Goodbye great moderation, hello financial fraud?

The calculations that lead up to fraud

Under normal circumstances, the checks and balances of capitalism work fairly well, particularly in good countries, when it comes to the problems of fraud. This reflects the rational decisions of individuals who compare the benefits from two paths:

Behaviour within the rules

This yields the NPV of cashflow from now until death from being able to work and earn profits in the business.

Breaking the rules

This yields some benefits immediately. There is a certain probability of getting caught and a certain delay in getting caught. Once the person is caught, a punishment is inflicted, and the NPV of cashflow from good behaviour is lost.

The system of checks and balances has been optimised for normal times and, by and large, in good countries, it does a good job of deterring misbehaviour.

Understanding the two big recent blowups

The global economic turbulence changes the balance between these elements. For many people who have their backs against the wall, when faced with imminent disaster in their ordinary business, the payoff to the first option -- behaviour within the rules -- goes down sharply. This increases the temptation of breaking the rules.

I think this is one insight into the disclosures about fraud by Marc S. Dreier [link] and Bernard L. Madoff [link, link].

The Madoff story will inspire some to say that the concept of a hedge fund is fundamentally broken. They will argue that in good times, the checks and balances work out okay, but when volatility is high and some hedge funds have made very large losses, the temptation towards malpractice becomes irresistible, and the lack of hands-on government involvement in hedge funds is a fatal flaw.

The story is a little more complex. A more careful examination shows that both cases (Dreier and Madoff) were a bit out of the ordinary. In the Dreier case, as the NYT article by Alison Leigh Cowan, Charles V. Bagli and William K. Rashbaum says:

Mr. Dreier, 58, controlled the finances of his law firm to an unusual degree, according to lawyers there, because of the unusual way it was set up.
Mr. Dreier was the only equity partner in the firm, and deals were structured so that only he knew all the specifics and had access to all accounts, people with the firm said in court papers. Mr. Dreier convinced lawyers that such an arrangement was best by emphasizing that it would allow them to concentrate on their first love, the law, while he worried about running the firm.
There would be no executive committee. No partners meetings. Mr. Dreier would handle all administrative chores.

Their checks and balances were unusually weak for this organisation, even by the standards of tranquil times.

In Madoff's case, as Roger Ehrenberg says:

Hedge funds, the purported touchstone of the unregulated entity, are far more regulated and subject to many more checks and balances than Madoff every was. I've long made the argument that hedge funds are actually heavily regulated, not directly but indirectly through their relationships with the heavily regulated prime brokers. Forget about the negative PR and spin - it's true. Prime brokers have full transparency into the books of hedge funds, contribute data to the reporting of Net Asset Value (NAV), which is generally pumped out by the hedge funds' administrator. There is a further layer of protection offered by the hedge fund's auditor. Unless everyone is in cahoots it is pretty hard to see how a hedge fund is systematically mis-reporting NAV (except with respect to illiquid assets, but this is another issue entirely). 

Some of the biggest non-market risks of hedge funds include style drift (veering from the strategy outlined in the prospectus, such as when Amaranth's natural gas trades ceased to make it a multi-strategy fund), creeping illiquidy (taking advantage of the illiquid asset carve-out in the prospectus only to see the value of the liquid assets fall, resulting in a prospectus-breaching concentration in illiquids), overuse of side pockets (concentrated, balky public positions that don't fall under the rubric of illiquids yet result in a similar risk profile) and manager fatigue ("If I'm down 50% and it will take me years to dig out from under my high water mark, I'll just shut down"). Note that these risks have to do with the character of the manager, things that a good due diligence process should ferret out. But they really don't have to do with the veracity of the firm's positions, books and records, as third-party involvement together with the regulatory oversight of the prime brokers makes the Madoff kind of fraud highly unlikely.
But Madoff is a completely different kind of firm. It is a broker/dealer with an asset management division, enabling it to rely entirely on itself for trading and settlement. Further, it used a no-name, three-person accounting firm, unheard of for a firm of Madoff's size, scope and complexity. A purely rational trader of Madoff's stature would have set up a hedge fund business to extract 2/20 from his clients. I guess we now understand why; it would have subjected his portfolio to the unwanted scrutiny of his prime brokers. By keeping his game completely in-house and on the down low, it essentially fell through the cracks of our regulatory structure. Will this cause the SEC to redouble its efforts in regulating broker/dealers? Force changes in transparency, similar to what I've pushed for in the OTC derivatives market to the broker/dealer community? Or is it simply a matter of creating rules that ensure credible third-party involvement in the validation of assets under management/NAV in order that Madoff's brand self-dealing couldn't be sustained? 

