Globalisation and the nation state

Much of the present narrative tends to treat nation states that throw up high walls as the default setting. A new idea called globalisation is seen as being about breaking down barriers imposed by the nation state against the freedoms of individuals on the movement of ideas, goods, services, capital and labour. Barriers are normal, globalisation is novel. This perspective is based on looking at the post-war experience.

Nikolaus Wolf has an article European economic integration: Undoing 1914-1945 on voxeu where he looks at `the division of labour in Europe'. His main story is about the German economy, where natural economic forces produced integration with Europe (i.e. globalisation) and not within Germany. It took quite a prodigous effort for the nation state to force Germany to trade within Germany. In a larger historical perspective, globalisation is the natural state, and nation states that throw up barriers against it the temporary aberration.

The day Bear Stearns died

A great three-part story in Wall Street Journal of the death spiral of Bear Stearns: part one, part two, part three.

I'm reminded of LTCM's death spiral, the story of which is best told in Nicholas Dunbar's book. In both cases, a firm holding large positions got hit by something like a speculative attack where every counterparty in the world had an incentive to bet against it.

No credit rating agency could have possibly comprehended with the complexity of information, and the pace of events, that unfolded in the endgame. Bear Stearns was a publicly listed firm, so the stock price generated a daily estimate of the default probability (as did the CDS). Both these market-based indicators of distress worked very well. A curious little difference between Bear Stearns and LTCM: Neither of these two realtime indicators existed for LTCM.

For older material on the death of Bear Stearns, do see this blog post. While we dodged a bullet here, the world bounced back quite nicely.

"Rearrange the world to fit my constraints"

Vijay Mahajan of BASIX [link] has an article in Financial Express inspired by RBI's efforts at preventing business correspondents (BCs) from taking banking services to people who are not within 15 km of an existing bank branch. (If people are already near a bank branch, they don't need BCs!) In it, he says:

Regulatory reputation and supervisory convenience is more important to RBI than financial inclusion.

This reminded me of a sentence from the Percy Mistry report (para 20, page 195, from the recommendations chapter):

In the view of the HPEC, regulatory arrangements and architecture should be rearranged to meet the market's needs; rather than having the market rearranged in order to meet the demands of regulatory convenience.

New aspects of capital controls

The `Indian Corporate Law' blog links to a story in the Economic Times which says that one factor why the Bharti/MTN transaction fell apart was: India's 75% restriction on foreign ownership of telecom companies. That fits in the larger theme of India's 21st century firms hitting limitations owing to 20th century controls.

They also have a story on a possible first Indian Depository Receipt (IDR) from Standard Chartered Bank. If it comes through, that would be cool. But that's going to take quite a few changes by SEBI and RBI to the existing policy framework for IDRs (which have helped ensure zero foreign listings in India).

The impact of recent government measures on the edible oil industry

by Malay Makkar.

Recent events

India is one of the world's largest importers of edible oil. Soybean and palm oil account for a major share of Indian imports. India's oil consumption is roughly about 120 lakh metric tonnes (MT) of which about 70 lakh MT is imported. Of the oils imported by India, Soyabean and palm form the primary constituents, since these are produced in sufficient quantities to be exported by the US and Malaysia and hence, are relatively cheaper. Futures contracts on NCDEX and MCX had daily turnover of roughly Rs.400 crore a day and Rs.100 crore a day, respectively.

In early May 2008, soyabean oil prices were 30% higher than the level of the previous year. The government believes that futures trading has helped induce this price rise. Hence, on 7 May 2008, futures trading was suspended for soyabean oil for four months (along with this, futures on potato, chana and rubber were also banned). All existing futures contracts were liquidated at the closing price as on that date on the respective exchanges. Owing to fears that such a move was imminent, the open interest on NCDEX, MCX and NBOT in soyabean oil had already halved to 0.15 million MT. For a comparison, monthly consumption is roughly a million MT.

Using powers under the Essential Commodities Act, 1955, various state governments have imposed stock limits on the edible oil traders in their states. On 10 May, the UP government imposed an inventory ceiling of 25 MT for any trader of edible oil. Large traders who normally carried stock in excess of 250 MT are now forced to live within a tiny limit of 25 MT. Similar stock limits were also imposed by the Maharashtra Government the same week. The central government has also advised state governments to strengthen their enforcement machinery to act against `hoarding' edible oil.

How much risk does an oil importer carry?

The task of importing Soyabean and palm oil exposes the edible oil trade to fluctuations in prices occurring internationally. A fall in price of the commodity has a severe impact, since it leads to losses and lower valuations of even the existing inventory. Oil refiners in India quote a daily selling price for the oils based on the international trends. The benchmark exchanges for trade in these two oils are the Chicago Board of Trade for soya oil and the Malaysian Derivatives Exchange for palm oil. In order to derisk or hedge their future risks, importers short-sell futures contracts. Selling futures helps in assuring a constant return to the importer and removes the uncertainty that he might have faced without a similar contract.

A standard oil tanker usually ferries 30,000 MT of oil. For one such shipment, the value at risk for the importer is large. From January 2008 onwards, the standard deviation of change in daily prices of soy oil has been $44.2 per tonne of oil. In other words an importers shipment could vary in value everyday by about $1.33 million dollars a day. No importer is willing to take that big a risk; since the return on investments (if the company is lucky) is only about 1% (around $0.36 million). Thus it becomes essential for any businessman who imports edible oil to be able to lock in his future selling prices and hence assure himself of the returns. But by banning the futures products, the government has taken away this risk mitigation tool from importers. Bereft of hedging using futures, importers impose bigger markups upon the local economy, thus exacerbating inflation.

