Sudip Bandyopadhyay’s Blog

Financial inclusion is one of the main planks in India’s drive to wipe out poverty – equal to efforts to build physical infrastructure.  Government experts define the policy as the “delivery of financial services at an affordable cost to the vast sections of the disadvantaged and low-income groups”.  Officials estimate that more than half of Indian rural household about 46m homes – do not have access to credit.

Two third of the country’s population doesn’t have a Bank account and this situation is not expected to change dramatically in the near future.  Inclusive growth demands providing financial services to this un-banked population.  The attempt of the government is now rightly moving towards using alternate non-banking channels to route financial services into the interiors of the country.  As a part of this process it would be only appropriate if the domestic remittance market is opened to the recognised money transfer agents who in any case are authorised to receive inward remittance from abroad.  In fact it is quite paradoxical that a person sitting in India can receive remittance from anywhere else in the world but from other locations in India through this RBI approved private Money Transfer Agents.  So a person in London can remit money to a person sitting in a remote village in Bihar by using the services of private Money Transfer players, whereas a person sitting in Bombay cannot do the same and the only option open to him is to use the postal department’s Money Order service.

The government has claimed it can end poverty by 2040.  Presently, more than 250m Indians live on less than $1 a day. The problems in India’s rural sector are well documented.  About 72 per cent of the country’s 1.14bn people live in rural areas, yet agriculture produces only about 21 per cent of gross domestic product, according to the World Bank.  That leaves the majority of the population living off a small chunk of the economic pie. Small and marginal farmers, those with two hectares (five acres) of land or less, comprise three quarters of the nation’s farming households but own less than one-quarter of its farmland.  In the poorest states, such as Bihar, small and marginal farmers comprise about  96 per cent of those working the land, industry experts say. A lack of transport and other infrastructure forces farmers to sell their produce to village “aggregators”, the middlemen who take it to markets in nearby towns.  With a better knowledge of prices than many of their poorly educated clientele, the middlemen can dupe farmers into a steep discount.  They double up as money lenders, providing farmers with credit for seeds and equipment, often at crippling interest rates. Micro finance and NBFCs can play a huge role in this space. Of course a fully developed & integrated commodity market can also bring in all  the related services including collateral management , warehouse receipt financing etc to remove the funding bottlenecks.

Defining which funds are sovereign wealth funds (SWF) is tricky at best.  A relatively strict definition is employed by Monitor Group, which defines SWF’s as investment funds that:

1.        Are owned directly by a sovereign government.
2.        Are managed independently of other state financial institutions.
3.        Do not have predominant explicit pension obligations.
4.        Invest in a diverse set of financial asset classes in pursuit of economic returns.
5.        Have made a significant proportion of their investments internationally.

This definition would exclude Saudi Arabian Investment Authority (SAMA) for example, as it is a central bank.  However, many analysts do include SAMA among the SWFs because its foreign assets are invested in a much more diverse portfolio than most central banks.  The Norwegian Government Pension Fund – Global is also included in the SWF group despite the name, because it functions as an endowment fund, and has no explicit pension liability stream. The issue becomes even thornier when government funds start to raise external debt to finance acquisitions, as in the case of Mubadala  and a few other UAE-based funds, as in this case it is not just ‘sovereign’ wealth that is being invested.  A distinction also has to be made between funds that invest the nation’s wealth, such as Abu Dhabi Investment Authority, and those that invest the wealth of the ruler, such as Dubai International Capital.  The latter is not usually described as a SWF.

Although sovereign wealth funds (SWF) pursue higher risk-adjusted returns than traditional central banks, through a diversified portfolio of assets, their appetite for risk does vary.  More conservative funds include Saudi Arabian Investment Authority (SAMA), the Russian funds, and Kuwait’s General Reserve Fund.  These tend to focus on fixed income securities and deposits, with a relatively small equity exposure.  Most of the larger SWFs, including Abu Dhabi Investment Authority (ADIA), Norway’s Government Pension Fund – Global and Government of Singapore Investment Corporation are largely passive investors, managing diversified portfolio seeking higher returns than the conservative funds.  Their portfolios include a substantial proportion of equities, as well as exposure to private equity and other asset classes, such as real estate. Finally, strategic investors take more active stakes in companies they invest in than either of the above two groups.  These SWFs are typically quite small.  Dubai’s Istithmar, Abu Dhabi’s Mubadala, and Singapore’s Temasek Holding fall into this category.

During the last few years there has been huge concern & skepticism over investments by SWFs in foreign assets.Although the US has moderated its stance on acquisitions by Middle Eastern Investors and sovereign  wealth funds (SWF) post-financial crisis, some European countries, including France and Germany, remain wary of foreign SWFs buying stakes in what are seen to be ‘strategic’ assets and sectors of the economy.  Late last year, France announced the creation of its own state-owned fund to support companies of national strategic  importance, and Germany passed legislation allowing the government to review an prohibit a non-European Union company from acquiring more than 25 per cent of the voting rights in a German company.

