ZIRP (zero interest rate policy) – The two edged sword

From Bloomberg:

“The U.S. Federal Reserve will probably cut interest rates to zero percent over the next two months to staunch deflation, according to JPMorgan Chase & Co.”

Some economists are already feeling that additional policy easing could be appropriate ... given recent data and developments in financial markets, 'some' may have turned into ‘most’,

While this may prove to be correct, it certainly isn't an obvious move. First, most central banks regard getting below 1% short term rates is dangerous territory. ZIRP let to a deflationary trap for Japan, and there isn't a particularly good reason to think it will fare better here.

Taking the target rate to zero percent would not be costless for the Fed. Public confidence may drop and led to the perception that the Fed has run out of options. Some saw a risk that the inflation rate will fall below the Fed's objective of price stability.

In addition, once short term rates fall below 1%, money market funds have trouble operating profitably. The Fed may find itself not merely acting as a big player in the commercial paper market (money market funds are big buyers of CP), but becoming the ONLY player. That would not be good.

700 bn bailout from Game theory perspective

Game Theory explains why the 700 Billion bailout might not work ...

Lets assume that there are only two banks - Bank A and B.

The Fed proposes a bailout in which both Bank A and B sell risk assets to the Treasury. In this case, the result is a more regulated banking industry, with imposed limits to salary, but importantly markets are clear.

However, it is in BOTH banks interest to deviate from that because if Bank A (or B) believe the other is selling their risky assets to the Treasury; they will each be better off holding on to theirs. The reason is simple - when the other bank sells and they hold, markets will still clear and the bank that holds onto their risk assets can sell at the new market prices. This results in increased market share as they:

1. can pay more for talent
2. are less regulated
3. Don’t have the stigma of selling to the Treasury

The likely result? No bank sells voluntarily and markets remain frozen.

The Swedish banking crisis response - a model for the future?

Source ( Taken as it is from the source .. not a single word can be deleted)
The Swedish Experience, Riksbankschef Urban Bäckström, Federal Reserve Symposium, 27 Aug 1997

The Swedish crisis - what happened?

The economic problems in Sweden in the early 1990s should be seen in their historical context. For several reasons, economic growth in Sweden has been relatively weak ever since about 1970. Following the collapse of the Bretton Woods system the creation of a stable macroeconomic environment turned out to be difficult. Wage formation functioned badly, fiscal policy was unduly weak and this was gradually compounded by structural problems.

Credit market deregulation in 1985, necessary in itself, meant that the monetary conditions became more expansionary. This coincided, moreover, with rising activity, relatively high inflation expectations, a tax system that favoured borrowing, and remaining exchange controls that restrained investment in foreign assets. In the absence of a more restrictive economic policy to parry all this, the freer credit market led to a rapidly growing stock of debt (Fig.). In the course of only five years the GDP ratio for private sector debt moved up from 85 to 135 per cent. The credit boom coincided with rising share and real estate prices. During the second half of the 1980s real aggregate asset prices increased by a total of over 125 per cent. A speculative bubble had been generated.

The expansion of credit was also associated with increased real economic demand. Private financial saving dropped by as much as 7 percentage points of GDP and turned negative. The economy became overheated and inflation accelerated. Sizeable current-account deficits, accompanied by large outflows of direct-investment and other long-term capital (once exchange control had been finally abandoned in the late 1980s), led to a growing stock of private sector short-term debt in foreign currency.

Step by step the Swedish economy became increasingly vulnerable to shocks. During 1990 matters came to a head. Competitiveness had been eroded by the relatively high inflation in the late 1980s, resulting in an overvalued currency. This caused exports to weaken and meant that the fixed exchange rate policy began to be questioned, leading to periods with relatively high nominal interest rates. Moreover, the tax system was reformed in order to reduce its harmful economic effects but this also contributed to higher post-tax interest rates. Asset prices began to fall and economic activity turned downwards. Between the summers of 1990 and 1993 GDP dropped by a total of 6 per cent. Aggregate unemployment shot up from 3 to 12 per cent of the labour force and the public sector deficit worsened to as much as 12 per cent of GDP. A tidal wave of bankruptcies was a heavy blow to the banking sector, which in this period had to make provisions for loan losses totalling the equivalent of 12 per cent of annual GDP.

While this course of events stemmed, as I have indicated, from a variety of factors, it was no doubt the financial vulnerability that helped make it so dramatic. The Swedish economy was steadily approaching a situation that entailed both a banking and a currency crisis. Matters were most acute in the fall of 1992 in conjunction with the European currency unrest. The crisis in banking was triggered, not by a classic bank run but by a loss of international confidence and difficulties with international financing. In many respects the crisis in Sweden resembled what has happened in a number of other countries.

By the summer of 1993 the economy was becoming more stable and the problems in banking receded. Fiscal and monetary policy contributed to this and so did a deliberate policy of handling problem banks.

The private sector's financial balance underwent a dramatic change, moving from a deficit of about 8 per cent of GDP in 1990 to a financial surplus of over 11 per cent in 1993. This was a swing of almost 20 percentage points of GDP in the course of only three years. A good deal of the swing no doubt came from private sector adjustments to cope with insufficient solvency. Falling asset prices in conjunction with high debt levels lead to balance-sheet problems in the private sector.

The automatic stabilisers in the government budget probably helped to lessen the contraction of GDP. This meant that business profits and household disposable income were sustained relatively well. But it also entailed a massive increase in the budget deficit and this in turn generated new problems. The government debt trend became unsustainable and economic policy's credibility was weakened.

In the early stages of the crisis, monetary policy was directed to maintain the fixed exchange rate. This line had broad support among the general public as well as in the political system. The aim was to establish a low-inflation policy once and for all. But in spite of major efforts, both political and economic, the international currency unrest in November 1992 meant that the fixed exchange rate had to be abandoned. It was replaced by a flexible exchange rate and an explicit inflation target. This resulted in a considerable depreciation of Sweden's currency but during 1993 the continued fall in international bond rates meant that Swedish interest rates also moved down to levels that were comparatively low. Together with the Riksbank's reduction of its instrumental rate, this gave the monetary conditions a stimulatory turn. It also helped to stabilise both the economy and the banking system. Lower market rates eased the fall in asset prices, lightened the burden of servicing private sector debt and mitigated the negative impact on the financial system.

Rescuing the banking sector was necessary to avoid a collapse of the real economy. There is no evidence that a credit crunch developed, though anecdotal information did suggest that creditors became more restrictive. I shall be returning shortly and in more detail to how the banking problems were tackled.

In 1994 the major budget problems and the expansionary monetary conditions rebounded. Inflation expectations began to move up in many parts of the economy and when interest rates increased worldwide in the spring of 1994, bond rates in Sweden rose much more than in other countries - from just under 7 per cent to over 12 per cent in a few months. This was accompanied by a further weakening of the exchange rate to levels that were appreciably below any reasonable assessment of the real equilibrium rate.

The situation called, in other words, for an economic policy realignment - for what we can call aftercare once the acute financial crisis had been checked. A major consolidation of government finance was launched, accompanied by a tightening of the monetary stance which demonstrated that the 2 per cent inflation target was to be taken seriously.

In time this course has enhanced economic policy's credibility and led to more permanent economic stabilisation.

Management of the bank crisis

To those of us who were working on the initial banking problems it was soon clear that the crisis in Swedish banking could become very serious. In spring 1992 preparations were therefore made to cope with a variety of conceivable situations. Later we found that our worst-case scenario was on the verge of happening.

