A meeting of opposites - the nobel prize in economics

My column for the Nov edition of Wealth Insight - here. The unedited version is below:


This month, the Nobel prize for economics was jointly awarded to Eugene Fama, Lars Hansen and Robert Shiller. In itself, the award to three economists is not comment worthy. What makes it interesting is the combination of individuals and the ideas they represent.  Fama and Shiller represent opposite views on how prices of financial assets are formed.

The Chicago Tradition

Between 1940-43, Friedrich Von Hayek, an economist at the London School of Economics, wrote a book – “The Road to serfdom”. Having watched the takeover of Vienna by Nazi Germany, this book outlined his opposition to “Big government”. In the book, Hayek says “when economic power is centralized as an instrument of political power it creates a degree of dependence scarcely distinguishable from slavery.”

The book was published by the Chicago University in 1944, and became the basis of “libertarianism” which found its chief proponent in Milton Friedman. Along with a group of friends, Friedman went on to form the “Chicago School”. Friedman believed that markets worked better than governments. Over time, the Chicago school started to believe that markets were “perfect”.

Fama and Efficient Markets

Fama arrived in Chicago as a MBA student in 1960 – and started work on stock price movements. His initial work was statistical – exploring the statistical distribution of stock price movements. Fama soon proposed that stock price movements were random – and that any non-random movement would be arbitraged away by traders so that any non-random patterns were essentially fleeting. He argued that “the actions of the many competing participants should cause the actual price of a security to wander randomly about its intrinsic value.” He called this the “Efficient Market“.

In 1964, Lawrence Fisher and James Lorie published a study covering data over 34 years – anyone who bought all stocks in the New York Stock Exchange and reinvested dividends would have earned 9% post costs over those 34 years. Subsequently, they demonstrated that a randomly selected assorted portfolio also performed as well. Monkeys with darts were as good as mutual fund managers. The markets were indeed efficient – and all available information seemed to be in the price.

Fama went on to teach portfolio theory and came across the work of Markowitz and Sharpe. He quickly realised that the Capital Asset Pricing Model (CAPM) was the model that proposed the economic theory of how stock prices moved – leading to efficient markets.

The analysis that mutual funds and fund managers rarely beat markets – especially after costs, led John Bogle to form the Vanguard Index fund. Indexed investing had come to the markets.

Behavioural Finance and inefficient markets

Later research into economic behaviour of individuals revealed that choices made by individuals were not all rational or “efficient”. People avoided certain loss while being willing to bet on uncertain gain. Somehow, efficient markets demanded that despite each individual decision being irrational, the collective was always rational. This was difficult to explain. Shiller, a PhD from MIT, started to test assertions of efficient markets. He found for example, that stock prices that were supposedly determined by future dividends, were way more volatile than the dividend paid. They were also more volatile than earnings, demand, replacement cost – or any other fundamental parameter. The “rationality” hypothesis of the market had no explanation for this volatility.

Shiller asserted that the leap from observing that stock prices were difficult to predict to that they were right, was “one of the most remarkable errors in the history of economic thought”.  Lawrence Summers a Harward economist, constructed an alternate finance universe where investors weren’t rational and prices did not reflect economic fundamentals. He was able to show that over a simulated 50 year period, no test could determine statistically the difference between the two market constructs – real market vs simulated market. Summers at a speech to finance professors said “Financial economists like Ketchup economists work only with hard data and are concerned with the interrelationships between the prices of different financial assets. They ignore what seems to many to be the more important question of what determines the overall level of asset prices.”

Slowly, the realization that markets could remain inefficient for long periods was being accepted by academicians. Fischer Black in a lecture titled “Noise” said that noise made financial markets possible but also imperfect. Without noise, prices would stay at their fundamental value and there would be no trading. Unfortunately, noise also made the detection of fundamental value impossible. 

As computers became more powerful, more instances of statistically significant “inefficiencies” started to be discovered. Some indicated that trends tended to persist – stocks prices continued to trend in one direction more often than random moves would imply. When corporate earnings differed from expectations, it took a while for the price to reflect the new expectations fully. The January effect and the “small stock” effect were also persistent.

Confronted with this data, Fama modified the CAPM to bring in factors other than just market moves to explain price behaviour. These were the 3 factor and 4 factor models. However, these turned out to be cases of data mining. Perhaps there was something to beating the market after all.

The Nobel committee in its press release summarises it thus “There is no way to predict the price of stocks and bonds over the next few days or weeks. But it is quite possible to foresee the broad course of these prices over longer periods, such as the next three to five years. These findings, which might seem both surprising and contradictory, were made and analyzed by this year’s Laureates, Eugene Fama, Lars Peter Hansen and Robert Shiller....The Laureates have laid the foundation for the current understanding of asset prices. It relies in part on fluctuations in risk and risk attitudes, and in part on behavioral biases and market frictions”. The search for a perfect market model continues.

Inflation indexed investment – finally a possibility

My column for Wealth Insight Sep edition

The RBI witnessed a change of guard on the 4^th of September with Dr. Rajan taking over as the new Governor. His first statement as Governor outlined a time bound policy program that enthused markets immensely. For the average retail investor though, the relevant point of interest was a mention that a new series of Inflation indexed government securities would now be issued – which would be linked to the Consumer Price Index (CPI) rather than WPI (wholesale price index).

This is indeed a big difference. In the past, the government has attempted to issue inflation indexed bonds (IIBs) several times but not met with success. Even the issuance earlier this year, while ostensibly a success, did not excite retail participants. After all, households are interested in insulating themselves against inflation as they see it – not as the government would like them to see it. The pedantic argument that WPI is computed more often than other inflation indices is not likely to cut ice with any investor who is receiving a return based on a number which is roughly half of what he actually experiences.

