The ultimate level of cannibalization

Being in demand forecasting, I am quite used to dealing with intra category and cross category cannibalizations esp. in consumer electronics industry (eg. Smartphones vs compact cameras; tablets vs netbooks; TVs vs mobile computers). But still the main reason for this cannibalization was over lapping features. 

However, the more I am studying consumer industry, the more interesting it’s getting. Ultimately people have limited resources (to begin with money (given this current economic situation for sure that’s not growing), but it doesn’t stop there as we can also argue over limitations on time and mental capabilities;) and they cannot have everything.

Recently I was reading one paper that took cannibalization to another level………… socio economic factors

Smartphones vs CARS (really cars!!)

Youth culture was once car culture. Cars were Friday night. Cars were Hollywood.

Yet these days, they can't even compete with a smartphone. Young adults are in fact buying fewer cars today than in the past. According to CNW Marketing Research, Americans between the ages of 21 to 34 purchased just 27 percent of new cars in 2010, down from 38 percent in 1985.

Is it really reasonable to blame that drop on Gen Y's love of technology? No, not entirely. But it is fair to think that our preoccupation with smartphones and laptops might be contributing to the fall. Here's why.

First, Gen Y is strapped for cash. Badly. Thanks to the recession and slow recovery, it's been slammed with high rates of joblessness

Second, young Americans aren't simply turning their back on buying cars. They're also turning their backs on driving. The percentage of teens and twenty-somethings with licenses has dropped dramatically over the past thirty years, which may be the sign that Gen Y's indifference towards autos is a cultural shift as much as an economic one.

Finally, this all might be part of a global pattern. There's a vivid, albeit anecdotal, evidence from Japan, where in 2008, the Wall Street Journal reported that the country's tech-obsessed youth had all but forgotten about cars:

“Unlike their parents' generation, which viewed cars as the passport to freedom and higher social status, the Internet-connected Japanese youths today look to cars with indifference, according to market research by the Japan Automobile Manufacturers Association and Nissan. Having grown up with the Internet, they (young Generation) no longer depend on a car for shopping, entertainment and socializing and prefer to spend their money in other ways.”

Sound familiar? As youth culture becomes tech culture, it may be be that cars just tend to get pushed out of the way. No matter where you are in the world.

Leaders need to "go to the source"

Having grown from being an analyst to a forecast team lead, I always used to think where to draw a line between micromanagement and delegation; then I came across the following article from WSJ and it cleared the mist

‘On April 30, associates who were gathered in a conference room handed Mr. Dimon summaries and analyses of the losses. But there were no details about the trades themselves. "I want to see the positions!" he barked, throwing down the papers, according to attendees. "Now! I want to see everything!"

When Mr. Dimon saw the numbers, these people say, he couldn't breathe.’

Seeing the data raw in addition to prechewed analysis can have enormous impact on perceptions. That's not to minimize the importance of analysis and interpretation. But when discontinuities defies the logic, nothing creates situational awareness faster than seeing with your own eyes what your experts are trying to synthesize. The raw ingredients are critical to success.

BUT is this micromanagement? You bet! There's difference between this kind of micromanagement and being a control freak. In the former, leaders want to see — and feel — what's going on with their own eyes and gut; they want to draw upon their own experiences and expertise. In the latter, they want a greater command of detail in order to tell people what to do. The best micromanagers go to the source, so they can see, listen, and understand better; the control freaks do it to remind people that they run the whole show.

Yes, there's something vaguely mistrustful and distrustful about insisting on a diet of raw data rather than a richly prepared presentation of analytics. The core message — that you want/need to see for yourself — may feel disempowering to some. But there's a fundamental difference between trusting your people and trusting their data.

May be there is a reason why great chefs visit the farms and markets that source their restaurants!!!

Sustainability and the meaning of life

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If confidence is the gasoline, then trust is the oil in the engine of Capitalism!

Being able to trust people might seem like a pleasant comfort, but economists are starting to believe that it’s rather more important than that. Trust is about more than whether you can leave your house unlocked; it is responsible for the difference between the richest countries and the poorest.

