinant of the differential impact was the size of the country’s financial market: countries with larger markets experienced more pressure on the exchange rate, foreign reserves and equity prices.
In this context, supporters of full convertibility point to the impossibility of effective enforcement of capital controls. This straw man is disingenuous since nobody disputes that capital controls are imperfect. In fact, several studies on the impact of capital controls in recent years while pointing to a mixed picture, also acknowledge the undoubted short-term benefits of capital flows management measures in limiting capital inflow surges. The best evidence that it has some intended effect comes from no less a person than Mohamed El-Erian, former CEO of world's largest bond trader PIMCO, as quoted in the Economist, who has this to say about capital controls,
They do exactly what they are intended to do : put sand in the market. We think twice, or three times.
From all these five things stand out. 
  1. Capital flows carry considerable risks.
  2. Even countries with credible institutional mechanisms are not immune to these risks.
  3. In fact, the vulnerability to global financial market volatility increases with increased economic integration with the world economy.
  4. There is nothing to suggest that full capital account liberalization should be the ultimate objective.
  5. Capital controls can be useful in certain circumstances.
This lends credence to the use of various capital flows management measures like capital controls and macro-prudential instruments. In fact, given their relatively greater effectiveness in comparison to capital controls, macro-prudential measures have become an increasingly common capital flows management instrument in the armory of central banks. They include counter-cyclically increasing capital reserve buffers on systemically important financial institutions, counter-cyclical leverage caps on trading positions and financial intermediaries, systemic liquidity surcharges, and regulatory restraints on asset markets (like loan-to-value and debt-to-income ratios in property markets) and external commercial borrowing (say, on short-term unhedged debts) to attenuate credit bubbles.  

Perceptions matter as much as reality, atleast in the short and medium term, in the financial markets. Credibility comes from consistency in public pronouncements. India's history of external account management is filled with some or other form of capital controls, the most egregious being the restrictions on gold imports, to mitigate the impact of worsening current account balance. The global consensus too is in that direction - all the major emerging economies have embraced capital controls in some form or other in recent years, albeit with varying levels of success. In the circumstances, it surely does little to enhance your credibility if we advocate the need for capital account convertibility.

Sunday, April 26, 2015

The power of marginal improvements

This blog has long argued that the cumulative effect of numerous small reforms and improvements can be dramatic. This assumes greater significance in systems where the low-hanging fruits have been plucked or decisional reforms implemented. Consider this,
UPS estimates that a savings of one minute per day per driver increases profit by $14.5 million over the course of a year.
All this and more from an excellent essay by Tyler Cowen and Alex Tabarrok on how technological advances have bridged information asymmetry and thereby lowered the resultant market failures.

Thursday, April 23, 2015

Institutional investors and widening inequality

Eric Posner and Glen Weyl points to a new paper by Jose Azar, Martin Schmalz, and Isabel Tecu who show how institutional investors like mutual funds reduce market competition and increase prices for consumers. They highlight the fact that a handful of institutional investors have large ownership stakes in the largest firms across industries, thereby raising the possibility of oligopolistic market power. In their paper they use the example of airline industry and write,
Many natural competitors are jointly held by a small set of large diversified institutional investors. In the US airline industry, taking common ownership into account implies increases in market concentration that are 10 times larger than what is “presumed likely to enhance market power” by antitrust authorities. We use within-route variation over time to identify a positive effect of common ownership on ticket prices. A panel-IV strategy that exploits BlackRock's acquisition of Barclays Global Investors confirms these results. We conclude that a hidden social cost - reduced product market competition - accompanies the private benefits of diversification and good governance... airline prices are 3 to 11 percent higher than they would be if common ownership did not exist. 
Posner and Weyl write,
Although we think of airlines as independent companies, they are actually mostly owned by a small group of institutional investors. For example, United's top five shareholders - all institutional investors - own 49.5% of the firm. Most of United's largest shareholders also are the largest shareholders of Southwest, Delta, and other airlines... If a mutual fund owns shares of United and Delta, and United and Delta are the only competitors on certain routes, then the mutual fund benefits if United and Delta refrain from price competition. The managers of United and Delta have no reason to resist such demands, as they, too, as shareholders of their own companies, benefit from the higher profits from price-squeezed passengers... The authors also point out that the investment management company BlackRock is the top shareholder of the three largest banks in the US; BlackRock is also the largest shareholder of Apple and Microsoft. The companies that are the top five shareholders of CVS are also the top five shareholders of Walgreens.  
Since the higher income people own a disproportionate share of the funds in institutional investors like mutual funds, the share of profits accruing to them is far higher. And this excess profits comes from the pocket of consumers, who cover a far wider income spectrum. In other words, these "institutional investors shrink the size of the market while giving the rich a larger share of what's left". The impact of these trends on inequality is unambiguous. 

