"Unusually uncertain” were the two words that Ben Bernanke, the Chairman of the Federal Reserve of United States, said about the state of economic recovery on July 21st 2010. After the remarks were released, the US stock market fell sharply which were followed later with subsequent fall in the Asian and European markets.
After showing signs of recovery in early 2010, the global economic outlook has deteriorated during the last couple of months. Economic growth in major advanced economies has been tepid at best, and the much talked about “green shoots” of recovery witnessed during mid 2009 hasn’t materialized into full scale economic expansion.
The unemployment rate in the US hasn’t budged from 9.5 percent to 10 percent range during the last one year. The high unemployment rate shows that business confidence is still low and companies aren’t hiring despite the recent surge in their profit. Household consumption accounts for over 70 percent of the US Gross Domestic Product (GDP) and because of struggling job market, households are chary of spending. As a result, savings rate in the US has increased after the global economic crisis: from a pre-crisis negative savings rate, the US household savings rate has recently increased to over 6 percent. One of the major reasons of global economic crisis was over-consumption of US households; hence, the increment in savings rate is good for the long run. However, in the short run, the US economy desperately needs its consumers to spend more to boost its growth prospects, which looks unlikely given the current US job market situation.
And, if leading experts are to be believed, US job market won’t improve any time soon. Mohammed El-Erian, chief executive officer and co-chief investment officer of PIMCO - the largest fixed income manager in the world - recently said that the US will witness a “lost decade” of jobs growth. Bill Gross, founder and Managing Director of PIMCO was first to coin the term “New Normal” in early 2009 to describe a prolong period of slow growth and high unemployment for the US economy.
When leading economists and central bankers from around the world gathered recently in Jackson Hole, Wyoming to discuss the future of the global economy, the mood amongst the members of this elite group was reported to be much somber. Having already taken unprecedented steps to bolster economic performance
after the crisis, central bankers have plenty to think about
given the daunting prospect of ‘double dip”. Speaking at the Jackson Hole Symposium, Bernanke reiterated his earlier comments about uncertain course of economic recovery and added that US growth will remain subdued for rest of the 2010 and that US economy will grow, albeit slowly, in 2011.
Few significant events have contributed to uncertain business environment which subsequently had an impact on economic performance of major economies. When the “green shoots” of the recovery first emerged during the second half of 2009, business confidence started to recover. However, much of the progress was dented when credit problems surfaced in Dubai in late 2009. Before the problems in Dubai were sorted out, Europe started to have its own debt problems. Overnight, the Credit Default Swap (CDS) - a risk measure of bond’s likely default - on the sovereign bonds of Portugal, Ireland, Greece and Spain (so called “PIGS” countries) increased to unprecedented levels. Much of the first quarter of 2010 was plagued with sovereign debt issues of Europe.
All these events have made businesses and investors wary about the next round of problems. As a result, business confidence has come down. And this has been reflected in the slow growth numbers. Recently, the US revised its second quarter economic growth from 2.4 percent to 1.6 percent. Japan grew at an annualized rate of paltry 0.4 percent. Yields on the US government bonds are incredibly low indicating investors’ flight towards safety.
What then does this slow growth and uncertain environment mean to the rest of the world, especially to emerging economies? If the recent economic performance of India and China is to be believed, then not much. India recently clocked an 8.8 percent growth in April-June quarter - highest growth figure after 2007. Indian policymakers are talking about the need to raise key policy rates to tackle high inflation. China has also been growing at its usual rapid pace. These are signs that, maybe, some of these emerging economies have started to decouple from the developed ones. However, it will be premature to assume that China, India and other emerging economies have fully decoupled from the US and other developed economies. One only needs to go as far as 2008 to see how the whole “decoupling” theory was turned on its head. Hence, as of now, “unusually uncertain” seem the right choice of words.
First published on the Kathmandu Post on Sept 13, 2010.
Permanent Link: http://www.ekantipur.com/the-kathmandu-post/2010/09/12/money/unusually-uncertain/212689/
Wednesday, September 29, 2010
Wednesday, September 8, 2010
The suspense is Killing Me
Do we have an incredibly resilient economy or are we on the verge of an economic collapse because of a disconnect between policymakers and the rest of the nation? I really hope that it’s the former and not the latter because it’s not very hard to comprehend what would happen to the level of business confidence and the state of the economy if any other country’s political situation were in as bad a shape as ours. Despite the insurgency, Tarai unrest, labour union problems, energy crisis and other exogenous problems, the business community in Nepal has preserved and continued with their operations.