Looking back, one can see that in the course of the crisis the seven largest banks, with 90 per cent of the market, all suffered heavy losses. In these years their aggregate loan losses amounted to the equivalent of 12 per cent of Sweden's annual GDP. The stock of non-performing loans was much larger than the banking sector's total equity capital and five of the seven largest banks were obliged to obtain capital contributions from either the State or their owners. It was thus truly a matter of a systemic crisis.

In connection with a serious financial crisis it is important first and foremost to maintain the banking system's liquidity. It is a matter of preventing large segments of the banking system from failing on account of acute financing problems.

In September 1992 the Government and the Opposition jointly announced a general guarantee for the whole of the banking system. The Riksdag, Sweden's parliament, formally approved the guarantee that December. This broad political consensus was I believe of vital importance and made the prompt handling of the financial crisis possible.

The bank guarantee provided protection from losses for all creditors except shareholders. The Government's mandate from Parliament was not restricted to a specific sum and its hands were also very free in other respects. This necessitated close cooperation with the political opposition in the actual management of the banking problems. The decision was of course troublesome and far-reaching. Besides involving difficult considerations to do, for example, with the cost to the public sector, it raised such questions as the risk of moral hazard.

The political system concluded that in the event of widespread failures in the banking system, the national economy would suffer major repercussions. The direct outlays in connection with the capital injection into the banking sector added up to just over 4 per cent of GDP. However, it is now calculated that most of this can be recovered.

One way of limiting moral hazard problems was to engage in tough negotiations with the banks that needed support and to enforce the principle that losses were to be covered in the first place with the capital provided by shareholders.

A separate authority was set up to administer the bank guarantee and manage the banks that landed in a crisis and faced problems with solvency, though the crucial decisions about the provision of support were ultimately a matter for the Government. A clear separation of roles was achieved between the political level and the authorities, as well as between different authorities. Naturally this did not preclude very close cooperation between the Ministry of Finance, the Bank Support Authority, the Financial Supervisory Authority and the Riksbank.

It was up to the Riksbank to supply liquidity on a relatively large scale at normal interest and repayment terms but not to solve problems of bank solvency. Collateral was not required for the loans to banks, neither intraday nor overnight. The banking system was free to obtain unlimited liquidity by drawing on its accounts with the central bank. The bank guarantee meant that the solvency of the Riksbank was not at risk. In order to offset the loss of foreign credit lines to Swedish banks, during the height of the crisis the Riksbank also lent large amounts in foreign currency.

Banks applying for support had their assets valued by the Bank Support Authority, using uniform criteria. The banks were then divided into categories, depending on whether they were judged to have only temporary problems as opposed to no prospect of becoming viable. Knowledge of the appropriate procedures was built up by degrees, not least with the assistance of people with experience of banking problems in other countries.

The Swedish Bank Support Authority had to choose between two alternative strategies. The first method involves deferring the reporting of losses for as long as is legally possible and using the bank's current income for a gradual write-down of the loss making assets. One advantage of this method is that it helps to avoid the bank being forced to massive sales of assets at prices below long run market values. A serious disadvantage is that the method presupposes that the bank problems can be resolved relatively quickly; otherwise the difficulties compound, leading to much greater problems when they ultimately materialise. The handling of problems among savings and loan institution in the United States in the 1980s is a case in point. With the other method, an open account of all expected losses and writedowns is presented at an early stage. This clarifies the extent of the problems and the support that is required. Provided the authorities and the banks make it credible that no additional problems have been concealed, this procedure also promotes confidence. It entails a risk of creating an exaggerated perception of the magnitude of the problems, for instance if real estate that has been taken over at unduly cautiously estimated values in a market that is temporarily depressed. This can lead, for instance, to borrowers in temporary difficulties being forced to accept harsher terms, which in turn can result in payments being suspended.

The Swedish authorities opted for the second method: disclose expected loan losses and assign realistic values to real estate and other assets. This method was consistent with other basic principles for the bank support, such as the need to restore confidence. Looking back, it can be said that in general the level of valuation was realistic.

Since the acute crisis had been triggered by difficulties in obtaining international finance, great pains were taken to give a transparent picture of how the crisis was being managed so as to gain the confidence of Sweden's creditors. This applied both to the account of the magnitude of the banking problems and to the content of the bank guarantee. Various informative projects were arranged for this purpose throughout the world. In Sweden, too, considerable efforts were made to legitimise the measures and their costs.

The banking problems did arouse a lively debate in Swedish society but the work could still be done in broad political consensus, which was a great advantage. The bank guarantee was terminated in 1996 and replaced with a deposit guarantee that is financed entirely by the banks.

Conclusions

The problems in the Swedish banking system at the beginning of this decade seem to have been more extensive than those which arose in Sweden in the early 1920s. The two periods also differ substantially in the management of the crisis. This may have had a bearing on the very different course of events in these two crises. In the early 1920s the fall in GDP totalled 18 per cent and the price level dropped 30 per cent in the course of two years. In the 1990s the loss of GDP stopped at around 6 per cent and the price trend did not become really deflationary.

Allow me now to summarise what I consider to be the most important lessons from Sweden's financial crisis:

1. Prevent the conditions for a financial crisis
The primary conclusion from our experience of Sweden's financial crisis is that various steps should be taken to ensure that the conditions for a financial crisis do not arise.

- Fundamentally it is a matter of conducting a credible economic policy focused on price stability. This provides the prerequisites for a monetary policy reaction to excessive increases in asset prices and credit stocks that would be liable to boost inflation and create the type of speculative climate that paves the way to a financial crisis.

- Looking back, it can be said that if various indicators that commonly form the background to a financial crisis had been followed systematically, then incipient problems could have been detected early on. That in turn could have influenced the conduct of fiscal and monetary policy so that Sweden's financial crisis was contained or even prevented. In spite of the evident signs, few if any in the public discussion warned of what might happen. Martin Feldstein offers an interesting explanation in his introduction to The Risk of Economic Crisis from 1991. At that time the industrialised world had not experienced an outright financial crisis since the 1930s. As a result, economists had devoted relatively little work to the analysis of this subject, being more concerned to understand the more normal economic world. This symposium is a positive sign that matters have changed in that respect. The conclusion drawn by the Riksbank is that various indicators must be followed systematically with the aim of detecting any signs of potential financial problems and systemic risks.

- In Sweden's case the supervisory authority was not prepared for the new environment that emerged after credit market deregulation. This meant that during the 1980s the banks were able to grant loans on doubtful and sometimes even directly unsound grounds without any supervisory intervention. In addition, in many cases the loans were poorly documented. The lesson from this is that much must be required of a supervisor operating in an environment characterised by deregulated markets.


2. If a financial crisis does occur
In a sense all major financial crises are unique and therefore difficult to prepare for and avoid. Once a crisis is about to develop there are some important lessons concerning its handling that can be learnt.

- If an economy is hit by a financial crisis, the first important step is to maintain liquidity in the banking system and prevent the banking system from collapsing. For the management of Sweden's banking crisis the political consensus was of major importance for the payment system's credibility among the Swedish public as well as among the banking system's creditors throughout the world. The transparent approach to the banking problems and the various projects for spreading information no doubt had a positive effect, too.

- The prompt and transparent handling of the banking sector problems in also important. The terms for recapitalisation should be such as to avoid moral hazard problems.

- Automatic stabilisers in the government budget and stimulatory monetary conditions can help to mitigate the economy's depressive tendencies but they also entail risks. Economic policy has to strike a fine balance so that inflation expectations do not rise, the exchange rate weakens and interest rates move up, which could do more harm than good. In this respect a small, open economy has less freedom of action than a larger economy.