When it comes to client funds, I believe the involvement of multiple third-parties in the validation of positions and NAV is critical. Checks and balances have to be built into the system, and by employing a structural approach to regulation as opposed to simply adding more regulations, I believe we can minimize the friction in the system while providing the necessary protections to individuals and institutions. The lack of trust so pervasive in today's financial markets just took another hit. But let's take a moment to think of the right way to address the issue (better due diligence, higher standards for fiduciaries, imposition of checks and balances with broker/dealers and asset managers working under the same roof), rather than the way that plays best for PR purposes.

In this case also, the checks and balances that prevailed on Madoff's operation were not typical of what is found with the ordinary hedge fund. The Madoff story is not an indictment of the concept of a hedge fund, but a critique of the specific form through which his fund was organised.

Benefits from the involvement of a third party

I see an analogy with the idea of the third-party repo.

A repo is a collateralised loan. You give me a security worth Rs.100 and I give you a loan of Rs.80. As the price of the security fluctuates, marking to market needs to be done to ensure safety. The difference (Rs.20) is called the `haircut'. The size of the haircut is chosen based on the price risk and liquidity risk of the security between two consecutive marks-to-market.

It is possible to organise a repo properly with bilateral credit risk exposures. If both parties were good and efficient, then marking to market of collateral values would take place properly, haircuts would be computed correctly and always maintained. But there is the risk of operational failures or outright fraud. This is where the `third-party repo' greatly improves matters. The borrower and lender do not directly deal with each other: each deals with the 3rd party who supervises the proper functioning of the transaction as time passes.

This helps simply by bringing in a third party into the transaction. It increases the number of people reconciling accounts. But at the same time, if the third party is just an accountant, there is a greater risk of his doing work only on a best efforts basis. What will really bind the incentives of the third party is for him to do netting by novation: for him to be the legal counterparty to both sides. So when X borrows from Y, at a legal level, X borrows from the third-party and the third-party borrows from Y. This ensures incentive compatibility for the third-party who is then much less likely to make mistakes.

An Indian perspective

In India, under normal conditions, blocking fraud is difficult because the probability of being caught is low, the delay in imposing punishment is high, and the punishment is often quite small.
In this backdrop, the events of 2008 have induced massive profits and losses in unexpected places. I suspect some scandals will pop up.

By and large, the world of SEBI, NSE, NSCC, CCIL, BSE, NSDL, CDSL and mutual funds works fairly well in having strong checks and balances. The life of a typical securities firm in connection with these elements of securities infrastructure is tightly integrated into IT systems run from above. These IT systems correspond to a real-time offsite supervision system. They substantially remove room for fraud. While I expect things will work out okay there, there is always the possibility of some chinks in the armour showing up.

The famous scandals of the past are instructive. Harshad Mehta exploited the flaws of the depository for government bonds. Ketan Parekh exploited the weak risk management of Calcutta Stock Exchange. Home Trade exploited the flaws of the settlement system for bonds. Each of these took place in a part of the system where the real-time offsite supervision system described above was absent. That's a fair guide to what might happen in 2009.

Problems are perhaps more likely in the less regulated companies including listed companies. Some firms have a lot of leverage on their balance sheets and some CEOs have a lot of leverage on their personal balance sheets. Some CEOs have personally given buyback promises to institutional investors who got invested in their stock. These individuals are under a lot of pressure. The less ethical of them could buckle under this pressure and resort to breaking the law.

Nandan Nilekani's book

Just so that you know where I'm coming from: The only book by a CEO that I can recall reading was Father, Son and Company, by Thomas J. Watson (which was a wonderful book). And I never read management gurus.