“If you take a broad enough definition of trust, then it would explain basically all the difference between the per capita income of the United States and Somalia,” ventures Steve Knack, a senior economist at the World Bank who has been studying the economics of trust for over a decade. (Any prices for computing - it’s 99% of the US economy!!)

“Virtually every commercial transaction has within itself an element of trust,” writes economist Kenneth Arrow, a Nobel laureate. When we deposit money in a bank, we trust that it’s safe. When a company orders goods, it trusts its counterpart to deliver them in good faith. Trust facilitates transactions because it saves the costs of monitoring and screening; it is an essential lubricant that greases the wheels of the economic system.

Since last two years, world clearly don’t trust the big banks and financial companies.

Trust is gone: there is no longer trust between counterparties in the financial system. The Fed has gone about as if the problem is a shortage of liquidity. That is not the basic problem. The basic problem for the markets is that uncertainty that the balance sheets of financial firms are credible. So even though the Fed has flooded the credit markets with cash, spreads haven’t budged because banks don’t know who is still solvent and who is not.

Bank lending won’t get going again until trust in the markets can be restored. Fighting a Great Depression era problem probably won’t help. More transparency, which means more write-downs and failures, is probably necessary if we’re going to get through this. Unfortunately, we’re still sailing in the opposite direction.

Importance of the feel good factor

I hope this explains why we might have a bumpy road to recovery ahead!!

Credit crisis in the making!!

Credit crisis in the making.. short and simple !

1. To understand the crisis lets first under stand the whole –process.

- Commercial banks sell loans get mortgages

- Investment banks buy mortgages from commercial banks, collaterised them and issues CDOs (trenches: superior/safe, mezzanine, equity/ unrated)

- Investors (Pension funds, hedge funds, individual investors) buy these trenches/ securities and keep with them / rebundle.

2. Scenario in 2002-2005
- Treasuries rate remain very low @ 1% even after a recovery in 2003 (loose monetary policy)
- Mortgages become really cheap and there was a lending boom
- Investors were not getting much returns on treasuries and started looking for other safe alternatives
- CDOs (superior trenches having AAA ratings) give better returns to the investor vis-à-vis treasuries.
- Demand for CDOs/ CLOs/ ABCPs increased.

SUB Prime:
- Commercial banks started lending to the sub prime lender to accommodate the demand.
- They introduced various schemes to rope in sub prime segments:
- No down payments, step up interest rate, no securities etc. All this under the premise that housing prices will keep increasing and the sub prime home owner can dispose of the property after few years.

3 Scenario in 2006-2009
- Home prices stagnated and even started decreasing. Interest rate also started to increase. This resulted in an increase in Sub prime default rate.
- This had a cascading effect:
...... Investors become weary of CDOs and other financial instruments (this was the result of bundling and rebundling of other financial securities with CDOs and subprime)

...... Lack of market for CDOs broughtdown the market prices
...... This further put pressure on already stressed LTV (loan to value) ratio.
...... Investors having these CDOs as financial assets had to report losses due to MtM (marked to market)pricing concept
...... Consequently they had to unwind their portfolio and sell securities (CDOs in the market) putting further pressure on prices and a vicious cycle took place.

4 Spreading of the crisis:
- Banks started taking less and less risk and started hoarding cash. They almost stopped lending to banks (call money rate went up), individuals (mortgage market further declined) and companies. Causing a financial meltdown.
- Institution and economies that worked on principle borrow short and lend long started failing as they found it increasing difficult to refinance the loans. Causing further pressure on the market. (Classical example is the case of Dubai).
- Businesses found it difficult to get loans. Banks were hoarding cash and bond markets were practically dead. Businesses stopped new and existing projects.
- Businesses started downsizing. Consumer confidence fell to the rock bottom. Consumerism went down and another vicious cycle took place!

Can't live without it, but can't live with it (in my portfolio).

The Internet Is Dead… well as an Investment.

