Solving the funding problems of the Employee Pension Scheme (EPS)

Vikas Dhoot has an important article in Financial Express today on changes being made to the Employee Pension Scheme (EPS). This is a fairly underfunded defined-benefit pension scheme created in 1995. The scheme was broke to start with. From 1995 onwards, interest rates have dropped, and mortality has gone down. These factors have worsened the funding status of the scheme. For more details on EPS, see this paper.

EPS is broke, and the only way to make ends meet is to increase contributions and/or decrease benefits. It is to the credit of the UPA that they are doing these politically unpopular things. However, this illustrates the three pathologies of defined benefit schemes. First, they are prone to get into funding trouble owing to elongation of mortality. Second, bringing the schemes back into balance is politically unpopular, and in the meantime, this induces costs on the taxpayer. Third, bringing them back into sound territory often involves reducing benefits. To this extent, they are actually not as `defined' a benefit as is often claimed.

The four stages of the global financial crisis

As this crisis has evolved over the years, I find my set of tabs in firefox has changed. The evolution of this set of things-to-watch is mildly interesting.

1. The first place to focus on was US housing construction. US housing was clearly in stratospheric territory. Once the US Fed started raising rates, and Mortgage Equity Withdrawal became less important, trouble was going to come about in US home construction. In this period, I watched the DJ US Home Construction Index.

2. By mid 2006, it was clear that big damage had taken place in this industry index. (E.g. see this article in Business Standard in September 2006). The next shoe to drop was the firms that had financed homes. Hence, my focus then shifted to US housing finance companies. By mid 2007, it was clear that big damage had taken place in this industry index.

3. Now the question became: where in the world of financial firms does the damage go? My focus then shifted to the DJ US Financial Services Index. And, by this time, it was clear that there were deep problems in the money market, so I started watching the TED spread. At first, after the death of Bear Stearns in March, US Financials bounced back and it looked like the trouble would subside.

4. And then, after the death of Lehman, the real question became: what would this do to the broad US economy. Now we're all down to watching the S&P 500 and VIX.

With VIX at 58, isn't it time to be shorting VIX? (You might like to see this slideshow on the global financial crisis, from a few weeks ago).

Indian growth outlook for 2008-09

See this slideshow by Mahesh Vyas at ICRIER, Sunil Jain's article in Business Standard about this, and the CMIE Monthly Review for September 2008.

Cash crunch at real estate companies

I am anxiously scanning the money market looking for dislocations. The closest that seems to be found is the funding crisis of real estate companies who appear to be facing a cash crunch. I have heard of interest rates going all the way to 36%. These are really attractive returns, but then there is the possibility of default.

I looked up accounting information about one such firm, Unitech, as an example. A glance at the liabilities shows a lot of leverage: net worth of Rs.2143 crore is supporting a balance sheet of Rs.17,327 crore. Current liabilities are Rs.7,069 crore, so there must be a lot of stress rolling these over. At the same time, the market value of equity is Rs.18,000 crore. From this perspective, the leverage is not particularly high (Jayanth Varma had made a similar point recently) even though the stock price has lost 67% in the latest 12 months. In a KMV/Merton model world, you wouldn't think this firm was particularly likely to go bust.

There is one problem in the measurement of accounting `equity' capital for some of these firms which needs to be borne in mind. India has capital controls against debt flows. There are many mechanisms for getting around these restrictions, for equity and debt are ultimately intimately intertwined [link, link]. One mechanism is for founders (`promoters') to sell shares to a foreign investor and have a private contract to buy these shares back at a future date. I have heard that quite a few small Indian promoters have done such deals with private equity funds and other funding sources. These transactions are really debt transactions, being disguised to look like equity transactions.

While such transactions are in flight, the accounting data for `equity' capital is overstated. And, given the drop in stock prices in recent terms, the cost of this borrowing for the promoter will prove to be very high. Such promoters must be in a tough spot looking for personal money to do the buyback, at a stock price well above the market price.