Some factories have closed down; the manufacturing sector in particular has suffered especially due to chronic labour problems and the energy crisis; but the overall economy has moved on, albeit slowly. But how long can we go on like this? Yes, we are a resilient bunch of people; and we have taken messy politics, numerous bandas, labour union problems and the energy crisis in stride and continued with our day-to-day affairs. However, instead of policymakers recognizing the past and current plight of the business community and working towards facilitating business through new policy measures, they have been perpetuating a policy vacuum created by the political stalemate which is worsening by the day.
During the last two months, we have failed to elect a new prime minister after holding elections for the umpteenth time. And because of the delay in the formation of a new government, our annual budget—where the government announces key fiscal policy measures for the coming fiscal year—is in limbo. The business community eagerly awaits the annual budget as major policy changes are mentioned in it—such as those related to taxation, foreign trade tariff, infrastructure and agriculture, among others. Moreover, the budget also gives an idea about the economic policy rationale of the policymakers, i.e., whether the incumbent government is more market friendly or has a socialistic ideology.
Businesses plan their next projects incorporating these policy changes. However, due to the delay in the formation of a new government and announcement of the budget, which is overdue by more than two months, there is uncertainty in the business community. And this is the catch: Uncertainty kills business activities.
When the business community is confident that a particular government will last for a certain period of time, they can plan and invest accordingly. They can rest assured that the prevailing policies will be maintained and that their investment won’t be put at risk because of sudden changes in economic policy due to a change in government. However, when there is uncertainty whether a certain government will last or not, business persons generally prefer to wait and watch.
This results in lack of investment and other business activities, and stifles economic growth. In Nepal’s context, there is no certainty as to when a new government will be formed and how long it will remain.
Since the restoration of democracy in 1990, Nepal has had 17 different governments, 16 prime minister changes, a decade-long Maoist conflict, direct rule under former king Gyanendra, the April movement of 2006 and numerous strikes and bandas. Political parties have split to merge again, and political leaders have left their respective parties only to return subsequently. Because of the frequent changes in government, there hasn’t been any continuity in economic policy. The lust for power among political parties has made Nepal one of the most politically unstable countries in the world. It’s no wonder then that over 60 percent of the respondents to an enterprise survey of Nepali industry for 2009 conducted by the International Finance Corporation (IFC) have identified political instability as the major obstacle to their business.
Despite this, our economy has moved on largely due to the perseverance of the business community. The business community has persevered hoping that things will change for the better some day. But then at some time, the policy vacuum caused by the political instability will start to take its toll. In fact, I believe it has already started to happen. While our neighbouring countries are witnessing a dramatic economic growth because of business-friendly policy changes, we are languishing in uncertainty. But for how long can we afford to suffer thus? This resilience won’t last indefinitely.
This article was first published on Aug 31st, 2010 on the Kathmandu Post
Permanent Link:
http://www.ekantipur.com/the-kathmandu-post/2010/08/30/money/the-suspense-is-killing-me/212212/
Some factories have closed down; the manufacturing sector in particular has suffered especially due to chronic labour problems and the energy crisis; but the overall economy has moved on, albeit slowly. But how long can we go on like this? Yes, we are a resilient bunch of people; and we have taken messy politics, numerous bandas, labour union problems and the energy crisis in stride and continued with our day-to-day affairs. However, instead of policymakers recognizing the past and current plight of the business community and working towards facilitating business through new policy measures, they have been perpetuating a policy vacuum created by the political stalemate which is worsening by the day.
During the last two months, we have failed to elect a new prime minister after holding elections for the umpteenth time. And because of the delay in the formation of a new government, our annual budget—where the government announces key fiscal policy measures for the coming fiscal year—is in limbo. The business community eagerly awaits the annual budget as major policy changes are mentioned in it—such as those related to taxation, foreign trade tariff, infrastructure and agriculture, among others. Moreover, the budget also gives an idea about the economic policy rationale of the policymakers, i.e., whether the incumbent government is more market friendly or has a socialistic ideology.
