Words ought to be a little wild, for they are the assault of thoughts on the unthinking
- J.M. Keynes

Thursday, 28 February 2013

Examining the Pensieve: Current wobble triggers trip down memory lane

The post Italian election wobble reminds me of February 2007. Then an unrelated sudden plunge (~9%) in the Shanghai Composite led to a sell-off in risk assets. The sudden jump in credit spreads and the plunge in equity markets caught quite a few by surprise. However the panic soon passed and spreads returned close to their earlier levels (Graph-1 & 2). The equity markets, oblivious to the storm brewing in the US housing market, went on to make new all time highs (Graph-3).

Graph-1: iTraxx Senior Financials (5Y generic)

Source: Bloomberg

Graph-2: iTraxx Sub Financials (5Y generic)

Source: Bloomberg 

Graph-3: S&P 500

Source: Bloomberg 

Similarly now a sudden dumping of risk assets was caused by the Italian election result, one which should not have been much of a surprise to those following opinion polls. It again points to a skittish market full of carry traders with large positions and low conviction captivated by the siren song of momentum. Similar to 2007, fundamentals are diverging from the rosy picture painted by risk assets. The European situation continues to deteriorate just like the US economy and housing market from March to July 2007 when the first realisation of the enormity of the problem dawned on markets (see credit index graphs above). At that time too the market believed in the omnipotence of geniuses who opined that "the impact on the broader economy and financial markets of the problems in the subprime market seems likely to be contained".

European growth is surprising on the downside, unemployment on the upside (apart from Germany for the time being) and deficit targets are being pushed back not just in the periphery (eg. France and surprisingly and ironically Holland). Moreover the internal situation in austerity-hit countries is being ignored. For example Greece, which has again slipped off the radar under the 'problem solved' assumption, is in panic as medical supplies run out because pharma companies are apparently not supplying the country.

Policymakers by continuing to do what it takes to revert to status quo ante are cutting the ground from under their feet. Nothing illustrates this better than the deafening silence on the fact that 55% of Italian voters rejected austerity. Yet the question being asked by the European political elite is not why electorate after electorate is rejecting their poisonous economic prescriptions but why Italy elected two "clowns"?

The current situation is not stable nor is it tending towards stability despite markets thinking otherwise. The only difference now is that in contrast to 2007, policymakers (read: central bankers) are insistent on reassuring the markets into a continued state of exuberance. How long this policymaker pretence of knowledge continues to fool is difficult to say. The lesson from 2007 is to patiently await the inevitable denouement by "hedging" negative carry contrarian positions with high-beta liquid positive carry ones[1]

[1] At that time I funded the carry on my ultra short financials positions by being long high-yield credit through iTraxx Xover. Apart from balancing the carry, this had three advantages: first, the relatively small size of the position ensured a quick and easy out; second, broad market rallies led to positive mark-to-market P&L as financial spreads moved only a little if at all; and third, Xover had a greater asymmetric payoff profile due to higher convexity as duration fell faster on spreads spiking up. 

Tuesday, 26 February 2013

Euro Drama Returns

Scene: Two European bureaucrats (Eurocrats) travelling in the first class carriage on the gravy train from Brussels to Strasbourg.

Eurocrat-1 (E1): C’est une catastrophe. This is a catastrophe. Dies ist eine Katastrophe…
Eurocrat-2 (E2): Stop it. There is no need to state the obvious in all the official languages.
E1: Sorry, drafting communiqués for all these emergency summits and meetings has made it a habit. But you know what I mean, those Italians have jeopardised all that we’ve worked so hard to achieve over the last three years.
E2: Yes. What a bitter pill to swallow. Undone by a comedian.
E1: You mean Berlusconi or Grillo?
E2 (continuing): This is the problem with Europe. Too much democracy. Too much power in the hands of the unwashed masses who do not possess our stupendous intellect. It was a simple enough task – go to the polling booths and elect the unelected technocrat. We, the mighty European machine would have taken care of the rest and set Italy on the path to recovery. But no, the average man is too concerned about his daily bread to look at the bigger picture. He is ignorant of the fact that the glory of Europe demands sacrifice.
E1: I couldn’t agree more. We have dedicated our lives to this ideal which has cost us so dearly. All the travel, all those summits, all those late nights. It is time the man on the street followed our example of personal sacrifice. By the way I’m about to order some champagne and canapés, would you like some too?
E2: Yes please. It’ll help figuring out how to deal with this wrong election result.

Eurocrat-1 orders a bottle of Grand Cru champagne and some canapés over the intercom.