This is more to the long list of market failures in financial markets. Roger Gordon, Daniel O' Brien and Steven Salop, and Julio Rotemberg have similar papers the role of financial interests and incentives of industrial firms. 

Wednesday, April 22, 2015

The flawed wisdom on microfinance

The conventional wisdom that underpins the micro-finance and self-help group movement is based on three assumptions about poor people
  1. They need money.
  2. They are willing to borrow if they have access to credit.
  3. They can use borrowed money to enhance their livelihoods. 
Now, a closer analysis would reveal that neither of these assumptions are as axiomatic as they would appear. Consider the first assumption. A recent J-PAL policy paper that summarizes findings from RCTs on micro-finance uptake among beneficiaries in Ethiopia, India, Mexico, and Morocco who were provided easier access to micro-credit, find modest demand for credit. A more plausible assumption is that poor people need money at certain times, when faced with certain unavoidable requirements.

As regards the second assumption, again the story may be complicated. Consider a society where debt comes attached with a stigma. If this were to hold, then families are unlikely to borrow even when plentiful credit is available. They would borrow to meet unavoidable consumption requirements - festival or marriage expenses, medical treatments etc. But they would not do so to meet avoidable consumption (eg. buy consumer durables) or investment (eg. expand business) requirements.  

Finally, the idea that poor people, in general, can work their way out of poverty through entrepreneurship is not only ahistorical (which society has escaped poverty by entrepreneurship?) but also simply an inversion of the conventional wisdom on risk allocation - risks should be assumed by those best able to bear it. Most business activities, however small, carries considerable commercial risks. Expecting poor people, who just about manage to make ends meet, to bear those risks appears a case of risk-burdening those with the least ability to assume commercial risks.

Incidentally, the J-PAL paper is a great read, with several interesting insights - micro-credit access did not lead to substantial increases in income; micro-credit driven business investments rarely resulted in profit increases;  none of the seven studies found a significant impact on average household income for borrowers; and there is little evidence that micro-credit access had substantial effects on women’s empowerment or investment in children’s schooling. 

Sunday, April 19, 2015

India and the AIIB

Last week the Chinese government announced that 57 countries, including India, have agreed to join the Asian Infrastructure Investment Bank (AIIB). The process of preparing the institution's shareholding pattern, governance framework and lending rules will soon start. So what should be India's strategy?

Foremost, India should realize that it is second only to China in all the parameters - GDP, population, actual infrastructure investments, financing needs and so on. But the politics and economics of joining AIIB pulls in different directions for India. 

Politically, it is undoubtedly in India's interest to not to be not part of the founding of an institution which now holds some global geo-political significance. India should aspire to a seat at the top of the table in an institution that has the potential to become one the leading multilateral financing institutions. But economically, India could well stay out of AIIB and not lose much. Its infrastructure investment needs are massive, nearly $ 1 trillion targeted for the 2012-17 period. The AIIB's contribution can, at best, be just a drop in the ocean. In fact, given its modest initial capital ($50 bn) and the perception discount (among investors and countries) associated with an institution that is clearly dominated by China, one could argue that economically the institution would benefit more from India's presence than India would. It is therefore safe to argue that the AIIB needs India atleast as much as India needs AIIB. India needs to leverage this to its advantage as it negotiates the Articles of Agreement (AoA) of the AIIB. It should not become just another invitee to a Chinese triumphal party.