Businesses plan their next projects incorporating these policy changes. However, due to the delay in the formation of a new government and announcement of the budget, which is overdue by more than two months, there is uncertainty in the business community. And this is the catch: Uncertainty kills business activities.
When the business community is confident that a particular government will last for a certain period of time, they can plan and invest accordingly. They can rest assured that the prevailing policies will be maintained and that their investment won’t be put at risk because of sudden changes in economic policy due to a change in government. However, when there is uncertainty whether a certain government will last or not, business persons generally prefer to wait and watch.
This results in lack of investment and other business activities, and stifles economic growth. In Nepal’s context, there is no certainty as to when a new government will be formed and how long it will remain.
Since the restoration of democracy in 1990, Nepal has had 17 different governments, 16 prime minister changes, a decade-long Maoist conflict, direct rule under former king Gyanendra, the April movement of 2006 and numerous strikes and bandas. Political parties have split to merge again, and political leaders have left their respective parties only to return subsequently. Because of the frequent changes in government, there hasn’t been any continuity in economic policy. The lust for power among political parties has made Nepal one of the most politically unstable countries in the world. It’s no wonder then that over 60 percent of the respondents to an enterprise survey of Nepali industry for 2009 conducted by the International Finance Corporation (IFC) have identified political instability as the major obstacle to their business.
Despite this, our economy has moved on largely due to the perseverance of the business community. The business community has persevered hoping that things will change for the better some day. But then at some time, the policy vacuum caused by the political instability will start to take its toll. In fact, I believe it has already started to happen. While our neighbouring countries are witnessing a dramatic economic growth because of business-friendly policy changes, we are languishing in uncertainty. But for how long can we afford to suffer thus? This resilience won’t last indefinitely.
This article was first published on Aug 31st, 2010 on the Kathmandu Post
Permanent Link:
http://www.ekantipur.com/the-kathmandu-post/2010/08/30/money/the-suspense-is-killing-me/212212/
Analyzing Deposit Insurance
At the height of the financial crisis of 2008, the US Federal Deposit Insurance Corporation (FDIC) decided to increase the deposit insurance limit from US$ 100,000 to US$ 250,000 to stem the general public’s eroding faith in the financial system. Many other countries followed suit. Australia and New Zealand, which did not have deposit insurance then, decided to introduce a 100 percent deposit insurance scheme.
As countries have realised the importance of deposit insurance, a number of countries with some form of deposit insurance scheme has increased multifold over the years. According to the International Association of Deposit Insurers (IADI), as of June 2009, 104 countries have instituted some form of explicit deposit insurance, up from 12 in 1974. Moreover, the IADI states that another 17 countries are considering implementing explicit deposit insurance in the near future.
With the recent introduction of the Deposit Guarantee Bylaw by the Deposit Insurance and Credit Guarantee Corporation (DICGC), Nepal will soon join the club of countries with deposit insurance. According to preliminary reports, Nepali banks and financial institutions (BFI) can now voluntarily decide to insure their deposits. However, the insurance scheme only applies to deposits of natural persons and not institutions or corporations. A ceiling of Rs. 200,000 per person has been applied, and BFIs registering for deposit insurance will be charged 0.2 percent or 20 paisa per Rs. 100 of deposit.
This is a welcome initiative as it will boost the general public’s confidence in the banking system. Deposit insurance is one of the most important tools to increase the public’s faith in the banking system. Diamond and Dybvig’s seminal research on bank runs and financial crises identified deposit insurance as the most viable tool to prevent bank runs and reduce contagion risk in the banking system. A run on the bank happens when the general public believes that a bank is about to go under and their deposits are at risk. As depositors rush to the bank to get their money out, the troubled bank isn’t able to fulfil all the withdrawal requests at once as a majority of their deposits are invested in long-term loans. The bank’s inability to pay its depositors creates further panic, and more depositors rush in to withdraw their savings, which ultimately leads to bank failure. Moreover, a bank run is contagious in the sense that it spreads from a troubled bank to the whole financial system like wildfire even when other banks are financially sound.