Nandan Nilekani's book is outstanding. Everyone who is interested in India's future should read it. It is by a thinking person for a thinking person; do not get put off by the fact that he's a billionaire. The website associated with the book is also interesting.

I updated my India bookshelf page.

Does anyone have a post-recession exit strategy?

by Percy Mistry.

[for the Financial Express, November 27th, 2008]

The past was prologue. The present is panic. The future: a conundrum? Banks in every country, along with their industry counterparts, are queuing up for liquidity, capital, or guarantee assistance. "If him, why not me?" Such 'me-too-ism' has triggered a cascade of knee-jerk reactions in governments around the world. The US has a bailout a day. The UK and EU follow a day later. The two giants of the future, India and China, are in on the act. The trend is snowballing downhill and we now have a recession.

Fiscal/monetary expansion in Sep-Oct, 2008 was aimed at averting financial system collapse. In November, it was redirected at preventing global demand collapse. Extolling the lessons of 1929-39, when the global economy was rescued (paradoxically) by a world war, governments seem willing do anything; no matter how unacceptable in 'normal' times (what were those like?) to avert deep, prolonged recession, even a growth recession. Politically and socially, its consequences are unthinkable; especially for administrations (like India's) at a critical juncture in their electoral cycles.

With gargantuan amounts of cash being pumped out, is there a risk of the world later drowning in a flood of worthless money created by well-intentioned public recession-fighters? Will such profligate largesse defer, or prevent from taking place, the adjustments needed to rectify chronic global imbalances in consumption, savings, investment, and borrowing? Policy-makers might regard such questions as misplaced, churlish, or premature. To them, any voice asking right now whether they know what they are doing or overdoing, is a foolish intrusion that will make this recession and financial crisis worse.

Keynes' solution of expanding countercyclical fiscal deficits to combat declines in output had a caveat; that, in boom times, governments must generate fiscal surpluses. Since 2000, most governments have been running large deficits in booms; not least in India. They now want to run even larger deficits to mitigate a bust. The logic seems to be that, since irresponsible government spending and borrowing created this mess in the first place, more reckless government spending and borrowing will get us out of it. Such reasoning may seem sensible to economists armed with theory. It is difficult to explicate to laymen armed only with common sense. That may be why economists are held in the regard they are. If experts think that unrestrained money-pumping will work out in the short and long term, they need to explain why. Perhaps we should be concerned that the experience of 1929-39 taught us what NOT to do in a recession; i.e. tighten the fisc and squeeze money supply. Unfortunately, it did not teach us WHAT to do, or be sure that what we are doing (i.e. the opposite of what was done before) is right. There is no play for this unprecedented scenario that has been rehearsed and worked out.

Looking to governments to solve the problem has dispensed with all concern about privatising profit and socialising cost. Diehard socialists and pompous purveyors of bizarre heterodoxy (suspicious of markets they cannot control directly) are gloating yet distraught. If we probe deep enough, looking to governments to solve the present crisis is not as odd as it seems. Our current predicament is rooted in: (a) prolonged, cavalier irresponsibility of governments - i.e. in irresponsible management of fiscal, monetary, trade, and external accounts (on the part of the US, UK and EU sans Germany), and (b) in self-serving, but globally damaging, exchange rate policies from 2000 to now on the part of China and, a lesser extent, India. The 2008 debacle is not, as populists would have it, rooted exclusively in financial system failure, with excess leverage and risk exacerbated by absurd compensation incentives that skewed the judgement and ethics of the financial community; though there was certainly plenty of that.

Winning the short-term battle of boosting demand and corporate cashflow now seems to be all that matters to former titans of finance and industry. Crisis-induced collapse of demand provides them with a timely excuse to obscure errors of vision, judgement, timing, strategy, and business-model failure. In making billions they believed they were omniscient, omnipotent, invincible, and infallible. Faced with losing billions they want society to bear the cost of their failures. That is the Faustian bargain of mutual assured destruction (MAD) that corporates, governments and consumers have made. So, the notion of taxpayer bailouts of banks and companies may be a tautological nonsense. In the final analysis, the taxpayer (or government on her behalf) is bailing out not banks and firms but herself - in her other avatars as consumer, borrower, depositor, businesswoman, employee, supplier, and producer.