E1: So what are our choices? First is to get the parties to form a grand coalition. Failing which, the other option is to have another set of elections and hope that the right parties somehow cobble together a majority.
E2: The right?
E1: No I didn’t mean the Right, but right parties which are not Right but Left. As you know for us in Italy, Left is right but Right is wrong unlike in Greece where Left is wrong and Right is right. Of course I mean mainly Centre with a small tilt left or right when I refer to either Left or Right being right. We don't support extreme parties who don't believe in democracy.
E2: Ah I see. You had me confused there.

Champagne and canapés are served by a liveried waiter.

E1: So can we manage to create a grand coalition?
E2: It is possible. In Italy more so than other places, the laws of political arithmetic have evolved into physics. Given enough, ahem, energy, you can place the electrons where you desire.
E1: Yes but the last grand coalition with an unelected technocrat was wrecked because of the repulsion between the electrons. How do we manage another which will last? And this time we won’t even have our man as the head of government. Instead we’ll have an elected head of some party interfering in our efforts to reform the country.
E2: True. He may be tempted to ignore our advice and do what will make him popular in the next election. That only means higher spending and not firing workers which is completely the wrong way to go about dealing with this recession.
E1: If only the people would realise that austerity is good for them. They can see that austerity is working in all the other countries. Even Greece is emerging from its slump without defaulting on its debt.
E2: Isn’t unemployment going up in Greece and the economy still contracting?
E1: Yes but the rate of change is slowing which shows we’re on the right track. Austerity is the path to prosperity. Oh…the champagne is over. Order another bottle. We might as well drink the Grand Cru while it is available. The budget cuts might lead to their serving only Premier Crus in the future.
E2 (shocked): Are you serious?

Both shudder. Eurocrat-2 orders another bottle.

E1: So if the grand coalition isn’t going to work then Italy has to have another election. But how do we guarantee that we get the government we think the Italians should have? Given how close the contest was this time there could be a bigger mistake in the next one.
E2: Yes and we can’t make the same threat of total instantaneous financial destruction which we made to ensure enough Greeks voted for our guys in their second election.

Both quietly contemplate while another bottle of champagne arrives and is served.

E2: I suppose ballot stuffing, booth-capturing, etc are out of the question.
E1: My dear fellow, that is outrageous! It’ll never escape the media and we can’t have a political scandal. No one has the time to deal with it since everyone is still quite busy dealing with the financial crisis and all the new regulation it has spawned.
E2: Yes, sorry. They really should have increased our budget to take into account all the new work. Well, coming back to the topic, we can still play the instantaneous financial destruction card for want of anything better.
E1: How so?
E2: Call up Draghi and ask him to start selling the Italian bonds ECB bought under SMP. It’ll raise the yield quite spectacularly on Italian debt and cause the anti-austerity brigade to come crawling back to us.
E1: Isn’t that a little dangerous? It might spiral out of control.
E2: Nonsense. Have we not been in control over the last three years and proved our critics wrong? Despite all their carping no one has defaulted and bond yields are coming back to the lows.
E1: True. I'll have a chat once we get off. (Raises his glass) Let’s drink to that.

Sunday, 24 February 2013

Narendra Modi - A Fact Based Look

The mere mention of Narendra Modi sparks off extreme reactions. His supporters idolise him as India’s saviour while his detractors are caught in a time-warp refusing to live beyond their version of the Gujarat riots. To form an informed opinion about the man who has ambitions of leading the country, we need to look beyond the caricatures painted by party hacks and opinion writers and delve into data to analyse his Chief Ministership.

Modi’s political success is not in doubt after his record fourth consecutive term as CM (Oct 2001- Present). However the question which needs answering is whether his electoral success is due to sound administration and economic management or is it based on pure demagoguery and organisational skills of Gujarat’s BJP cadre. Gujarat’s economic performance certainly points to the former. As Graph-1 shows, from the time Modi became CM Gujarat has grown faster than India and increased its share in Indian GDP. Per-capita income has risen to almost one-and-a-half times India’s average versus around parity in 2000-01. Further proof of improved living standards is captured by the massive decline in poverty. The percentage of population living below the poverty line fell faster in Gujarat than India as a whole. In 2004-05 Gujarat had 31.6% of its population living below the poverty line compared to 37.2% for India. By 2009-10 this had fallen to 23% compared to India’s 29.8%1.

Graph 1: Gujarat’s Economic Performance Under Modi

Source: Ministry of Statistics and Programme Implementation, Author’s calculations

Critics are loath to credit this stellar economic performance to Modi’s stewardship preferring instead to make noises about Gujarat’s inherent dynamism. However as Table-1 shows, they are short on facts and long on rhetoric. Of course Gujaratis are enterprising and Gujarat has been one of the more prosperous states of India but the difference in performance under Modi is too stark to ignore. From a middling performer, Gujarat became one of the top three fastest growing states during 2001-11 and overtook West Bengal to become the 5th largest Indian state by GDP.