However, with deposit insurance, depositors know that they will get their money back, to the extent of the insurance coverage, even in the case of a bank failure; and there is no reason for depositors to participate in the bank run. Hence, to a large extent, deposit insurance helps prevent bank runs and contagious banking crisis by building depositor confidence. As the social and economic cost of a bank run and financial crisis are very high, institutions such as the International Monetary Fund (IMF) have been recommending deposit insurance as part of best financial practices for developing countries.
Having said that, deposit insurance, however, does create perverse incentives for both depositors as well as BFIs. Without deposit insurance, depositors are expected to carry out due diligence before putting their savings in any bank. Depositors punish financially weak and risky banks by asking for a risk premium in the form of a higher interest rate. The riskier the bank, the higher will be the risk premium, so banks are compelled to be financially sound and stable. With deposit insurance, however, depositors will no longer have to monitor the performance and activities of their bank as they will be compensated even if it were to fail. As banks face less scrutiny from depositors, they are free to indulge in risk-taking activities—a so-called moral hazard problem in economics. Banks are more than happy to pay nominal premium for deposit insurance as they no longer have to pay a higher risk premium for taking great risks.
Moreover, voluntary deposit insurance, like the one proposed in Nepal, creates another serious problem of adverse selection. The problem of adverse selection can be illustrated by the link between smoking status and mortality (adapted from Wikipedia). Non-smokers, on average, are more likely to live longer, while smokers, on average, are more likely to die younger. If insurance companies do not vary prices for life insurance according to smoking status, life insurance will be a better buy for smokers than for non-smokers. So smokers may be more likely to buy insurance, or may tend to buy larger amounts, than non-smokers. The average mortality of the combined policyholder group will be higher than the average mortality of the general population. From the insurer’s viewpoint, the higher mortality of the group which “selects” to buy insurance is “adverse”. The insurer raises the price of insurance accordingly. As a consequence, non-smokers may be less likely to buy insurance (or may buy smaller amounts) than if they could buy it at a lower price to reflect their lower risk. The reduction in insurance purchase by non-smokers is also “adverse” from the insurer’s viewpoint, and perhaps also from a public policy viewpoint.
The same scenario can arise in the context of Nepal with voluntary deposit insurance where riskier banks may buy more deposit insurance while less risky banks may buy less or opt out of deposit insurance. Even with insurance premiums adjusted for risk-based capital fund of banks, historical evidences have shown adverse selection to be a problem for voluntary deposit insurance schemes. In a classic paper published in 1995, Kumbhakar and Wheelock found that adverse selection was one of the major problems with voluntary deposit insurance. Their study found that risky banks are more likely to join voluntary deposit insurance despite the presence of insurance premiums that were inversely related to the bank’s capital to deposit ratio.
The problem of adverse selection is due to asymmetric information where the management of a bank has a better picture of the true risk level of its balance sheet than the regulators; and depending on the riskiness of the bank’s assets, it can decide whether to enrol in deposit insurance or not. In such a context, penalising banks with higher insurance premiums on the basis of their capital adequacy ratios, as is being prescribed in Nepal, may not work.
Because Nepal is entering such a scheme, these are invaluable lessons. From a public policy standpoint, riskier banks dominating the deposit insurance scheme will be a disaster as taxpayers will have to later foot the bill if these banks were to fail down the line.
This article was first posted in the Kathmandu Post on July 21st 2010.
Permanent Link: http://www.ekantipur.com/the-kathmandu-post/2010/07/20/oped/analysing-deposit-insurance/210683/
As countries have realised the importance of deposit insurance, a number of countries with some form of deposit insurance scheme has increased multifold over the years. According to the International Association of Deposit Insurers (IADI), as of June 2009, 104 countries have instituted some form of explicit deposit insurance, up from 12 in 1974. Moreover, the IADI states that another 17 countries are considering implementing explicit deposit insurance in the near future.
With the recent introduction of the Deposit Guarantee Bylaw by the Deposit Insurance and Credit Guarantee Corporation (DICGC), Nepal will soon join the club of countries with deposit insurance. According to preliminary reports, Nepali banks and financial institutions (BFI) can now voluntarily decide to insure their deposits. However, the insurance scheme only applies to deposits of natural persons and not institutions or corporations. A ceiling of Rs. 200,000 per person has been applied, and BFIs registering for deposit insurance will be charged 0.2 percent or 20 paisa per Rs. 100 of deposit.