I can spend the whole day on the Internet and it would be a day well spent. I can chat, listen to music, watch videos, study, trade stocks, play games, do work - all on the Internet and I believe that its true for almost everybody in my generation. But still when it comes to getting advertisements(revenues) on the Internet, even big names scramble to find a few.

To share a few stories: Microsoft has spent zillions on Internet strategy without a single ray of hope. Every other day Yahoo is closing some of its offering, today it was geocities. Even Google finds it difficult to introduce any other business model other than the one they stumbled upon when they bought Applied Semantics in 2001 that had a little piece of software called AdSense. Google's flagships- Gmail, Youtube, Orkut, Google Earth are all bleeding. Time Warner would rather keep their legacy old media businesses than hold onto one of the biggest Internet companies out there, AOL. News Corporation is shaking up its MySpace business as it figures out its next steps. And the new business in the block: Twitter and Facebook are still struggling for profits despite exponential usage growth

Don't just ask me. Ask the best – Warren Buffet. Nobody can figure out a business model.

Gone are the days of infinite margins, 1000% productivity gains, and growth of market throughout the universe. Internet companies are, at best, like utility companies albeit the only difference being that they get bought at about 10 times earnings and sold at 13 times earnings.

Let's face it. Electricity greatly improved our quality of life. But we are not going to get excited about buying a basket of utility companies. Now, the same applies to the the Internet. Can't live without it, but can't live with it (in my portfolio).

CDS riddle

It isn’t the housing market devaluation, or the sub-prime mortgage market defaults that have us in real trouble. Those are nice fakes to sway attention away from the place where greed truly flourished — trading phony instruments to the tune of $700 trillion.

Let’s figure how to get out from under that. Then maybe the capital will begin to flow again through the markets. Right now, this elephant isn’t just in the room, it’s sitting on us. Banks in Europe and the US face a new wave of losses linked to contracts issued to insure against companies going bust and defaulting on their loans, City analysts have warned. After the billions lost over the US subprime market and leveraged loans, investment banks such as Morgan Stanley, Deutsche Bank, Barclays, UBS and RBS face losses on credit default swaps (CDS) – contracts that allow an investor to be repaid if a company loan or a bond defaults. CDS contracts became a favourite tool of speculators, mostly hedge funds, which bought the contracts without having any link to the original lending. They bought the contract to trade or in the expectation the company would in fact default, meaning they could claim back the full value of a loan they never made.

The CDS market exploded to be worth as much as $50 TRILLION, many times the size of the underlying assets. Each loan could have thousands of protection contracts, even if there were only a few lenders. Hedge funds accounted for about 60% of CDS trading, according to ratings agency Fitch.

The reality of the situation is akin to a game of musical chairs — without any chairs. So now the music has finally stopped.

Lingering financial crisis - a satirical explanation

My apologies for putting an old joke in this blog (Actually, of late I got tired of reading the bad news all over the net). Nevertheless, this joke does a pretty good job of explaining the lingering financial crisis and aptly ridicules the corporate world’s reactions towards solving this crisis. The joke:

Boat Race
Two teams, Team A and Team B decided to engage in a competitive boat race. Both teams practiced to reach their peak performance. On the big day, Team B won by a mile. Afterwards, Team A was shattered by the loss. Their morale sagged. Corporate management decided that the reason for the crushing defeat had to be found. So a consulting firm was hired to investigate the problem and recommend corrective action. The consultant's findings: The Team B team had eight people rowing and one person steering; Team A team had one person rowing and eight people steering. After a year of study and millions spent analyzing the problem, the consultant firm concluded that too many people were steering and not enough were rowing on Team A.
With this new finding they decided to go for another race. So as the D day nears, Team A decided to completely reorganize their team structure. The new structure: four steering managers, three area steering managers and a new performance review system for the person rowing the boat to provide work incentive.
The next year, Team B won by two miles. Humiliated, Team A's corporation laid off the rower for poor performance and gave the managers a bonus for discovering the problem....