- It is important both to avoid a widespread failure of banks and to bring about a macroeconomic stabilisation. The two are interdependent. The collapse of much of the banking system would aggravate the macroeconomic weaknesses, just as failure to stabilise the economy would accentuate the banking crisis.

The Liquidation-Trap

The financial system is caught in a destructive liquidation-trap that has falling asset prices cause financial distress, which in-turn compels further asset sales and price declines. If not addressed, it risks sending the economy into deep recession may be even depression.

Current conditions are the result of bursting of the house price bubble and the end of two decades of financial exuberance. That exuberance was fostered by a number of forces.

First, economic policy replaced wages and productive investment as the engines of growth with debt and asset inflation. Second, greed and free market ideology combined to promote excessive risk-taking and restrain regulators. This was encouraged by audacious claims that mathematical economic models mapped reality and priced uncertainty, making old-fashioned precautions redundant.

Recognition of the scale of financial folly has created a rush for liquidity. This is causing huge losses, triggering margin calls and downgrades that cause more selling, damage confidence, and further squeeze credit. That is the paradox of deleveraging. One firm can, but the system as a whole cannot.

Having failed to prevent the bubble, regulatory policy is now amplifying its deflation. One reason is mark-to-market accounting rules that force companies to take losses as prices fall. A second reason is rigid capital standards.

Application of mark-to-market rules in an environment of asset price volatility can create a vicious cycle of accounting losses that drive further price declines and losses. Meanwhile, capital standards require firms to raise more capital when they suffer losses. That compels them to raise money in the midst of a liquidity squeeze, resulting in fresh equity sales that cause further asset price declines.

Bad debts will have to be written down, but it is better to write them down in orderly fashion rather than through panicked deleveraging that pulls down good assets too.

This suggests regulators should explore ways to relax capital standards and mark-to-market rules. One possibility is permitting temporary discretionary relaxations akin to stock market circuit breakers.

Later, regulators must tackle the underlying problem of price bubbles. Currently, central banks are only able to control bubbles by torpedoing the economy with higher interest rates. New flexible measures of control are needed. One proposal is asset based reserve requirements, which systematically applies adjustable margin requirements to the assets of financial firms.

The Fed must also lower interest rates, and not just for standard reasons of stimulating spending. Lower short term rates are needed to make longer term assets (including houses) relatively more attractive, thereby shifting demand to them and putting a bottom to asset price destruction.

Fears about a price – wage inflation spiral remain misplaced. Instead, the threat is deep recession triggered by the liquidation trap. If inflation is a wild card, now is the time to use the credibility the Fed has earned. Emergency rate reductions can be reversed when the situation stabilizes.

The great irony is central banks can produce liquidity costlessly. Usually the problem is restraining over-production: today, it is over-coming political concerns about “bail-outs”. Those concerns are legitimate, but they also risk inappropriately restricting liquidity provision and unintentionally imposing huge costs of deep recession.

At the moment the Fed is protecting banks and the treasury dealer network but leaving the rest of the system in the cold. That is perverse given how the Fed went along with expansion of the non-bank financial system. Instead, the Fed should consider an auction facility that makes longer duration loans available to qualified insurance and finance companies too.

The facility’s guiding principle should be an expanded version of the Bagehot rule. Accordingly, the Fed would auction funds at punitive rates, with loans being fully collateralized. The goal should be to facilitate repair of distressed financial companies with minimum market disruption and at no taxpayer expense. By creating an up-front facility, the Fed can get ahead of the curve and reduce need for crisis interventions that are always more costly and disruptive.

Among financial conservatives there is a view that financial markets deserve punishment for their “sins” and only that will cleanse them. This view is often presented in terms of need to restore market discipline and stay moral hazard.

The view from the left is strangely similar, arguing Wall Street “fat cats” need to be punished. Asset prices should fall, banks must eat their losses, and all but the most essential financial firms should be allowed to fail.

Both views have a moralistic dimension, and both risk unnecessary economic suffering. The mistakes of the past cannot be undone. All that can be done is to minimize their costs and then truly reform the system so that they are not repeated.

This blog is adopted from the entry that was posted on Wednesday, September 17th, 2008 at 10:10 am and is filed under Economics, U.S. Policy.

Prisoner's Dilemma and the Credit Crisis

There are two topics are different but related in a weird way: we are now seeing a lot of "every man for himself" behavior (liquidity hoarding is one of many examples) that seem rational (or at least defensible) on an individual basis, but are destructive to the financial system as a whole. The second is that, per Richard Bookstaber, our financial system is "tightly coupled" and in tightly coupled systems, risk reduction measures (which too often look at risks in isolation) will typically have the perverse effect of increasing risks.

In financial markets tight coupling comes from the feedback between mechanistic trading, price changes and subsequent trading based on the price changes. The mechanistic trading can result from a computer-based program or contractual requirements to reduce leverage when things turn bad.

Eugene Linden, who has written extensively on animal behavior as well as markets, gave this observation:

The problem facing the credit markets right now is yet another iteration of the "prisoner's dilemma" from game theory, at least in the sense that participants know that if everybody takes the stance of "every man for himself" the markets will crater, but they also know that if they rush for the exits there's a chance that they will get out the door relatively unscathed. Studies of the problem suggest that the more anonymous the context, the more likely that players will adopt "every man for himself," and, of course there's nothing more anonymous than markets. Nature has a long time to work out solutions for problems, and it turns out that a number of animals have converged on the same optimal solution that game theorists have worked out. It's called "tit for tat," and it simply means that if someone extends trust to you reciprocate that trust, and if not, not. The best example comes from vampire bats. When a bat is short on blood it will call on a copain for a sip, and if its bat buddy does the right thing, then the thirsty bat will reciprocate at some point in the future when the tables are turned.

It is wonderfully perverse that vampire bats are more community-minded than Wall Street.

The problem now is, save perhaps within the dealer community itself, many players deal with each other on an anonymous, one-off, or transactional basis. So the opportunity to discipline bad behavior is diminished considerably (but ironically, one of the big factors behind Bears' demise was anger in the community that it had behaved badly both in the LTCM crisis by being the only firm called by the Fed who refused to participate, and its reluctance to shore up its failed hedge funds last June).

Now consider how this conspires with the second element, the perverse outcomes that result from trying to reduce risk in a tightly coupled system. We had written about these examples of efforts to fix the housing/credit crunch backfiring. I'll start with the first, which is that aggressive cuts at the short end of the yield curve initially did nothing to lower long-term rates, which are the basis for pricing most mortgages; the later cuts have steepened the curve, making matters worse.

Reader Lune came to similar observations independently and put them together well, so we'll continue with her list:

We've already seen the law of unintended consequences so far:

1) Congress raises conforming limits on Fannie/Freddie to help unfreeze the mortgage market. Result: agency spreads skyrocket, bringing down Bear and a host of hedge funds. Mortgage markets still remain frozen.

2) Fed opens TSLF to unfreeze mortgage market. Result: Carlyle goes bankrupt as people rapidly arbitrage the difference between holding MBS in firms that can and can't access the new credit facility. Mortgage markets remain frozen.

How It could be a part of Indian Democratic Culture?

I am not commenting anything my own, on the what are going on in the recent few days, in the context of survival of Indian Democracy (this is not a question of survival of 14th Loksabha). I am placing few words from various news items from Newspapers, which quoted as UPA : United Poachers Association, NDA: Non Delivery Agents, SP: Service Providers, BSP: Buying Samajwadi Party and CPM : Cross Party Manoeuvres, Jailbirds spice up humdrum day; and Dealers not Leaders. Is it a result of a democratic/election process, of democratic India, or it suggesting to looked in to the root of the basic problem caused by our democratic/election system, which encourages role of the money and muscle powers to keep the rein of the powers in command, adopting all illegal, corrupt and wrong means. The basic principal of a democracy should be based on “Truth Shall Prevails” and that Government must be for the People, by the People and through the people.