Given the deep Chinese interest in displaying how the new institution will be fairer and more equitable than the Bretton Woods twins, India has the opportunity to play ball with China over negotiations on the AIIB's governance framework. Furthermore, given China's dominance in AIIB (its initiative, headquarters, leadership position etc), a framework which is fairer and more equitable than the Bretton Woods institutions would involve considerable sacrifices by China and gains for countries like India. 

Apart from the limited financing opportunities, what should be India's possible takeaways from an AIIB? 

1. India should push the AIIB away from multilateral sovereign lending and towards project finance lending. A country like India should have limited interest in sovereign loans and should be more concerned about using all potential sources to leverage international long-term capital to finance its, predominantly, privately financed infrastructure projects. For example, like with the case of World Bank and IFC, even a small AIB share in a project could serve as a credit enhancement and help crowd-in international capital at lower cost than otherwise. 

2. India should advocate issuance of bonds by the AIIB in not just dollar and renminbi (as is most likely, since China would not lose this opportunity to promote the renminbi as a reserve currency), but also rupees. This would help in the internationalization of the rupee as well as help Indian borrowers more cost-effectively hedge their losses and thereby lower the cost of their foreign capital. 

3. India should strive to use the AIIB as an instrument to promote the interests of its own infrastructure firms. It should not be a surprise if China uses the cover of AIIB lending to promote contracts for Chinese firms. There is a strong likelihood of this given the perception that China could use the AIIB to formalize the massive lending currently being undertaken by institutions like the China Development Bank, all of which are conditioned on awarding contracts to Chinese firms. In that case AIIB could become an extended arm of Chinese aid diplomacy. Instead, India should negotiate hard to ensure a level-playing field for Indian firms.

4. The bonds issued by the AIIB could be a potentially good source of risk diversification as well as earning higher returns for India's growing foreign exchange reserves, a large share of which are currently invested in low-yielding US Treasuries. In fact, India should use its reserves and unilaterally match any Chinese contribution either by subscribing to bonds or equity capital. 

China high-speed rail fact of the day

From Forbes,
An average kilometer of HSR track in China costs between $4.8 million USD (Jiaoji Line) to $32.7 million USD (Zhengxi Line), which is significantly less than the estimated $380 million USD to $ 625 million USD it will cost for laying down the British HSR2 project.
The cost variation is a truly stunning differential, which defies all conventional explanations. 

My guess is that the Chinese estimates do not cover many requirements ('right of way' procurement etc) and excludes the massive subsidies (cheaper land and other inputs, cost of capital, tax concessions etc) enjoyed by Chinese equipment makers. Even with these and assuming the highest efficiency standards among Chinese developers, there is still a lot of explaining to do. 

Saturday, April 18, 2015

The declining capital intensity and secular stagnation

Barry Eichengreen (via Mark Thoma) examines the various explanations for secular stagnation,
Four explanations for secular stagnation are distinguished: a rise in global saving, slow population growth that makes investment less attractive, averse trends in technology and productivity growth, and a decline in the relative price of investment goods. A long view from economic history is most supportive of these four views. 
The same investment projects can be pursued, it is hypothesized, by committing a smaller share of GDP, and any additional projects that might be rendered attractive by this lower cost of capital are not enough to offset the decline in the investment share. With less investment spending chasing the same savings, the result can be lower real interest rates and, potentially, a chronic excess of desired saving over desired investment.
He has this graphic which highlights the declining relative price of investment goods. 
While this may be true of many developed economies, where the services sector predominates, it may be less so with developing economies. In these countries, manufacturing still makes up a significant share of the GDP and services a less dominant one. This is one more reason for appreciating the international dimension of secular stagnation hypothesis. Once we assume an open economy, the potential for mutually beneficial outcomes from international trade and cross-border capital flows are immense.