The possibility that victory in the short-term battle of reviving cashflow might result in losing the long-term war of financial responsibility and equilibrium, seems not to matter. To comfort the public that they will do everything in their power to avert prolonged recession, governments are acting in ways that we may not realise the consequences of. The US' serial bailouts have enlarged its fiscal deficit by over 10% of US-GDP. We have not seen the end of them. Adding the UK and EU you get another 8-10% of their GDP. Add others and you have incremental fiscal deficits and incremental net public borrowing piling up to over $5 trillion in the next 1-2 years. This will all need to be borrowed from central banks (risking future inflation) or capital markets where savings are overstretched.

A dramatic shift in risk preference now favours bank deposits and government bonds. But, what happens when that preference shifts to other investments, as it eventually must? Will the shift of all incremental savings into US/EU government debt create stickiness for the eventual recovery of equity markets thereafter? By then the US will owe the rest of the world US$7-8 trillion. What does it mean when the only large reserve currency issuer is the world's largest debtor, sucking in capital from countries that need it more for their own development? Should the world's reserve currency issuer and largest debtor remain exempt from multilateral control, surveillance and guidance when it continues to risk endangering the health and balance of the global economy and financial system?

Likewise, the new liquidity facilities announced by the Fed amount to over US$7.5 trillion; of which US$4 trillion have been used. Those of the EU and other developed countries amount to US$6 trillion. India and China account for yet another US$800 billion. These bloated deficits and liquidity emissions are not trivial. They will have significant future side-effects. Will they succeed in staving off a long and deep recession? We do not know. Will they create post-recession complications that thwart sensible recovery? That likelihood may be higher than it appears now.

After these humongous deficits and liquidity emissions, what strategies will be deployed to bring deficits and money supply back under control; to generate fiscal surpluses and contract liquidity to avoid intractable post-recession inflation? If serious dislocation is to be avoided, and a soft re-entry to normalcy for the world is to be orchestrated, how long will that take? What will it mean for relative growth trajectories in the US, EU, Japan, China, India and other developing countries? What will it imply in terms of achieving essential adjustments: such as the US consuming and borrowing much less, reducing its debt to the world, while saving and investing much more? Will it lead to Europe finally acknowledging the unaffordability, unsustainability, uncompetitiveness, and counter-productivity of its basic economic model: i.e. that of an ever enlarging and intrusive welfare state, increasingly dependent on high-tax but inefficient government intervention to solve every personal/social problem and providing cradle-to-grave insurance, against every contingency? Or will some element of personal responsibility for healthcare, education, and managing personal risk be re-introduced?

Will China be convinced to consume/import more, while exporting, saving and investing less, for global balance to be restored? Will India take the steps necessary to consume, save and invest more, by reducing its fiscal deficit through public asset sales? Will it liberalise its financial system while relieving government of its ownership? Will it transform its labour and land laws/markets? Will it simplify and reform its absurd FDI, FII, NRI capital control regimes to achieve greater efficiency and productivity? Can India and China stave off protectionism by the US and EU by demanding an open global trading regime, while continuing to manage exchange rates (thus preventing adjustment from occurring automatically in global markets) and leaving their capital accounts partially closed? Are open current accounts compatible or congruous with conveniently perforated capital accounts indefinitely?

Such questions may be premature. But are they churlish? The answers may be elusive. So, should these questions not be posed? Indulging in my usual perversity let me ask again: does anyone have a post-recession exit strategy for correcting the fiscal/monetary imbalances we are temporarily but intemperately exacerbating to fight recession? Or have we become so myopic that we are unable to look beyond the next month? If so, the generation just entering the labour market should be seriously afraid about the inter-generational tax and other burdens they are about to inherit involuntarily.