If we postmortem that why such a situation is developed in India, we find in clear terms that since we have adopted British Module of the Democracy, without examining its feasibility in India in the context of varied cultural, linguistic, religious established differences from the Britain. Our Constitution is based on British Rule, adopted in India through the Government of India Act, 1935, which was basically aimed to divide Indians to Rule India. Result, now we can see that India is divided on various counts, supponsored by our political system. Our democratic culture, is developed in such a way under which Prime Minister is not a Popular Leader and nor he is a Member of Lok Sabha, rather he is appointee and assignee of some one else. To save his Government, a so-called clean Prime Minister is bound to become a silent spectator what is going on to survived his Government, and what compromises are made by his party for survival of his Government. In fact, this is result of our faulty election system, which not suitable to Indian Society, which divided Indians by various means.

Infrastructure Bottlenecks in India

Infrastructure Bottlenecks in India
An opportunity in Disguise!

“The economic boom that India is currently enjoying is built on the shaky foundations. GDP would run more than 2 % higher if India had decent roads, railways and power according to industry estimates” - McKenzie India - 2001


Current Scenario and XIth five year plan by Indian Government

As India continues to grow at more than 8%, a balanced increase in the gross capital formation (GCF) in infrastructure as a proportion of the GDP emerges as the most important key in sustaining high economic growth. Though recently there have been investments in the infrastructure sector, the GCF as a proportion of GDP continues to be lower at around 5%. As far as the physical infrastructure is concerned, there exists a huge deficiency. Inadequate infrastructure is identified as one of the biggest constraints of doing business in India.


GCFI aimed to be increased to 9% of GDP by end of XI Plan. Based on case studies of fast-growing Asian economies, the gross capital formation in infrastructure (GCFI) in India should rise to 11% of GDP for sustaining GDP growth at 9%. However, given that the current investment rate is only at around 5%, a steep jump in investment rate may not be feasible over the next five years. Therefore, the Planning Commission of India estimates build in a gradual increase in infrastructure investment-to-GDP ratio to increase to 9% by the end of the Eleventh Five-Year Plan. The Planning Commission document states that investment in the Asian economies has been higher than required, and, hence, the projected investment in infrastructure can also help sustain GDP growth of 9% over the Eleventh Plan period.

The projected investment in infrastructure in the Eleventh Plan is 2.3 times the amount in the Tenth Plan. Power and road sectors form the bulk of the investment. The largest inflection in investments is expected to be in ports, airports, railways, and water supply and sanitation over the next five years. Framework is being put in place to enhance participation of the private sector in various segments of infrastructure. Private participation is crucial to meet the investment goal in infrastructure because there are limitations to budgetary support from the Indian government. The Planning Commission estimates private sector share in the total investments to increase from 17% in the Tenth Plan to 30% in the Eleventh Plan. It is expected to witness a strong private participation in roads, power, ports and airport sectors.


One of the key features of infrastructure investment in the Eleventh Plan is the expected rise in private participation. According to the plan, the share of private participation is expected to be almost 30% compared with 17% in the Tenth Plan. This implies an investment of 4 times by the private sector over the last plan. Roads, ports, airports and the power sectors, where the PPP model is well documented, are likely to witness a strong participation from private companies .Almost all sectors, except for railways, irrigation, and water supply and sanitation, are expected to witness strong private participation
.
Steps are being undertaken to increase private participation

Government support, an establishment of stable and efficient regulatory framework and credible mechanism for dispute resolutions are essential to attract private participation in infrastructure. The government is taking steps across sectors to facilitate private investment. For e.g., the model concession agreement (MCA) is being put in place in sectors like roads and ports. The MCA framework addresses issues that are crucial for limited recourse financing, force majeure and termination. Furthermore, there are provisions such as increase and decrease in the concession period that help reduce traffic risk and improve viability of a project. For large infrastructure projects like electricity generation and transmission, projects are being awarded to the private sector through the special purpose vehicle (SPV) route. Here, the SPV or shell company is responsible for obtaining mandatory clearances and approvals before the projects are bid. The SPV addresses issues such as land acquisitions, availability of the right of way, environmental clearances, fuel linkages and power purchase agreements. These issues help reduce execution risk and potential delays once the project is available for bidding. Private sector investment is now established in roads, ports, electricity generation, telecom and airports.
Major Areas of Focus

I. Roads: Investment to increase 2.15 times
The Indian road system has been the first area within infrastructure to gain serious attention from the government. The sector has gained political consensus across the board as against the stiff opposition seen in other areas, such as airports and power. The Planning Commission of India has estimated an investment of INR 3,668 billion under the Eleventh Plan versus the INR 1,448 billion spent under the Tenth Plan.


II. Ports : Indian ports are operating close to 100% capacity
India has around 12 major ports and 187 minor ports, with the major ports handling around 73% of the traffic. In FY07, ports in India handled 650 million tonnes of traffic, which witnessed a CAGR of 10% over the past three years. All of the major ports in India are currently operating at close to 100% capacity and congestion at ports has worsened over years. Six out of the twelve major ports had capacity utilization of greater than 100%. Overall capacity utilization of Indian ports had increased from 86% in FY03 to 92% in FY07. By FY12, the traffic in Indian port is projected to cross 1,000 metric tonnes. The Ministry of Shipping intends to add capacity ahead of the requirement. It intends to increase capacity to 1,300 metric tonnes by FY12, 30% higher than the required capacity

III. Power Generation: High demand deficit and high demand forecast…
The power situation in India remains grim, with a deficit of 9.6% and peak demand deficit of 14%. Demand growth is expected to accelerate over the next few years as the economy grows at around 8-9%, and the manufacturing sector grows at an even faster pace. In comparison with other leading developed and emerging economies, power consumption in India still lags behind these other economies by a large margin. According to the Ministry of Power, in order to support GDP growth of around 10% per annum, the rate of growth of power supply needs to be over 15% annually. In view of rising power consumption, the Ministry of Power has projected demand requirement of 157,000 MW under the 11th Five-Year Plan.
Capacity additions in the sector have lagged substantially from planned targets in the past Five-Year plans. For instance, under the Tenth Plan, a total of 21,180 megawatts was added against the original plan of 41,110 megawatts. However, implementation is expected to be far superior during the Eleventh Plan period as the plan document envisages capacity addition of around 78,000 MW and around 58,000 megawatts is already under construction.
FIGURE 4: Capacity under construction

IV. Transmission: Investments in transmission need to keep pace with generation
It is estimated that the will need 37,150 megawatts of inter-regional transmission capacity by 2012 to fulfill its power requirements. Underinvestment in the segment has resulted in flawed T&D networks, resulting in power shortages, in our view. Investments in transmission fell short of the target set in the Tenth Plan. The Planning Commission of India expects investments worth INR1,292 billion for transmission in the Eleventh Plan against a target plan estimate investment of INR457 billion in the Tenth Plan, an increase of 183%.

The Indian government has now opened up the transmission sector for 100% participation by the private sector, which can take up projects on a BOT basis. As per the Eleventh Plan, 14 transmission projects are to be constructed by the private sector, which would constitute 23% of the investment in transmission.

V. Airports: Acceleration in traffic growth
Air traffic in India has witnessed substantial growth in the recent past. The growth rate in passenger traffic is on the rise. In FY07 Indian airports handled 71 million domestic passengers, which grew by 40% compared with 10-25% over the earlier three years. International passenger traffic also is growing at a steady pace of 15%. The Center of Asia Pacific Aviation expects domestic traffic to grow at 25-30% and international traffic at 15% until FY10.