Table-1: Striving for the top spot
Rank amongst states & UTs (out of 35)
Modi’s tenure
GDP (End of period)
GDP growth
Per-capita income (End of period)
Per-capita income growth
Source: Ministry of Statistics and Programme Implementation, Author’s calculations
As expected, Gujarat’s infrastructure kept pace with its economic development. In a power hungry nation it maintained its 5th rank in installed state power generation capacity during 2001-112. It ranked the same in road infrastructure as measured by the length of state highways per 100 square kilometres. In addition it has the highest proportion of asphalt roads amongst Indian states at 90.6% of total road length. This is miles ahead of the Indian average of 61.8%3.

Along with bringing greater prosperity to Gujarat, Modi’s supporters also credit him with improving law and order in the state. Once again they are backed by data which shows that crime in Gujarat (total incidence of cognizable crimes under IPC4) increased only 2% over 2006-11 while for the whole of India it increased at an alarming 23.8%. As a result, from being ranked 21st and one of the worst states in terms of cognizable crimes as a percentage of population, Gujarat has become one of the best being ranked 6th in 2011.

However before Modi supporters become too smug, they should take a look at his abysmal record in improving social conditions. Gujarat’s health and social indicators are at odds with its economic development. As Table-2 shows, Modi’s tenure as CM has done little to improve Gujarat’s relative ranking amongst states in stopping female foeticide/infanticide, enhancing literacy levels and reducing infant mortality. The widespread slaughter of girl children as shown by a shockingly skewed sex ratio is a criminal offence and cannot be countenanced by a leader who prides himself on his law and order credentials. As for literacy and infant mortality, it is true that there has been improvement in absolute levels but the pace of change is slow (Table-2). 
Table-2: Lagging behind the economic miracle
Absolute level
Rank amongst states and UTs (out of 35)
Sex Ratio (0-6 years)
28 (improved)
Sex Ratio (Total)
24 (worsened)
18 (worsened)
Female literacy rate
20 (improved)
Infant mortality rate
24 (improved)
Source: India census 2001, 2011 (www.censusindia.gov.in), Author’s calculations 

Modi’s administration seems to have missed the opportunity for a more substantial improvement. The rise of Asian tigers and China attest to the fact that rapid growth in a modern economy is sustained by a pool of healthy and educated young men and women. Modi’s impressive performance in the economic sphere will be for naught unless social change and health infrastructure follow. 

However, it is not Modi’s relative failure in the social and health sphere that his detractors love to cite. Their opinion on Modi fossilised with the Gujarat riots of 2002 and has stood the test of time and facts. Evidence contrary to their world view has been rejected as biased opinion while corroborative evidence has been accepted at face value as fact. Hence the glib dismissal of reports from investigation teams, commissions and court judgements exonerating Modi. Interestingly for a state which they think is governed by a “genocidal religious maniac”, there have been no major communal clashes since 2002. Moreover the number of murders with a communal motive recorded during 2003-10 in Gujarat were lower than Chhattisgarh, Haryana, Madhya Pradesh and Maharashtra according to the National Crime Records Bureau. Also, Karnataka and Uttar Pradesh had the same number of communal murders. Is there a “pogrom” operating across all these Indian states?

Unfortunately for Modi, his detractors are not some fringe conspiracy theorists but powerful shapers of public opinion. They have successfully cloaked him in fascist garb by alleging complicity with genocide and harping on his “dictatorial” style of administration. It is ironic that many such critics obsequiously ignore the wilful and unchecked exercise of power by other Indian leaders. Unaware of their doublethink, they are also perfectly at ease with the quasi-monarchical succession prevalent in Indian politics. Modi’s image problems are magnified because such subjective criticism cannot be conclusively dispelled. Moreover it is impossible to remove his critics extreme confirmation bias through facts and data. The long running 9/11 Truth Movement which believes that WTC attacks were orchestrated by the US government is testament to the power of belief over objective facts.

However as responsible democratic citizens we need to judge Modi’s performance on facts and form our own opinion. On this basis he scores an A in economic management but only a B in law and order as the impressive performance in controlling crime was substantially undone by continued female foeticide/infanticide. This also detracts from his already poor performance in social and health spheres where he scores a below average C-. Although as expected he falls short of the superhuman leader status that his supporters have bestowed on him, his performance has been credible enough to back his ambition to be the leader of the country. Even his strongest detractors would agree that at least there is a performance record and resumé to judge as opposed to a blank sheet with only a name.