Crisis watch, 10 Dec

TED spread	2.15
S&P 500 returns	-2.31%
VIX	58.91
Nikkei 225 (9:28 AM IST)	+1.92%
US Financials index	-5.02%
ICICI Bank ADR	-3.33%
Call rate on 8th	5.2601
Currency futures (9:31 AM IST)	49.3075

• Monetary and fiscal policy actions over the weekend. Read my blog post on fiscal, financial and monetary policy responses to the downturn, Ila Patnaik in Indian Express and this editorial in Indian Express.
• John Gapper on hedge funds going down. The old conventional wisdom was that banks were good and hedge funds were bad. I feel the future is going to have more hedge funds and a smaller role for banks.
• Consensus on policy issues on credit rating agencies, by Edward Altman, New York University; Kose John, New York University; Harold Bierman, Cornell University; Edward Kane, Boston College; Marshall Blume, University of Pennsylvania; George Kaufman, Loyola University Chicago; Willard Carleton, University of Arizona; Dennis Logue, Dartmouth College; Andrew Chen, Southern Methodist University; Jay Ritter, University of Florida; Tom Copeland, Massachusetts Institute of Technology; Kenneth Scott, Stanford University; Elroy Dimson, London Business School; Lemma W. Senbet, University of Maryland; Franklin Edwards, Columbia University; Jeremy Siegel, University of Pennsylvania; Robert Eisenbeis, Economic Consultant; Chester Spatt, Carnegie Mellon University; Wayne Ferson, University of Southern California; Robert Stambaugh, University of Pennsylvania; Charles Goodhart, London School of Economics; Laura Starks, The University of Texas at Austin; Martin Gruber, New York University; Marti Subrahmanyam, New York University; Lawrence Harris, University of Southern California; Ingo Walter, New York University; Richard Herring, University of Pennsylvania.
• Avinash Persaud in Financial Express on the fiscal responses to the downturn.
• An editorial in Financial Express on the Chinese exchange rate regime.
• Bruce Bartlett in Forbes on What would Keynes do?
• Larry Summers is going to be a key player in the response to the downturn in the US.

Policy responses to India's economic slowdown

What might come next in the Indian economy?

India is more integrated into the world economy than ever before. In 2000, goods and services exports were roughly 12% of GDP. Today, they are at roughly twice this number. Gross flows on the BOP (summing across the current account and capital account) were roughly 50% of GDP in 2000. Now they are at 125% of GDP. As these numerical values suggest, the pace of change on India's integration into the world economy has been quite dramatic. This increased integration into the world economy means that global shocks affect India more.

Turning to the global economy, the depth and international co-movement that we are seeing in this business cycle downturn is worse as compared with prior experience.

We are thus faced with an unprecedentedly large shock hitting an unprecedentedly integrated economy. The impact of this external shock will hence be unprecedented. We are in new terrain here. Our intuition has been shaped by the past 20 years. But this intuition is a poor guide to optimal decision making at the level of a firm or the country in the situation that we now face.

What are the channels through which the changed environment impinges on us? The first channel is reduced demand for Indian exports. The second channel is the impact on profitability of many Indian companies owing to lowered prices of their products on the world market. The third channel is the reduced investment owing to the change in animal spirits of CEOs.

Some people are emphasising financing constraints as the channel through which investment could drop. But even before you get to financing, the really important problem is about whether a CEO wants to invest or not. When the future looks difficult, CEOs undertake less investment.

Fluctuations in investment are now the big force shaping the Indian business cycle. Gross capital formation to GDP has jumped from 25% to 38% in a few years. A massive investment buildout is presently underway. Private corporate investment has fluctuated quite a bit with changes of as high as 10 percentage points of GDP in a few years. If expectations become very pessimistic, investment could drop by 5 to 10 percentage points of GDP. This would be a massive shock which would set off a business cycle downturn.

For more on the new forces shaping the Indian business cycle, see my article New issues in macroeconomic policy from last year. You will also find the first chapter `The Economy' of this book to be of interest, particularly Section 1.4.2 titled Perfect Storm?.

In short, the scenario to worry about for calendar 2009 is one where investment drops by a few percentage points of GDP because entrepreneurs are pessimistic about what the future holds.

What can monetary policy do?