The Indian government has stated that the total funds requirement for the modernization program of airports is INR408 billion by 2011, out of which around INR300 billion will be invested by private players. However, according to the recent Planning Commission consultation paper, the total investment in the Eleventh Plan is expected to be around INR348 billion (a 15% cut from the initial estimate of INR408 billion) against INR68 billion spent in the Eleventh Plan.

VI. Railways
The Indian Railways currently handles 40% of freight and 20% of passenger traffic. Growth rates in both passenger and freight traffic has seen accelerating in the recent past. Annual passenger traffic growth, which was at 2% between fiscal years 1991-2004 has increased to 8% between FY05-FY07. During the same period, annual freight traffic growth increased from 4% to 9%. Historically, the elasticity of the rail traffic to GDP has been between 0.6-0.75. However, in the Tenth Plan, growth in freight traffic was in line GDP growth. According to the Ministry of Railways, freight traffic growth is expected to be around 8%-9% in the Eleventh Plan. It also estimates that passenger growth will be around 6% per year over the Eleventh plan. Key thrust areas of the Eleventh Plan will be Freight business, Passenger business and Capacity enhancement

VII. Oil & gas
Capex in the oil and gas space is likely to increase significantly over the next five years compared with the previous five-year period. These investments would be driven by upstream development, refining, petrochemicals and downstream projects. As per the plan documents, the overall outlay for public sector units (PSUs) in the Eleventh Plan is INR2,690 billion versus INR1,219 billion capital expenditure in the Tenth Plan. Investments in upstream projects by national oil companies (ONGC, OIL and OVL) are likely to be around INR1,591 billion. This is almost twice the investment in the Tenth Plan. In refining and marketing, investments are likely to increase 3.3 times in the Eleventh Plan to INR876 billion.

VIII. Urban water supply and sanitation
India is now the second largest urban system in the world after China. According to the Ministry of Urban Development, the proportion of the urban population is expected to increase from 30% currently to 40% by 2030. The government estimates that 91% of its urban population has access to drinking water, but only 58% have availability within their premises. The coverage of sewerage and sanitation is at a mere 63%. It is estimated that the sewage generation in Class I cities and Class II towns is 33,212 million liters per day, and the current treatment capacity is only 6,190. Currently, only a tenth of the sewage generated is treated before discharge.

The Eleventh Plan aims at covering 100% of the urban population for drinking water, sanitation and waste management. There is a substantial increase in the estimates because the total funds requirement for the Eleventh Plan is INR 1,276 billion, which is 6.3 times the allocation in the Tenth Plan. Almost 55% of this outlay is scheduled to be met through the Jawaharlal Nehru Urban Renewal Mission (JNNURM) and the Urban Infrastructure Development Scheme for Small and Medium Towns (UIDSSMT). JNNURM is the flagship program of the Central government covering 63 cities. UIDSSMT, under the Ministry of Urban Development, caters to 5,098 small and medium towns.

Conclusion
The link between infrastructure and economic development is not a once and for all affair. It is a continuous process; and progress in development has to be preceded, accompanied, and followed by progress in infrastructure.
I believe that India is on the right track and that the public and private sectors, working in partnership and in collaboration with development agencies, will be able to bring about significant and sustainable improvements in India’s infrastructure, which will also help the overall process of growth.

A classic Wall Street joke illustrating an important concept

Forgive me if you've heard this one before.

One sday in the markets, trader A decided to open bidding on a can of Olives. He offered it at $1. It was snapped up by B at $2, who sold it to C at $3. D jumped in at $4 and E finally prevailed at $5.

Proud owner E opened the can and found the Olives had gone bad. He went back to A and complained, " You sold rotten Olives! I want my money back."

Grinning, A said, "Son, those weren't eating Olives. Those were trading Olives."

Anything can be made into a store of value if everyone agrees. Western societies have had a fondness for gold and precious metals, but any material will do. The Mayans used feathers.

Oil and commodities are increasingly being used as a store of value as inflation concerns make the wisdom of relying on financial instruments seem dubious. But per the little story above, once participants quit seeing commodities as an inflation hedge, they will revert to their fundamental price level. And the indications increasingly are that those values are well below the price the market currently assigns them.

The cure for high prices is high prices :)

The cure for high -prices is high -prices and once the customers , enjoying these subsidies ,are increasingly exposed to world -price levels, their demand will fall.

From "Enjoy the Energy Subsidies While You Can," by Stephen Jen and Luca Bindelli:

A quarter of the world’s gasoline consumption is subsidised, and, in terms of population, half of the world uses energy subsidies. This policy has created an important distortion, whereby rising oil prices have been effectively prevented from destroying oil demand. Subsidies have artificially raised inflation in the developed world (through artificially high oil prices) and suppressed inflation in the developing world (inflation would have been even higher in the absence of subsidies). As fiscal pressures mount, some countries will be forced to incrementally remove these subsidies. The net result will be an unwind of these distortions. For currencies, I believe that the net effect will be negative for emerging countries, as this process will be stagflationary for them.

Economists tend to be less well-versed in supply conditions in the energy sector. But the current oil price increases are curious. They are not quite supply driven, and the fact that global demand is decelerating appears to be inconsistent with accelerating oil prices. While the logic behind the increasing structural energy demand from emerging makes a lot of sense, it is still difficult to justify how oil prices could more than double in 15 months, or rise by six-fold in seven years, unless one subscribes to the ‘Peak Oil Thesis’, i.e., we are at the steep part of the supply curve.

Right now, half of the world’s population enjoys gasoline subsidies, and a quarter of the world’s gasoline consumption is subsidised. While three-quarters of the world’s gasoline consumption is taxed, the level of ‘net taxes’ has actually declined as oil prices have increased, for various reasons. To show this look at the end- 2006, when crude oil was trading at around US$60 a barrel. Back then, only 10.4% of the world’s gasoline consumption was subsidised (compared to 22.2% right now). Essentially, what this means is that the extent to which the world has been subsidising its consumption of gasoline has actually increased, with the rise in crude oil prices.

Is China's growth sustainable !!

Demographics is often an under -appreciated determinant of the fates of countries. Certainly the baby boomer generation in the U.S., the rapidly aging population of Japan andthe outright declines of Russia's population all have a tremendous long-term impact on their respective countries.

China will need to deal with the long-term consequences of its one-child rule, both the lack of youngsters, and the lack of young females (how do you manage a bunch of single, young males with no prospects of marrying and raising a family? That is, outside of starting a war to reduce their ranks?)

With regards to return on capital investments, it has been frequently pointed out that India, with about half the GDP of China, manages to get about 75% of China's growth rate with about 1/10th the foreign capital investment. Soon people might start to wonder which country is a better investment.

And of course, perhaps the biggest question mark is the stability of China's political system, which is facing stresses and pressure to change despite achieving stunning growth for its people for the past few decades. What happens to the communists when they get their first recession? Perhaps they should ask Suharto in Indonesia what economic crises tend to do to authoritarian governments.

So I agree that China, despite achieving impressive goals in the past few decades, has difficult challenges ahead. And I wouldn't be surprised if it stumbles over one or the other of them.

Commodities bubble

There is , what i believe, a bubble -mentality with respect to oil and other commodities -i.e. long term trends of increasing demand and diminishing supply are used to justify any increase in prices as sustainable, no matter how high. I realize that near-vertical supply and demand curves as well as other non bubble dynamics can explain sharp price increases, but the pervasiveness of this 'do not question it' mentality seems to make a bubble likely in any market where the mechanics of exchange and inventory make it feasible.