To a large extent, this simply reflects the lack of information about how these funds are managed and what their investment objectives and strategies are.  Since the furore over the DP World deal in 2006, SWFs have made efforts to improve their transparency, disclosure and general public relations efforts.  At a meeting hosted by the International Monetary Fund (IMF) in May 2008, SWFs clarified that they have always invested “on the basis of economic and financial risk and return related considerations”, allaying fears of political motivations behind SWF acquisitions in the West.  An International Working Group of SWFs, led by Abu Dhabi Investment Authority (ADIA) and the IMF, was also established to put in writing a series of ‘best practices and principles’ that SWFs would strive to adopt voluntarily to improve their transparency and governance.  This code of conduct was published later last year and is known as the Santiago Principles.  Essentially, the Santiago address the need for greater accountability and disclosure of objective and fund strategies; a sound legal framework for the funds to operate within; improved governance structures and processes to ensure risk management and accountability; and prudent investment practices based on financial and economic risk and return.

Although increased transparency has benefits both for the SWFs and the recipient countries, there can be a cost in terms of the fund’s flexibility, which could compromise the SWFs returns – Norway’s oil fund, one of the most transparent, has on average achieved an annual return about 4 per cent since it was established, compared with an estimated average annual return of about 10 per cent for ADIA.  Nevertheless, there is evidence that many funds are making efforts to implement the Santiago Principles, particularly those relating to disclosure of investment objectives and strategies. Temasek recently revised its charter, downplaying its links to government policy or strategic interests, while China Investment Corporation published its first annual report in July 2009.  SWFs are also becoming involved in joint ventures, both with each other and with third parties, allaying fears in recipient countries of political motivation in investment decisions transaction.

In the 1960s—the time of one of the worst food crises in India—it had seemed that the Malthusian theory was correct and the country’s population was exceeding its ability to feed its citizens. With the threat of famine looming large on the country, the government solicited help from abroad. It imported huge quantities of grain from the US. This was followed by import of new varieties of wheat and grain to be grown in India’s soil. The green revolution meant development of higher-yielding seeds and unprecedented expansion in the use of irrigation, fertilizers and pesticides in developing countries.

Norman Borlaug, the father of green revolution, brought Indo-US ties to a new level. Borlaug, who died last  Saturday, was often credited with saving over a billion people worldwide from starvation. Borlaug,solved that  food shortage challenge by developing genetically unique strains of  “semidwarf” wheat, and later rice, that raised food yields as much as sixfold.  The result was that a country like India was able to feed its own people as its population grew from 500 million in the mid-1960s, when Borlaug’s “Green Revolution” began to take effect, to the current 1.16 billion. World food production more than doubled between 1960 and 1990 and in Pakistan and India, two of the nations that benefited most from the new crop varieties, grain yields more than quadrupled over the period. Today, famines – whether in Zimbabwe, Darfur or North Korea – are politically induced events, not true natural disasters. In later life, Borlaug was criticized by self-described “greens” whose hostility to technology put them athwart the revolution he had set in motion.  Borlaug fired back, warning  that fear-mongering by environmental extremists against synthetic pesticides, inorganic fertilizers and genetically modified foods would again put millions at risk of starvation while damaging the very biodiversity those extremists claimed to protect.  In saving so many, Borlaug showed that a genuine green movement doesn’t pit man against the Earth, but rather applies human intelligence to exploit the Earth’s resources to improve life for everyone.

Agriculture in India is not an occupation but rather it’s a way of life as more than 65% of the population is directly employed in it. It may contribute only 17% to GDP but the challenges faced by it are as gigantic as faced by physical infrastructure. Green revolution had created a sense of elation that we have resolved our production problem. But, now we have reached a plateau in production and productivity. There is a dire need to follow a multidimensional approach towards agriculture. Indeed, what is now required is a second green revolution to increase productivity and take people out of low returns farm jobs. We need another Borlaug-like inspiration.

Lord Mervyn King, Governor of Bank Of England crisply summed up the dilemma of the Governments across the globe when he said that… global financial institutions are global in their life, but national in their death. Each nation has to take steps to ensure that failure of foreign institutions does not disrupt its domestic markets.

Indeed,one of the objective of financial sector reforms  must now be to make sure that, the next time that a major bank founders, there is no need for governments to step in and save other institutions, as they had to do in the aftermath of the Lehman collapse, when they fought to avert a second Great Depression.  So bankruptcy regimes for banks must be improved. Combined with  pushing derivatives on to exchanges, such measures should reduce the chances of a repeat of the severe uncertainty that emerged in the frenzy of last September.