The paper The current liquidity crunch in India: Diagnosis and policy response, that Jahangir Aziz, Ila Patnaik and I wrote in early October, frames the questions of monetary policy in the downturn. By and large, RBI has done all the right things on rupee liquidity. Dr. Subbarao did something new and important yesterday when, for the first time, he said that RBI will try to ensure that the call rate stays within the LAF. This will help stabilise the expectations of the bond market about the volatility of the short rate, and thus reduce the fears of banks who were otherwise hoarding liquidity.

With the latest RBI actions layered on top of what they have done in previous weeks, I think the short rate and rupee liquidity are broadly okay. The problem of rupee liquidity is broadly under control.

Monetary policy in India has the power to do damage. If the liquidity tightness of late September had continued, we could have had a run on many or all private banks. Many mutual funds could have experienced acute distress. A broad-based financial crisis could have erupted. These unhappy scenarios have been forestalled by the timely, unorthodox and effective RBI actions.

While bad monetary policy in India can do a lot of damage, there is little room for monetary policy to help counter a business cycle downturn by cutting rates (as is done in mature market economies). The reason for this is the lack of a monetary policy transmission. When the central bank of a mature market economy cuts rates, a complex and sophisticated financial sector takes the `raw material' from the money market and transforms it into enhanced asset prices across a wide range of assets all across the economy. In India, owing to the lack of the `Bond-Currency-Derivatives Nexus', this monetary policy transmission does not take place. The policy rate, expressed in real terms, has gone into negative territory but there is little likelihood of it having a serious impact on aggregate demand. The problem is not a liquidity trap; the problem is the broken monetary policy transmission.

What about the exchange rate, which can be a key element of monetary policy if it's not allowed to float? I think RBI is making some progress on getting away from pegging to the dollar. RBI doesn't release adequate data but my guess is that roughly half of the change in reserves is valuation changes. Many people have focused on the large drop in reserves (measured in USD) as a measure of RBI's attempts at currency trading. But when valuation changes are taken into account, what RBI has been doing there is smaller than it seems [link].

The bottom line is that when the Asian crisis struck, and a business cycle downturn in India was impending, India raised rates (200 bps on 16 January 1998). Exchange rate pegging led to the loss of monetary policy autonomy. This time around, the currency has been allowed to depreciate in exchange for domestic monetary policy autonomy: i.e. lowering interest rates when there is an impending downturn.

What can fiscal policy do?

Can fiscal policy help? I feel this is not the case for two reasons. First, there isn't the fiscal space. Second, the institutional mechanisms through which spending can happen do not exist. I am hence not surprised by the modest aspirations of the recently announced fiscal stimulus. Each percentage point of GDP is Rs.50,000 crore and we are discussing a drop in investment of a few percent of GDP. When it comes to movements of a few percent of GDP, fiscal policy in India is just a spectator.

In terms of automatic stabilisers, there is really only one: corporation tax. In a downturn, corporation tax will drop. At present, it is at roughly 3% of GDP. So perhaps there will be a swing of as much as 1 percent of GDP there. While this is nice in terms of getting countercyclical fiscal policy, it simultaneously makes India's fiscal position look precarious. As an example, this makes it harder for Indian firms to borrow abroad because the Indian sovereign credit rating may worsen in an environment of lower GDP growth and a bigger fiscal deficit. And in this global environment, lenders are much more careful about buying junk (which is where Indian issuers are now).

Summary: the macroeconomic policy response to an impending downturn

The textbook response to an impending downturn is to cut interest rates and enlarge the fiscal deficit.

In the past, the word `business cycle' didn't mean much in India, and macroeconomic policy never tried to do such things. It is an important milestone in India's economic history that we have a weekend in which both monetary and fiscal policy have attempted to respond to business cycle conditions. Stabilisation of the business cycle is one important task of the State in a well functioning mature market economy. We have atleast come to the point where such aspirations are starting to be heard. This is progress.

But in terms of the actual capability to stabilise, a lot is lacking. Long-standing policy blunders, particularly on prevention of a liquid bond market and a liquid currency market, have ensured that India does not have a well functioning Bond-Currency-Derivatives (BCD) Nexus. As a consequence, the monetary policy transmission is weak. As a consequence, the impact of cutting interest rates is small. Mistakes in monetary policy can do damage, and RBI has been doing the right things in helping ensure that it does not do damage. But monetary policy cannot stabilise to a substantial extent.