Has anyone seen attempts at predicting consequences if commodities are in a huge bubble? i.e., if peaking speculative interest and a demand shock cause oil prices to drop in half over a period of months, the impacts on agriculture commodity prices, US trade deficit, currencies, etc seem likely to be quite dramatic.

Moral Hazard

Risk transfer is the gist of modern economies. Citizens pay taxes to ever expanding governments in return for a variety of "safety nets" and state-sponsored insurance schemes. Taxes can, therefore, be safely described as insurance premiums paid by the citizenry. Firms extract from consumers a markup above their costs to compensate them for their business risks.

Profits can be easily cast as the premiums a firm charges for the risks it assumes on behalf of its customers - i.e., risk transfer charges. Depositors charge banks and lenders charge borrowers interest, partly to compensate for the hazards of lending - such as the default risk. Shareholders expect above "normal" - that is, risk-free - returns on their investments in stocks. These are supposed to offset trading liquidity, issuer insolvency, and market volatility risks.

The reallocation and transfer of risk are booming industries. Governments, capital markets, banks, and insurance companies have all entered the fray with ever-evolving financial instruments. Pundits praise the virtues of the commodification and trading of risk. It allows entrepreneurs to assume more of it, banks to get rid of it, and traders to hedge against it. Modern risk exchanges liberated Western economies from the tyranny of the uncertain - they enthuse.

But this is precisely the peril of these new developments. They mass manufacture moral hazard. They remove the only immutable incentive to succeed - market discipline and business failure. They undermine the very fundaments of capitalism: prices as signals, transmission channels, risk and reward, opportunity cost. Risk reallocation, risk transfer, and risk trading create an artificial universe in which synthetic contracts replace real ones and third party and moral hazards replace business risks.

Moral hazard is the risk that the behaviour of an economic player will change as a result of the alleviation of real or perceived potential costs. It has often been claimed that IMF bailouts, in the wake of financial crises - in Mexico, Brazil, Asia, and Turkey, to mention but a few - created moral hazard.

Governments are willing to act imprudently, safe in the knowledge that the IMF is a lender of last resort, which is often steered by geopolitical considerations, rather than merely economic ones. Creditors are more willing to lend and at lower rates, reassured by the IMF's default-staving safety net. Conversely, the IMF's refusal to assist Russia in 1998 and Argentina in 2002 - should reduce moral hazard.

Why Mr. Buffett plays bridge

Aside from an affection for charity and cherry Coke, one of the personal facts commonly known about Warren Buffett is his love of bridge, which he periodically plays other active people like Katharine Graham, from The Washington Post and Bill Gates.

Why bridge? Though Graham wasn't talking about Buffett at the time, he offers a clue:

“I recall to those of you who are bridge players the emphasis that bridge experts place on playing a hand right rather than on playing it successfully. Because, as you know, if you play it right you are going to make money and if you play it wrong you lose money – in the long run. There is a beautiful little story about the man who was the weaker bridge player of the husband-and-wife team. It seems he bid a grand slam, and at the end he said very triumphantly to his wife ‘I saw you making faces at me all the time, but you notice I not only bid this grand slam but I made it. What can you say about that?' And his wife replied very dourly, ‘If you had played it right you would have lost it.'”

It seems to me (and it has certainly been others' experience) that it takes an enormous amount of restraint to focus on playing every investment hand “right,” according to an established discipline, allowing the law of averages to work in your favor, rather than trying to win every hand. I would guess that this is exactly what appeals to Warren Buffett's temperament. Over the long-term, good investing requires it.

Inequality : Is Globalization to Blame?

by Prabhu Bardhan

Internal forces, technological change and problematic policies spur growing inequality

Economic inequality is on the rise around the world, and many analysts point their fingers at globalization. Are they right? Economic inequality has even hit Asia, a region long characterized by relatively low inequality. A report from the Asian Development Bank states that economic inequality now nears the levels of Latin America, a region long characterized by high inequality.

In particular, China, which two decades back was one of the most equal countries in the world, is now among the most unequal countries. Its Gini coefficient - a standard measure of inequality, with zero indicating no inequality and one extreme inequality - for income inequality has now surpassed that of the US. If current trends continue, China may soon reach that of high-inequality countries like Brazil, Mexico and Chile. Bear in mind, such measurements are based on household survey data - therefore most surely underestimate true inequality as there is often large and increasing non-response to surveys from richer households. The standard reaction in many circles to this phenomenon is that all this must be due to globalization, as Asian countries in general and China in particular have had major global integration during the last two decades. Yes, it is true that when new opportunities open up, the already better-endowed may often be in a better position to utilize them, as well as better-equipped to cope with the cold blasts of increased market competition.

But it is not always clear that globalization is the main force responsible for increased inequality. In fact, expansion of labor-intensive industrialization, as has happened in China as the economy opened up, may have helped large numbers of workers. Also, the usual process of economic development involves a major restructuring of the economy, with people moving from agriculture, a sector with low inequality, to other sectors. It is also the case that inequality increased more rapidly in the interior provinces in China than in the more globally exposed coastal provinces. In any case it is often statistically difficult to disentangle the effects of globalization from those of the ongoing forces of skill-biased technical progress, as with computers; structural and demographic changes; and macroeconomic policies.

The other reaction, usually on the opposite side, puts aside the issue of inequality and points to the wonders that globalization has done to eliminate extreme poverty, once massive in the two Asian giants, China and India. With global integration of these two economies, it is pointed out that poverty has declined substantially in India and dramatically in China over the last quarter century. This reaction is also not well-founded. While expansion of exports of labor-intensive manufacturing lifted many people out of poverty in China during the last decade (but not in India, where exports are still mainly skill- and capital-intensive), the more important reason for the dramatic decline of poverty over the last three decades may actually lie elsewhere. Estimates made at the World Bank suggest that two-thirds of the total decline in the numbers of poor people - below the admittedly crude poverty line of $1 a day per capita - in China between 1981 and 2004 already happened by the mid-1980s, before the big strides in foreign trade and investment in China during the 1990s and later. Much of the extreme poverty was concentrated in rural areas, and its large decline in the first half of the 1980s is perhaps mainly a result of the spurt in agricultural growth following de-collectivization, egalitarian land reform and readjustment of farm procurement prices - mostly internal factors that had little to do with global integration.

In India the latest survey data suggest that the rate of decline in poverty somewhat slowed for 1993-2005, the period of intensive opening of the economy, compared to the 1970s and 1980s, and that some child-health indicators, already dismal, have hardly improved in recent years. For example, the percentage of underweight children in India is much larger than in sub-Saharan Africa and has not changed much in the last decade or so. The growth in the agricultural sector, where much of the poverty is concentrated, has declined somewhat in the last decade, largely on account of the decline of public investment in areas like irrigation, which has little to do with globalization.

The Indian pace of poverty reduction has been slower than China's, not just because growth has been much faster in China, but also because the same 1 percent growth rate reduces poverty in India by much less, largely on account of inequalities in wealth - particularly, land and education. Contrary to common perception, these inequalities are much higher in India than in China: The Gini coefficient of land distribution in rural India was 0.74 in 2003; the corresponding figure in China was 0.49 in 2002. India's educational inequality is one of the worst in the world: According to the World Development Report 2006, published by the World Bank, the Gini coefficient of the distribution of adult schooling years in the population around 2000 was 0.56 in India, which is not just higher than 0.37 in China , but higher than that of almost all Latin American countries.