This is a welcome initiative as it will boost the general public’s confidence in the banking system. Deposit insurance is one of the most important tools to increase the public’s faith in the banking system. Diamond and Dybvig’s seminal research on bank runs and financial crises identified deposit insurance as the most viable tool to prevent bank runs and reduce contagion risk in the banking system. A run on the bank happens when the general public believes that a bank is about to go under and their deposits are at risk. As depositors rush to the bank to get their money out, the troubled bank isn’t able to fulfil all the withdrawal requests at once as a majority of their deposits are invested in long-term loans. The bank’s inability to pay its depositors creates further panic, and more depositors rush in to withdraw their savings, which ultimately leads to bank failure. Moreover, a bank run is contagious in the sense that it spreads from a troubled bank to the whole financial system like wildfire even when other banks are financially sound.
However, with deposit insurance, depositors know that they will get their money back, to the extent of the insurance coverage, even in the case of a bank failure; and there is no reason for depositors to participate in the bank run. Hence, to a large extent, deposit insurance helps prevent bank runs and contagious banking crisis by building depositor confidence. As the social and economic cost of a bank run and financial crisis are very high, institutions such as the International Monetary Fund (IMF) have been recommending deposit insurance as part of best financial practices for developing countries.
Having said that, deposit insurance, however, does create perverse incentives for both depositors as well as BFIs. Without deposit insurance, depositors are expected to carry out due diligence before putting their savings in any bank. Depositors punish financially weak and risky banks by asking for a risk premium in the form of a higher interest rate. The riskier the bank, the higher will be the risk premium, so banks are compelled to be financially sound and stable. With deposit insurance, however, depositors will no longer have to monitor the performance and activities of their bank as they will be compensated even if it were to fail. As banks face less scrutiny from depositors, they are free to indulge in risk-taking activities—a so-called moral hazard problem in economics. Banks are more than happy to pay nominal premium for deposit insurance as they no longer have to pay a higher risk premium for taking great risks.
Moreover, voluntary deposit insurance, like the one proposed in Nepal, creates another serious problem of adverse selection. The problem of adverse selection can be illustrated by the link between smoking status and mortality (adapted from Wikipedia). Non-smokers, on average, are more likely to live longer, while smokers, on average, are more likely to die younger. If insurance companies do not vary prices for life insurance according to smoking status, life insurance will be a better buy for smokers than for non-smokers. So smokers may be more likely to buy insurance, or may tend to buy larger amounts, than non-smokers. The average mortality of the combined policyholder group will be higher than the average mortality of the general population. From the insurer’s viewpoint, the higher mortality of the group which “selects” to buy insurance is “adverse”. The insurer raises the price of insurance accordingly. As a consequence, non-smokers may be less likely to buy insurance (or may buy smaller amounts) than if they could buy it at a lower price to reflect their lower risk. The reduction in insurance purchase by non-smokers is also “adverse” from the insurer’s viewpoint, and perhaps also from a public policy viewpoint.
The same scenario can arise in the context of Nepal with voluntary deposit insurance where riskier banks may buy more deposit insurance while less risky banks may buy less or opt out of deposit insurance. Even with insurance premiums adjusted for risk-based capital fund of banks, historical evidences have shown adverse selection to be a problem for voluntary deposit insurance schemes. In a classic paper published in 1995, Kumbhakar and Wheelock found that adverse selection was one of the major problems with voluntary deposit insurance. Their study found that risky banks are more likely to join voluntary deposit insurance despite the presence of insurance premiums that were inversely related to the bank’s capital to deposit ratio.
The problem of adverse selection is due to asymmetric information where the management of a bank has a better picture of the true risk level of its balance sheet than the regulators; and depending on the riskiness of the bank’s assets, it can decide whether to enrol in deposit insurance or not. In such a context, penalising banks with higher insurance premiums on the basis of their capital adequacy ratios, as is being prescribed in Nepal, may not work.
Because Nepal is entering such a scheme, these are invaluable lessons. From a public policy standpoint, riskier banks dominating the deposit insurance scheme will be a disaster as taxpayers will have to later foot the bill if these banks were to fail down the line.
This article was first posted in the Kathmandu Post on July 21st 2010.
Permanent Link: http://www.ekantipur.com/the-kathmandu-post/2010/07/20/oped/analysing-deposit-insurance/210683/
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