With fiscal policy also, we are paying for our sins of not reforming. The great business cycle expansion from 2002 onwards should have been a time to put our fiscal house in order. As Vijay Kelkar used to evangelise, the time to fix the roof is when the sun is shining. By today, we should have been holding a GST fully integrated into the Tax Information Network run by NSDL, and we should have had a central fiscal deficit of zero. That would have given us the ability to make large reductions of the GST as counter-cyclical fiscal policy. The right things were not done in the last five years. As a consequence, today, fiscal policy is largely ineffective.

Then what can be done?

A big negative shock is hitting the firms. Some of the firms are fundamentally sound but will require external finance to make it through the downturn. The most important question now is: Can external finance be delivered fast enough and to the right places?

Some of the firms are going to die. There, what would be nicest is if they free up resources gracefully and frictionlessly. By and large, the labour market (that's dominated by the informal sector) works well: firms will shed people, wages will go down, the labour will be absorbed in new places. India has a fairly classical labour market. One key thing we need to do different is to not draft speeches where Indian firms are urged to not sack people; speechwriters should instead be singing paeans to the great flexibility of the Indian economy, that even exceeds the flexibility of the US.

Turning to the assets of weak firms, what is required is good bankruptcy process, or even before that, the control transactions through which brands, factories or companies are sold. To the extent that these control transactions take place, it is best. But for these control transactions to take place, the strong firms require external financing to buy assets.

In calendar 2009 and 2010, economic efficiency will be about the extent to which a discriminating financial system is able to deliver a breath of life of external financing to the good firms (while denying finance to weak firms and encouraging and enabling control transactions for their assets). We should do everything we can to increase the ability of the financial system to play these roles.

The Indian banking system is singularly ill-equipped for this role. In 2009 and 2010, most borrowers will look bad in terms of standard accounting data. Banks in India have a bias in favour of putting investment opportunities in the hands of firms with strong cashflow in historical data. Processes of banks are oriented towards looking back in accounting data and not forward in projecting the outlook for firms. But what will matter the most in 2009 and 2010 is getting working capital and growth capital to good firms which are currently not doing well.

In the big picture, a good financial system is one that is able to deliver low correlations between the cashflow of a firm and the investment of the firm. This issue looms large in thinking about 2009 and 2010. Achieving low correlations between cashflow and investment requires forecasting the prospects of firms instead of looking back at their accounting performance; it requires loans based on future cash-flow rather than loans based on assets. It requires brainpower, organisation culture, and a regulatory environment that is not found in Indian banking. On a horizon like 2009 and 2010 I am pessimistic about achieving change on these things.

Hence, the opportunity for public policy to make a contribution in handling 2009 and 2010 lies in non-banking finance. The positive contribution that policy makers can make towards 2009 and 2010 lie on three directions.

I. Removing capital controls

Removing capital controls will directly augment external financing. By `external' here, I mean financing that is external to the firm. In addition, foreign capital tends to come through more intelligent channels of intermediation such as private equity funds or securities markets, which helps improve the quality of use of this capital.

As an aside, capital inflows will reduce the pressure on RBI to sell reserves if they succumb to currency pegging. But that's not an important issue. The really important issue is to get a financial system that will be able to deliver external financing to good firms in 2009 and 2010.

II. Financial sector reforms

The second direction is the implementation of the Patil, Mistry & Rajan reports, so as to achieve a better functioning financial system.

A few days ago, Tata Motors resorted to borrowing Rs.2000 crore using fixed deposits: i.e. direct deposit taking from households. As Piya Singh points out in The Telegraph, Tata Motors is not alone in doing this. I asked why such a 19th century structure was being used, why it wasn't just a bond issue that was being purchased by households, and the answer was: because regulations interfere with doing an unsecured bond issue.

The right way to organise this transaction is as a bond issue. As an example, in the US, unsecured debt is listed and traded on exchanges. These debentures are issued with face value of $10 or $25, with a 5-8% dividend yield. For Ford and GM, these are trading under $5. Almost all unsecured debt (e.g. AT&T, Sprint, Kraft, etc.) is now available at low prices i.e. high interest rates. Here is an example of bonds issued by GM: their share, the bond and the offer document for this bond. For more on this, go to http://www.quantumonline.com and type "XGM" into the search box. A household that believes these firms will make it through the downturn can buy this paper. Instead of households doing company deposits, this interaction should be done through public securities markets.