Another part of the conventional wisdom in the media as well as in academia is how the rising inequality and the inequality-induced grievances, particularly in the left-behind rural areas, cloud the horizon for the future of the Chinese polity and hence economic stability.

Frequently cited evidence of instability comes from Chinese police records, which suggest that incidents of social unrest have multiplied nearly nine-fold between 1994 and 2005. While the Chinese leadership is right to be concerned about the inequalities, the conventional wisdom in this matter is somewhat askew, as Harvard sociologist Martin Whyte has pointed out. Data from a 2004 national representative survey in China by his team show that the presumably disadvantaged people in the rural or remote areas are not particularly upset by the rising inequality. This may be because of the familiar "tunnel effect" in the inequality literature: Those who see other people prospering remain hopeful that their chance will come soon, much like drivers in a tunnel, whose hopes rise when blocked traffic in the next lane starts moving. This is particularly so with the relaxation of restrictions on mobility from villages and improvement in roads and transportation.

More than inequality, farmers are incensed by forcible land acquisitions or toxic pollution, but these disturbances are as yet localized. The Chinese leaders have succeeded in deflecting the wrath towards corrupt local officials and in localizing and containing the rural unrest. Opinion surveys suggest that the central leadership is still quite popular, while local officials are not. Paradoxically, the potential for unrest may be greater in the currently-booming urban areas, where the real-estate bubble could break. Global recession could ripple through the excess-capacity industries and financially-shaky public banks. With more internet-connected and vocal middle classes, a history of massive worker layoffs and a large underclass of migrants, urban unrest may be more difficult to contain.

Issues like globalization, inequality, poverty and social discontent are thus much more complicated than are allowed in the standard accounts about China and India.

About the Author: Pranab Bardhan is professor of economics at the University of California, Berkeley, and co-chair of the Network on the Effects of Inequality on Economic Performance, funded by the MacArthur Foundation. He was the editor of the "Journal of Development Economics" for many years.

Tackling Financial Crime

As Financial Institutions, Banks are in a unique position to contribute to the fight against financial crime. It is vital that they keep pace with new threats as they emerge. And they must have the best processes in place to protect us and our customers and to minimise the impact of financial crime on the communities we serve.

In 2006, global money laundering was estimated at over USD500 billion¹. In the political arena, this criminal activity is increasingly linked to international terrorism a, hecnd, as a result, is subject to more stringent sanctions and regulations.

The Banks should go beyond the minimum legal requirements, setting standards that lead by example. Tackling financial crime is an area where they have a significant influence . The procedures they adopt will improve their understanding of the customers and help protect their business as well as helping them build a sustainable business for the Bank and the communities these bank operate in.

¹ Source: United Nations Office of Drugs & Crime, 2006

Connecting Financial Markets to the Sustainable World

Submitted by Amit AGNIHOTRI - HEC Paris

THE CONTEXT

Sustainability has become a fashionable, if not particularly well-defined, term in recent years. The issues that were once regarded as irrelevant to economic activity, today are dramatically rewriting the rules for business, investors, and consumers. The key component of the general discourse around sustainability has been so-called multi-stakeholder initiatives, which bring together corporations, governments, and non-governmental organizations to develop mechanisms for addressing, particular areas of concern addressing important human rights, environmental and labor issues.

Around the world, innovative responses to climate change and other environmental problems are affecting more than $100 billion in annual capital flows as pioneering entrepreneurs, organizations, and governments take steps to create the Earth’s first “sustainable” global economy.

A key problem affecting all such initiatives is that they are just voluntary, and thus lack any real enforcement mechanism for sanctioning corporations that fail to comply with the principles or standards promoted by the initiatives. The lack of enforcement capacity has led some skeptics to argue that these initiatives are nothing more than corporate "greenwash" that enable corporations to argue that they are taking sustainability issues seriously but are in reality not fundamentally changing the ways they operate.

Off late there have efforts to find a solution to this problem and answer were found in identifying what corporations are most interested in: Access to capital and access to markets. If ways can be found to link corporate performance on sustainability issues to continued access to both of these things, real leverage could be established for holding corporations accountable. For capital linkage, the focus fell on the private banks that finance transnational corporations. They provide the lifeblood to corporations. Respect for human rights and environmental standards could be made a legally-binding part of the loan agreements between the banks and the corporations.

In 2003, a group of private banks, in line with World Bank’s approach with its social and environmental safeguard policies, has adopted the Equator Principles, essentially committing to following World Bank standards for projects it lends to. Yet here again, there is no real sanction for violations of these policies. What incentive would these banks have to require compliance with CSR criteria?

Putting teeth into sustainability is a challenge. Incentivizing lenders to care enough to recall their capital or cancel contracts if problems arise is a conundrum. Answering this question is about hitting corporations where they live—in the worlds of capital and markets—rather than in the comfortable confines of sustainablity dialogues.

This report discusses the limitations of current voluntary initiatives to manage the negative social and environmental impacts generated by the finance sector in both developed and developing countries. It proposes an alternative agenda that is far more likely to deliver greater accountability and lasting sustainable development.

THE EQUATOR PRINCIPLES

The Equator Principles is a set of environmental and social benchmarks for managing environmental and social issues in development project finance globally. Once adopted by banks and other financial institutions, the Equator Principles commit the adoptees not to finance projects that fail to follow the processes defined by the Principles. The Equator Principles were developed by private sector banks – led by Citigroup, ABN AMRO, Barclays and WestLB – and were launched in June 2003. The banks chose to model the Equator Principles on the environmental standards of the World Bank and the social policies of the International Finance Corporation (IFC). Over 50* financial institutions have adopted the Equator Principles, which have become the de facto standard for banks and investors on how to assess major development projects around the world. In July 2006, the Equator Principles were revised, increasing their scope and strengthening their processes.

The Equator Principles represent a significant industry-wide initiative. They were drafted by the banks in consultation with the IFC, project sponsors, project engineers, and non-government organizations.

The Equator Principles state that adopting financial institutions will provide loans directly to projects only under the following circumstances:

Scope: The Principles apply to projects over 10 million US dollars. (The scope has been brought down from 50 million USD in 2006)

* The details of the principles are given in separate blog - the Equator Principles.

Principle 1: Review and Categorisation

Principle 2: Social and Environmental Assessment

Principle 3: Applicable Social and Environmental Standards

Principle 4: Action Plan and Management System

Principle 5: Consultation and Disclosure

Principle 6: Grievance Mechanism

Principle 7: Independent Review

Principle 8: Covenants

Principle 9: Independent Monitoring and Reporting

Principle 10: EPFI Reporting

THE CRITICS

The world welcomed the principles and revisions but remained cautious, arguing that the principles still suffered from fundamental governance and accountability problems. They want the EP banks to adopt more robust governance and implementation systems, such as a procedure for dealing with "free riders" and a regular reporting requirement. So the sentiment remains that in spite of the overwhelming evidence belies the reality that the industry has so far failed to move beyond largely ineffectual attempts at self-regulation. It is the view that this agenda neglects the ‘big picture’ issues and the sector’s responsibility as a major actor in today’s globalised world. As such it represents a missed opportunity.

This report discusses various case studies and examples, which clearly demonstrate the finance sector’s inability to embed corporate responsibility on a voluntary basis. In particular, it reveals that the finance sector (Many a times EP Banks):

• Perpetuates poverty and social exclusion, by providing unscrupulous levels of debt at high rates to those least able to afford it, all the while bringing in record-level profits
• Regularly undermines human rights protection, by financing projects which pose a threat to the implementation of human rights laws in developing countries, in breach of some companies’ own codes of conduct;
• Often fails to assess adequately the environmental impacts of projects and to address issues raised before releasing project finance, yet continues to reap the reputational benefits of participation in voluntary sustainability and corporate social responsibility initiatives.