There also needs to be systemic regulation to prevent too many financial institutions from sharing the same vulnerabilities, and from posing avoidable risks to the institutions trading around them.   In Europe and in the US, there is a consensus about the need for such oversight. But this agreement has quickly turned into an argument about which institution should be the Super Regulator and whether such responsibilities can be split. It is more important to decide what regulation is supposed to do. There needs to be political debate about whether regulators should target asset price inflation by varying capital requirements, or simply fortify the banks against crashes. There should be public discussion about whether it is better to make big banks failsafe with thicker capital buffers or force them to slim down so that when they do fail, they fail safely. Policymakers must own up to the fact that there are some institutions they can never credibly claim they will let fail. They must identify who they are implicitly backstopping so they can charge a fee for that insurance. Vague talk of systemic regulation and higher capital ratios is not enough. Politicians need a strategy for making finance safer, and soon.

The collapse or near collapse of several large US securities firms did not pose any threat to the solvency of Indian equity markets because of the margin requirements that we impose on FIIs. Under the doctrine that each country buries its own dead, foreign creditors of a bankrupt FII can lay claim to this collateral lying in India only if there is something left over after the claims of Indian stock exchanges and other Indian entities have been satisfied. In this context, the existence of a large over the counter (OTC) derivative market in India where foreign banks trade without posting margins is a huge systemic risk. Lehman was a bit player in the interest rate swap and other OTC markets in India. As such, its collapse did not create a major disturbance. However, the failure of a large foreign bank which is very active in the OTC market would be very serious indeed. It is absolutely imperative to move the OTC markets to centralised clearing to eliminate this source of systemic risk.

The efficient markets hypothesis is the catwalk supermodel of economics.  Strutting down the runway in haute couture, catwalk supermodels present an elegant stylized vision of fashion that bears scant resemblance to the reality of buying clothes on the high street.

Through its failure in successive crises – the 1987 stock market crash, the collapse of Long-Term Capital Management and the current financial crisis – the EMH and the models it has spawned has been shown to have a similar lack of relevance to how financial markets actually work.  The recent series of articles in the Financial Times highlighting the shortcomings of the EMH are important because, despite the flaws, the ideas underpinning the theory remain the well-entrenched orthodoxy. Trading rooms are not filled with bankers pontificating on the finer points of economic theory, but the tools they employ on a daily basis – from derivatives pricing models to risk management metrics such as Value at Risk – are all ultimately based on a vision of the world that assumes constant liquidity and the near impossibility of extreme events.

Several of these critiques view the failure of EMH as an opportunity to replace it with something else. Writing on behavioural finance,Jonathan Davis showcases the work of Professor Andrew Lo of Massachusetts Institute of Technology, who admits financial markets simply do not lend themselves to deductive theory as well as the physical world. Similarly,Paul De Grauwe,Professor of Economics at the University of Leuven, suggests the crisis creates the opportunity to develop better models, but notes “the interaction between… imperfectly informed individuals regularly creates collective movements of euphoria and panics. These phenomena are hard to model. Yet this is what macroeconomists will have to do if they want to regain respectability as scientists.”

This last statement contains the essence of the problem. Over the past 50 years economics has attempted to turn itself into a “hard” science through mathematical rigour. But as Professors Lo and De Grauwe both admit, the real world does not lend itself readily to this form of analysis. Rejecting the simplicity of the EMH and focusing on how economic agents actually behave may well produce models that are an improvement on their predecessors, but this is still asking the wrong question. Using the catwalk analogy, we shouldn’t ask how supermodels could be made to look more like normal people and dressed accordingly. Instead, the important question is “do we really need supermodels and haute couture fashion shows to shop on the high street?”

The first step is to accept the futility of attempting to describe human interactions with mathematical models, particularly ones that return automatically to an equilibrium state. Economics used to be a descriptive discipline – Keynes’s original work was not a mathematical treatise – and would benefit from becoming descriptive once more.

The second step is to accept that extreme events are not that rare. Models based on the EMH are often used as an excuse when things go wrong.   The one-in-a-million year or 25 sigma event that no model could predict is regularly trotted out as an excuse – every few years or so. The important point about extreme events, Black Swans to quote prominent critic Nassim Taleb, is that they cannot be predicted or modelled. The conclusion, put forward in a new book, Lecturing Birds on Flying by Pablo Triana, is that “[having] no model is better than a dangerous model”.

If we discard the flawed models, what do we replace them with? Taleb and Triana’s answer is experience honed by common sense.  If this sounds anathema, it is a reflection of how powerfully entrenched the false sense of precision offered by models has become.  But, in fact, this approach has already been successfully used during the credit crisis. At the end of 2006, when their peers were still accumulating ever-larger credit exposures, senior management at Goldman Sachs took a negative bet on the US sub-prime mortgage market. Goldman’s subsequent financial performance relative to other investment banks is testimony to the power of experience and common sense over slavish adherence to mathematical models.