These are the sort of things that can and should be rapidly fixed. We need to urgently get the corporate bond market going, and solve myriad other problems on financial sector regulation, so as to get Finance in shape for performing the roles that are required of it in 2009 and 2010. As an example, there has never been a time when Chapter 7 of Raghuram Rajan's report, on the infrastructure for the credit market, was more important.

The time horizon required to make a big difference on the Bond-Currency-Derivatives Nexus, by implementing the Patil, Mistry and Rajan reports on this subject, is roughly one month. There are no difficulties in these financial reforms in terms of how voters will feel.

III. Economic reforms : the only effective counter-cyclical lever

Given that we do not hold the capability to do counter-cyclical monetary or fiscal policy, what tools for stabilisation do we have? If the root cause of our problem is the animal spirits of CEOs, and the damage that we take on private corporate gross capital formation when they lose confidence, then the most important lever that India has by way of countercyclical policy is : economic reforms. To the extent that domestic and foreign investors think that India is on the right track and that India is doing the right things, the willingness to invest will be greater.

This is both about doing the right things and not doing the wrong things. E.g. we dodged some bullets recently on issues like short selling or shutting down markets after terrorist attacks in Bombay: while wrong policy paths were carefully evaluated, in the end these paths were not taken.

I feel we have to work particularly hard on doing the right things in economic policy reform, for this is the only real countercyclical lever that we control.

It is interesting to look at this in a global perspective. There are $100 trillion of resources worldwide that are trying to get invested, and assets in numerous countries do not look so attractive. Alternatively, look at the world from the viewpoint of an Indian multinational. The prospect of expanding in many other countries is now less appealing than it was last year. In India, in contrast, the deep drivers of growth remain intact. There are very few countries which have the positive long-term growth possibilities of India. The key question is whether the State will do the right things so as to create the enabling framework of public goods to enable and support the rise of a mature market economy. If foreign and domestic investors are persuaded that India is on the right track of market-oriented reforms, investment can come about on a scale enough to matter for business cycle stabilisation.

Crisis watch, 5 December

We get back to our regularly scheduled financial crisis.

TED spread	2.18
S&P 500 returns	-2.93%
VIX	63.64
Nikkei 225 (9:31 AM IST)	+0.81
US Financials index	-2.07%
ICICI Bank ADR	+0.36%
Call rate on 4th	6.0995
Currency futures (9:31 AM IST)	49.91

• Ila Patnaik on the role of FIIs in the equity market.
• John Cassidy in The New Yorker on Ben Bernanke.
• The SEC seems to be uninterested in obtaining deeper change with credit rating agencies.
• Martin Feldstein and Barry Eichengreen on the challenges before the Euro.
• Richard Lambert on the role of the media.

Greater transparency at SEBI

I have often written about the gaps in transparency at RBI. Yesterday, the SEBI board took a major step forward in improving their transparency. Their press release says:

In order to bring transparency in the working of the Board it was decided that the agenda papers submitted to the Board on all policy issues will be made available in the public domain by putting them up on the SEBI website after the Board has taken a decision on the issue. The minutes of the meeting relating to such items will also be made available on the SEBI website after the Board has approved the minutes. Accordingly the agenda papers for today’s Board meeting will be made available on the SEBI website by December 15, 2008.

I think this is a big step forward in transparency. Those not present at the board meeting will have a much better sense of what was discussed and the kinds of arguments made.

Some of the components of the agenda papers will be criticised in public -- and that is a good thing. This will put pressure on SEBI staff to perform to a higher level of quality in their staff work. For a person who wants to induce a wrong decision in the SEBI board, now it will not just be a matter of navigating the preparation of agenda papers and handling the discussion in the board meeting. Now the media, the general public and the broad policy discourse will be able to look more deeply at each decision. Also see Gautam Chikermane in Hindustan Times on 7 December.