THE CASE STUDIES

Baku-Tbilisi-Ceyhan pipeline

The pipeline which in 2004 was financed by eight Equator Principles' banks and the IFC despite an NGO assessment which alleged 127 breaches of the Principles. The banks and IFC said they were confident that the Equator Principles were followed, and said an independent consultant had confirmed this assessment. Critics of the pipeline have pointed out that the region through which it travels is highly seismic, suffering from frequent earthquakes. The route takes the pipeline through three active faults in Azerbaijan, four in Georgia and seven in Turkey.

Trans Thai-Malaysia Gas pipeline

The Trans Thai-Malaysia pipeline development is a collaborative enterprise between the state-owned oil companies Petronas of Malaysia and the Petroleum Authority of Thailand. The route of the pipeline also runs through important areas of wetland forest and some of the few remaining stretches of rare sand dune forest along the coast of southern Thailand. There are also concerns that it will give rise to harmful effluents and emissions that will threaten local livelihoods and have negative health impacts. In 2004, Barclays, one of the four banks that led the way in the creation of the Equator Principles, agreed to lead on the arrangement of finance for the pipeline. The bank has provided a loan of $257.1 million, nearly half of the total loan, giving it significant leverage over the project. The participation of Barclays has played a crucial role in attracting finance from other foreign investors. Barclays was also responsible for carrying out a satisfactory risk assessment for the project, ie to consider all problems associated with the project, including the potential for environmental and social harm.

ABN AMRO Bank

One of the adopting banks is the most climate-unfriendly bank in the Netherlands, with estimated annual indirect CO₂-emissions of almost 250 million tonnes in 2005 from industries to which it provides financial services. NGOs say this is just over the annual CO₂-emissions of the Netherlands and almost 1% of the total annual worldwide CO₂-emissions. ABN AMRO defends its environmental record and has announced steps to reduce its direct emissions, but some NGOs say it is the indirect emissions through their clients that make global banks such important targets in climate change.

Angola’s Indebtedness (Bank lending perpetuates indebtedness, corruption & poverty)

At the heart of Angola’s poor development record lies its huge indebtedness which currently stands at $9.5 billion, equivalent to 50 per cent of the country’s GDP. The international donor community and development banks have continued to insist on concrete improvements in good governance, including progress towards more responsible and transparent management of the country’s natural resource revenues, before providing Angola with concessional loans and debt relief. However, the willingness of western banks to lend to Angola has undermined international pressure for reform. The government continues to seek expensive commercial loans backed by oil rather than seeking cheaper loans from development banks, which would require a commitment to more transparency.

The Angolan case is symptomatic of many resource-rich poor African countries. With many states already heavily indebted, lenders have turned to more complex methods to extend credit to those countries, such as using increasingly sophisticated financial instruments to exchange future mineral exports for money today.

Sakhalin II oil and gas project (2007)

The Sakhalin II project in the Russian Far East is said by project sponsors to be the largest integrated oil and gas project in the world. The project is subject to various investigations by the Russian Authorities . The Russian Ministry of Natural Resources has found violations relating to protected forest being felled, water code violations associated with river and other damage, and risks of landslides. The project is now over 90% built, and has caused damage to salmon spawning rivers and exposed endangered gray whales to excessive noise. IFC and other major european banks are contemplating to invest in the project. Any investor will inherit the problems that have been built-in to the project, and cannot ignore the numerous breaches of the Equator Principles that have already occurred.

Miscellaneous events

In 2004, environmental groups called on banks including Goldman Sachs, Merrill Lynch and HSBC not to sell bonds worth more than $2 billion on behalf of the China Development Bank and the China Export Import Bank. They argued the bonds would be used to finance controversial infrastructure projects, including the Three Gorges Dam. Still the banks went ahead and issue the bonds.

According to a 2004 study by KPMG and F&C Asset Management, ‘there is little evidence that human rights are being systematically integrated into sovereign or project credit risk assessments’.

These case studies show, voluntary nature of Equator Principles, limited or no oversight mechanisms or sanctions has proved incapable of preventing the serious problems and abuses they purport to address.

RECOMMENDATIONS :

Taken solely in numbers, the influence that finance sector has on every aspect of our lives can, at times, seem to dwarf the influence that governments have. One bank in the UK alone, the Royal Bank of Scotland, accounted for £600 billion in global assets in 2004, which is seven times the total flow of foreign direct investment to developing countries. While the finance sector has enormous influence, this must not override the responsibilities of governments to protect the public interest and to hold companies accountable for their actions.

Yet so far, the governments around the world have shied away from exercising the necessary leadership to ensure that the finance sector does not continue to undermine global policy objectives. Instead, they have relied on weak efforts to promote ‘corporate social responsibility’ and a patchwork of voluntary initiatives that perpetuate an unsustainable system. Voluntary initiatives, no doubt, have an important role in helping to define standards of best practice, but they are wholly inadequate on their own and must be coupled with binding standards of corporate behaviour. In particular, I recommend that:

• Efforts to self-regulate the finance sector be strengthened with a rules-based approach which clearly defines the expectations of behaviour in this area
• Any initiatives must include an independent monitoring and enforcement regime
• Binding and credible sanctions for instances of non-compliance must also be implemented and enforced.
• Moves to make financial institutions more directly accountable for their actions through such steps will go a significant way to enabling the finance sector to contribute to sustainable development targets, rather than undermine them.

• Adopt a more inclusive approach to Company Law and require companies to be legally responsible for their social and environmental impacts both within the EU and overseas.

REFERENCES

Articles

• KPMG and F&C (September 2004) Banking on Human Rights: Confronting human rights in the financial sector.
• ‘Combating Corruption in Africa’, report presented at January 2003 African Union Conference,
• World Bank (2005) Global Development Finance: Mobilising finance and managing vulnerability.
• BankTrack (June 2004) Principles, Profits or just PR?, 1st anniversary assessment of the Equator Principles.

Websites

• http://www.equator-principles.com
• http://www.globalpolicy.org/
• http://www.worldbank.org/
• http://www.ifc.org/
• http://www.ft.com/

APPENDIX I

Institutions which have adopted the equator principles (Jan 2008)

1. ABN AMRO Bank, N.V.

2. ANZ

3. Banco Bradesco

4. Banco do Brasil

5. Banco Galicia

6. Banco Itaú

7. BankMuscat

8. Bank of America

9. BMO Financial Group

10. BTMU

11. Barclays plc

12. BBVA

13. BES Group

14. Calyon

15. Caja Navarra

16. CIBC

17. CIFI

18. Citigroup Inc.

19. CORPBANCA

20. Credit Suisse Group

21. Dexia Group

22. Dresdner Bank

23. E+Co

24. EKF

25. Export Development Canada

26. FMO

27. Fortis

28. HBOS

29. HSBC Group

30. HypoVereinsbank

31. ING Group

32. Intesa Sanpaolo

33. JPMorgan Chase

34. KBC

35. la Caixa

36. Manulife

37. MCC

38. Mizuho Corporate Bank

39. Millennium bcp

40. National Australia Bank

41. Nordea

42. Nedbank Group

43. Rabobank Group

44. Royal Bank of Canada

45. Scotiabank

46. SEB

47. Societe Generale

48. Standard Chartered Bank

49. SMBC

50. TD Bank Financial Group

51. The Royal Bank of Scotland

52. Unibanco

53. Wachovia

54. Wells Fargo

55. WestLB AG

56. Westpac Banking Corporation