None of these particularly attenuates the stock price, though, once there is adequate stock market liquidity, for speculators on the market know all these things. So I would still maintain that by market value measures, there is a lot of equity in Unitech. If you have insights to offer on the funding crunch of real estate companies, and why they're paying as much as 36%, do tell.

What is at stake in Afghanistan

Read Robert Kaplan in the New York Times.

What restrains authoritarianism 2.0

Authoritarianism 2.0 is the mixture of a degree of economic freedom without political freedom that is in force in parts of Latin America, Russia, the Middle East, and China. The new conventional wisdom is that Milton Friedman was wrong, that capitalism does not generate a lot of pressure in favour of movement towards democracy. Russia, China, UAE, etc. have found the recipe to harness globalisation and free markets for obtaining high growth, but at the same time not permitting freedom. This is an important phenomenon that merits exploration. More importantly, it poses a challenge to prosperity and freedom in the world today.

In China, one sees the phenomenon of urban intelligensia - who should have ordinarily been a fertile ground for subversive ideas - being quite comfortable with the deal that the State offers them, and settling into the roles of consumers, workers and entrepreneurs without hankering for the role of citizens. In this case, the domestic channel through which capitalism can help induce freedom is blunted.

I feel that while this domestic channel is weaker than expected, an external channel does operate. Authoritarianism 2.0 does involve embracing globalisation, of engaging with trade and capital flows with the world. As an example, Russia and all the autocracies of the Middle East have full capital account convertibility, and China has a very large current account. This induces some checks and balances. Consider the Russian stock market index:

The recent experience with Russia is interesting. In recent months, considerable economic pain has come about, as a consequence of decisions of the State. This suggests that there are external economic constraints upon Authoritarianism 2.0. See this excellent article by Charles Clover and Catherine Belton in the FT. The key events in tracing the loss of confidence on the part of private capital seem to be as follows. (I'm quoting from this article):

Late May

"BPs 50 per cent stake in the TNK-BP oil venture, came under pressure from Russian shareholders and the government seemed powerless or unwilling to intervene. As the dispute escalated Robert Dudley, the BP-backed chief executive, left the country in July blaming official harassment."

The same day

"At a meeting of metals industry chieftains in Siberia, Mr Putin lashed out at Igor Zyuzin, the owner of Mechel, the Russian steel and coal producer, for price-gouging. With trademark gallows humour, he threatened to send a doctor to cure Mr Zyuzin, who was absent from the meeting claiming illness. Markets sank and half the value of Mechel, which is listed on the New York Stock Exchange, was erased amid fears that the company was finished."

After that

"Then the anti-monopoly service began to investigate other big metals companies for price-gouging as part of a battle to fight rampant inflation, later extending the probe to price fixing in fertilisers and cement. Investors began to fear the government could start imposing price caps on some of Russias biggest blue chips, limiting their earnings capacity."

6 August

War in Georgia. "Fear of a capricious and arbitrary Kremlin put flight to foreign investors, with analysts estimating that $21bn left the country in the weeks that followed Russias military intervention. Adding to the pressure was the weakness in global stock markets and the falling price of oil, on which Russia is dependent for its fiscal health."

These events give us a useful framework to think about the evolution of stock prices in Russia. Stock prices are down to the levels of 2006. Some of this is owing to global events, that have impacted upon all emerging markets. As a control, consider India.

This is an unfair comparison because Russia is an oil exporter while India is an oil importer. This suggests that roughly speaking, the Russian stock market has suffered a 20-30% loss over and above that suffered by India.

If Putin had chosen to not engage in global economic integration, he would have had the autonomy to pursue political actions much like Stalin did under Authoritarianism 1.0: there would have been essentially no checks and balances. But under Authoritarianism 2.0, he does face external constraints.

Evolution of the web browser

By one measure, Microsoft's market share in browsers dropped below 50% in September 2008. They are now at 48.6%. I suspect that this measure (w3schools.com) understates the importance of mobile phones, so this probably overstates the importance of Microsoft.