1. Planning Commission; Data for use of Deputy Chairman, Planning Commission, 5th December 2012, pp55
2. Planning Commission; Data for use of Deputy Chairman, Planning Commission, 5th December 2012, pp119
3. Basic Road Statistics of India 2008-09, 2009-10, 2010-11; Ministry of Road Transport and Highways; August 2012
4. Cognizable offences under IPC are: crimes against body; crimes against property; crime against public order; economic crimes; crimes against women; and crimes against children

Thursday, 21 February 2013

King's Disastrous Reign

The British it seems are truly unlucky in their central bankers. During the tumultuous period following the First World War and into the Great Depression they had Montagu Norman at the helm. He is the unsung hero of all those who fought against the British colonial yoke. By fanatically adhering to the cross of gold he made sure that the economic sinews holding the British Empire atrophied. Shortly before Britain finally went off the gold standard in September 1931, Churchill had this to say about him: “Everyone I meet seems vaguely alarmed that something terrible is going to happen financially…I hope we shall hang Montagu Norman if it does. I will certainly turn King’s evidence against him.”[1] Fortunately for him he was not hanged but reappointed governor in 1931 for another 11 years.

The rhyming of history never stops and some eighty odd years later another financial crisis struck even as the governor of the Bank of England (BoE) believed that the risk to financial stability appeared to be low[2]. The traditional defence for this colossal error of judgement is to lay the blame on Gordon Brown’s door for bifurcating regulatory responsibility between the BoE and the Financial Services Authority (FSA) with the result that neither organisation had their eye on the ball. Even if this is accepted without argument, which it should not be as Chris Giles makes clear in this FT piece – The Court of Sir Mervyn, it is impossible to excuse BoE’s abysmal record of containing inflation.

Inflation targeting was proposed by Sir Mervyn King in his role as BoE Chief Economist. It is supposed to be his forte and there is no greater responsibility for a central bank in charge of fiat currency than to contain inflation. However as Dr. Tim Morgan at Tullet Prebon makes clear Sir Mervyn King and the BoE have been unable to contain their chosen measure of inflation below their chosen 2% target for 8 of the 9 years from 2004 (Graph-1). (Sir Mervyn King became governor in July 2003).
Graph 1: Failure to contain inflation 
Source: 'Measuring the real cost of living'; Tullet Prebon Strategy Notes; Issue 43, 20-Feb-13
What makes matters worse is the fact that real inflation has been much higher than the academic kind captured by CPI numbers. This is shown by the table below which has been constructed working along the lines of Dr. Morgan’s report. The result has been to erode the consumer's non-discretionary purchasing power.
Table: Proportion spent on non-discretionary purchases has increased  
2003 share of disp. income
Dec'02-Dec'12 inflation
Current share of disp. income
Food and non-alcoholic
Alcoholic beverages and
Electricity, gas and other
Water supply and misc.
services for the dwelling
Fares and other travel costs
Mortgage interest payments
Regular maintenance and
repair of the dwelling


CPI if 2% target had been hit
over the decade




Non-discretionary spending
as % of income for renter

Non-disc. spending as % of
income for homeowner

Note: Share of disposable income is assumed for 2003. Current share calculated based on price inflation and average wage increase. Disposable income is assumed to have increased at the same rate as nominal wages. This ignores direct tax effects.
Source: ONS, Tullet Prebon, Author's calculations 

Is it any wonder that retail sales have flatlined since the onset of the crisis? (Graph-2) In fairness other factors such as increase in unemployment and underemployment also play a role in stagnant retail sales. But this leads to the third failure of the BoE.

Graph-2: Stagnant retail sales
Source: Office of National Statistics

The lacklustre recovery from the crisis and threat of a triple-dip recession shatter the self-constructed image of BoE’s omnipotence. A humbler central bank less steeped in monetary dogma and therefore cognizant of the liquidity trap may be forgiven for being unable to resuscitate the economy especially in the face of an increasingly tight fiscal policy. But the highly intelligent academics inside BoE must also answer this charge of failing to revive the economy despite their repeated and counterproductive attempts at unconventional monetary policy. These attempts which clearly run contrary to their inflation targeting mandate were justified on the assurance that inflation would return to target in the medium-term. In this case the medium-term is certainly taking a long time to materialise. 

Just as Montagu Norman valiantly stuck to the then prevalent dogma of the gold standard all those years ago, Sir Mervyn King has steadfastly refused to reconsider QE let alone rein it in. In fact, his parting gift to the nation would have been an enlargement of the QE programme even as there is increasing disquiet about the effect of such “unconventional” monetary policies (as shown by the Fed minutes released yesterday). QE has been a Faustian bargain, not only failing to ensure a sustainable recovery but leading to inflation through debauching the currency. Thankfully the governor’s term is over and hopefully Britain’s luck turns with the new man, Mark Carney. But don't start buying Sterling just yet.

[1] Based on ‘Lords of Finance’ by Liaquat Ahmed, Windmill Books 2010
[2] http://www.ft.com/cms/s/2/f853d068-94b7-11e1-bb0d-00144feab49a.html#axzz1wg5hOORI