Gaussian Distributions .. the building block of Risk management OR the building block of a financial CRISIS

I came to this topic as someone who understands a bit of statistics and a bit of engineering. The usual way to get Gaussian fluctuations is to add up lots of independent little fluctuations (the central limit theorem). The little ones (the individual traders in a market) have to act independently of each other, or the theorem doesn't follow. Obviously, in real markets, the traders' behavior is influenced by the actions of other traders. In the aggregate system, small fluctuations about the mean will still often be Gaussian, but that doesn't mean the big ones are. It was Mandelbrot that discovered "fat tails", that very extreme price movements are far more likely than the theories predict. His findings were initially rejected, and continued to be resisted even when they were replicated in other markets (and then proved out in the real world: a daily price move like that of the 1987 crash was so extreme as to verge on being statistically impossible). 

As a practical matter, non-Gaussian 1/f noise (as opposed to Gaussian -white noise) has been well known to radio engineers since the 1920s and 1930s.

I was shocked when I read a vice-chairman of the Fed , at the time of the LTCM breakup, saying that information feedback is always a stabilizing factor. Any engineer who has studied control theory knows the opposite is true. The math of control theory was first developed by Maxwell (his equations still haunt me), who studied a lever arm connecting a pressure gauge on a steam boiler back to the feed at the bottom of the coal hopper (for that reason called feedback). If the pivot is too close to the boiler (too much feedback), the boiler goes into uncontrolled oscillations and explodes.

Recently, I read a friend's blog whose batchmate from college had become a quant on Wall Street. He said, ofcourse they know that fluctuations aren't Gaussian, but Gaussian fluctuations are the only ones they could model. They're paid to develop models like everyone else's models, not to develop models that are correct !! Shocking but very true. I believe that his revelation is also pervasive because if anybody models in the fat tails, as against the market, the risk premium would be comparatively high, which means costlier end products and little or no sales.

Sometimes I feel that in the race to become effecient, we manipulate facts in our favour and undermine basic risks...

BAD BANK .... is this the only solution

This week, banks ran into yet deeper crisis - the sector is in more trouble than was feared.

In October, following a British lead, governments around the world recapitalised their banks. This drastic measure saved the sector from collapse. But, as the events of this week have demonstrated, the banks are still on the ropes. Bank of America required $20bn of capital and guarantees from the US taxpayer and Anglo Irish Bank was nationalised to halt a run by depositors. Deutsche Bank, revealed striking fourth-quarter losses. Banks are not lending, but are hoarding capital in readiness to absorb losses from existing bad loans and securities. Governments must now act swiftly to move ahead of the crisis. Ad hoc nationalisation of insolvent banks and recapitalisation of impaired ones is simply not enough. Governments must act to draw out the poisonous uncertainty caused by the toxic assets held by solvent banks.

The first option is to create a “bad bank”: in this model, the state would buy up toxic securities from a range of banks and hold them. This would force participating banks to declare large losses, but by removing these illiquid assets from the balance sheet, create certainty about their solvency. It would be a difficult policy to run: it would involve pricing assets that have proved unpriceable and require enormous, up-front costs. The US Treasury’s $700bn troubled asset relief programme was originally intended as a bad bank programme, but changed focus for these reasons.

A better solution, albeit one that must be worked out bank-by-bank, is the insurance model used at Citigroup and, this week, at Bank of America. Governments can, for a fee, issue insurance on the value of a bank’s unpriceable assets, making up the difference if they fall below an agreed floor price. Investors would know that the bank is secure – as with the bad bank model – but it reduces the need for already stretched finance ministries to find money immediately. Simply writing the insurance makes it less likely it will even be needed.

Even after that, however, governments may need to do yet more. They may guarantee credit yet further, perhaps even lending directly, in sectors where commercial lenders have all pulled out. Countries that used to rely on credit from abroad that has now disappeared, as is the case in the UK, may still be stretched even if their domestic banks extend themselves fully. Fixing the banks will not cause a return to growth: we are now caught in the jaws of a global recession. It is, however, a necessary precondition for recovery.

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.