Impact of the ban

In absence of an avenue for price discovery, the entire trade channel consisting of distributors, wholesalers and retailers has lost a price signaling method. They are unable to observe market estimates of future prices. Due to this confusion, there is less long-term planning (through forward contracts) and there is more short-term cash trading. This in turn poses new problems for the business. Firstly, it increases the possibilities of stock outs occurring and forces the suppliers to frequently replenish the shelves of the retailers. Secondly, the oil refining companies are losing out since higher stocks have to be maintained in their own godowns for frequent replenishment requirements of the retailers and lesser stocks can be pushed down the supply chain. Additionally, increased transportation costs associated with repetitive distribution of small quantities of goods is expensive for the companies and reduces energy efficiency of the economy.

There are indirect effects also. Higher uncertainty has made firms involved in this trade more risky and reduced their access to borrowing. Firms are using their own capital for holding inventories which is adversely affecting new investment.

The importers are now forced to hedge their risks on foreign exchanges like Chicago and Malaysian derivatives exchanges. While this should work well in theory, in practice, there are many impediments against doing this correctly and fully owing to the system of capital controls that India has against use of offshore derivatives markets.

Indian finance professionals stand to lose since companies are reluctant to hire new traders and maintain on their rolls, since the ban has been imposed. This adversely affects the building-up of derivatives competence in India.

Due to lack of a pan India benchmark price, inter-regional arbitrage opportunities have appeared. The prices in spot markets have jumped and traders are making a killing by exploiting these informational asymmetries. Moreover, small time traders who cannot be out of business for a long time will now resort to forwards contracts (the `number 2' market that survives even though futures trading has been banned) and hence the risks in the whole system will be magnified as counter party risks will also appear. Finally, the prices will now align themselves completely to international markets. When our local crops are harvested price discovery will be difficult as the price discovery mechanism will take its signals from international exchanges.

Impact of imposition of stock limits

A short term effect will be that people will be forced to reduce their existing inventories of oil. This will please the policy makers who think hoarding is bad. But holding large inventories is essential to a well functioning trade. With lower stocks the overall business will go down and shortages will appear in a few months. Lower business volumes also imply loss in income for all the people involved in the process - the refiners, brokers, distributors (and lower tax revenues for the government). In order to circumvent the state wise stock limits oil companies will be forced to open oil depots in states which do not have stock limits. And then oil will be routed to other states through them.

Another way to circumvent the system is by opening a large number of firms by the same individual. For example a distributor earlier maintaining stocks of about 250 Tons on any given day will now open 10 firms in his name thereby fulfilling the condition of 25 Tons per firms stock limit also but maintaining his usual oil stock also. All this will simply lead to more corruption in the system; it constitutes a bias in favour of less ethical companies.

Government import of edible oils

The government has floated tenders for import of oil about 12 lakh MT of oil in the coming 12 months. By this action, the government, in one step, has replaced the private sector and emerged as the single largest importer of oil into India. This is inconsistent with the efforts in other industries in India, where the government has retreated from business into the core tasks of public goods. The decision of the government to move into this business reduces the incentives of firms to invest and build businesses.

Moreover, the imported oil will be available only to poor people through the public distribution channel but the remaining market (read the middle class) has to deal with the troubled private trade. Companies who were selling to poor people would lose market share.

It is possible that in order to lower the oil prices, the government may also release this imported oil in the markets by floating tenders in the Indian markets. In absence of clarity about the government's future policies, importers will remain unwilling to import oil. This could lead to acute difficulties in coming months.

Understanding food prices

I wrote an article in Business Standard titled Understanding food prices.

An additional consideration in thinking about optimal currency areas

Traditionally, when we think about currency pegging, we think that if two countries are exposed to highly correlated shocks, then pegging is not a bad idea. E.g. if Austria and Germany have the same business cycle, it is not a bad idea for Austria to adopt German monetary policy. By this logic, it is a bad idea for Qatar to adopt US monetary policy.

Now suppose there are two countries which have common shocks but dissimilar per capita income and thus different CPI consumption baskets. This leads to poor correlation between the two CPI measures. Example: one is a poor country and has a high weight for food and fuel while the other is a rich country where this is not the case.

Now suppose the poor country runs a pegged exchange rate to the rich country. Even though the two countries have common shocks, the inflation process in the poor country will be different when compared with the rich country. A monetary policy that delivers low and stable inflation in the rich country will fail to do this for the poor country even if the two countries have common macroeconomic shocks. The rich country will achieve the frontier in terms of low output gaps with a low and stable inflation rate, but the same would not be the case with the poor country.

By this logic, if Canada and Mexico have similar correlations with the US business cycle, it's less sensible for Mexico to adopt US monetary policy. By this logic, there are two strikes against India adopting US monetary policy by running a pegged rupee-dollar rate: Neither are the shocks common nor are the CPI baskets alike.

Differences in CPI baskets have another interesting implication. If one measures competitiveness by using the REER, but with CPIs that have very different weights, one could come to potentially odd conclusions. Even if PPP holds perfectly, CPIs with different weights can diverge. One country will show a loss of competitiveness, even though by definition competitiveness hasn't changed at all.