The mechanics of IIBs

In a normal bond, investors take a risk on inflation and interest rates. For example, investors have no incentive to buy a government security yielding say 8% today, with CPI at 9%. The investor has no incentive to save. Additionally, if inflation were to rise to say 9.5%, the saver would be further penalized. This behaviour forces investors to seek higher yields in real assets – gold and real estate – as we have indeed witnessed over the past few years.

IIBs offer an investor a “real” return on investment. The bond is initially issued with a face value of say Rs 100. The coupon rate would be a “real rate”, say 2%. If the CPI for the quarter is 9% annualized as in the example above, the interest rate of 2% would be computed on Rs102.25 i.e. Rs(100+0.25*9%). The face value at the quarter end would now stand at Rs 102.25. In other words, the inflation is factored into the principal, while the interest is paid on the enhanced principal.

The long term investor does not need to worry about the direction of inflation – since the position is hedged. Interestingly, it is possible that if inflation falls below zero (yes, it can), i.e. price levels start to fall, the bond principal would be adjusted downwards. In theory, it is possible that the bond may not repay the entire principal on maturity – if negative inflation persists. However, in India this is unlikely. Additionally, RBI has structured the bonds in a manner that in the unlikely event of this occurring, the investor still receives the principal back.

Nirvana or...?

When it is too good to be true, it usually is too good to be true. Let’s look at cases where the bond may not offer great value to investors.

In an environment where inflation rates are already high, and are likely to fall, an investor may be better served buying a fixed maturity instrument (a la FMP) which offers a high fixed rate. As inflation falls, the yield on the FMP may turn out to be higher than on the IIB – despite the real return. IIB’s therefore may make more sense in a rising inflation scenario especially where the interest rates are unnaturally subdued by government or RBI action.

Another key dampener is the presence of institutional investors subscribing to IIB issuances. RBI issued IIBs in Q1 of the current fiscal where institutional investors were expected to bid for bonds to determine coupon rate. Many such investors are entities controlled by government. This automatically skews the bids in a direction that suits government – lower payouts – the exact opposite of what suits the retail investor. If RBI is serious about involving retail households and offering them a real protection against inflation, it needs to be honest about the cost of doing so.

The tax angle

A possible confusion could be taxation on these bonds. RBI has clarified that IIBs are not tax free. However, it is not clear whether the increase in principal as a consequence of inflation indexing will be treated as capital increase or as income in the year.

The assumption is that only coupon will be treated as income, while the rest goes as capital and is treated as capital gains at the time of redemption. Since indexation is allowed while computing capital gains, for the sake of consistency, the tax indexation should be the same as that used in modifying the principal. In such a case, there should be no tax on redemption. This is not likely to be the case. The income tax authorities will likely use their own series for inflation adjustment, which will, in all probability, be lower than the adjustment factor applied to the bond – resulting in some capital gains.

Alternately the principal adjustment could be treated as income in the year of accrual. In either case, IIBs are no less tax efficient compared to tax on a comparable bond, in the first case, they are significantly better. Tax efficiency may be higher in the case of a debt mutual fund though – and this is something that could worry the retail investor. An early clarification on this would help.

An alternative to gold

Assuming that there are no attempts to downplay CPI, and investors trust that they are indeed protected against inflation, CPI indexed IIB’s are probably the most potent step that the government has taken to reduce Indian household’s love for gold. Quantitative restrictions or higher tariffs – both of which have been introduced - have a tendency to push the gold trade underground. Offering positive real interest to investors will go a long way in restoring viability of financial savings in the portfolio of Indian savers. Of course, this calls the bluff of all those who have been advocating lower interest rates – despite persistent negative real interest rates.  

IIBs, if widely traded, offer a precise way to measure inflation expectation of investors. This, in theory, is supposed to push governments towards greater fiscal prudence – since the market signal will set the tune for other forms of government financing as well. If heeded, this would indeed be a great step. IIBs have the best chance of inducing genuine retail interest in government securities market. Let’s hope they work.

Funding the current account deficit - focus on the real economy

My column for "Wealth Insight" for July 2013. It was a follow up on the earlier theme.

Rupee weakness continues

In July, a desperate RBI allowed asset financing non-banking financial companies (NBFC’s) to raise external commercial borrowings (ECB’s) under the automatic route for financing import of infrastructure equipment. This comes as part of a series of moves by the government and the RBI to raise foreign resources. The rupee continues to remain under pressure.

Earlier moves to “allow” investments in Indian debt have boomeranged. Starting in Jan 2013, India increased the limit for foreigners seeking to invest in government debt in India. Instead, by the end of June, foreigners had withdrawn $1.2bn from Indian debt in the calendar year. Most of the outflow happened in June. The rupee fall was collateral damage, but once it started, it added to the panic and the outflow. The government has blamed the current account deficit for the falling rupee, but is that the whole story?

A look at the theory

A country’s current account is defined by the following equation:

Current account = (private savings – Investments) + (Tax – Government expenditure)

If the government runs a fiscal deficit i.e it spends more than it earns as taxes, it has to be financed either by a fall in investments (for a given level of national income/savings) or, the country will run a current account deficit(CAD). In other words, domestic consumption has to be financed by foreign inflows. This in itself is not a problem. Countries like the USA and Australia have managed persistent CAD’s without negatively impacting growth rates, or pressuring their currency. India too has had many years of CAD without the rupee depreciating. Of course, these years had increased inflows from invisibles or investments.

Fiscal deficit too is not always bad. In fact for developing countries running below full employment of resources, it can be argued that the government can increase growth rate by running a deficit. Indeed, it must. In effect, an economy operating below potential will benefit from government spend and foreign investment. India has for long run these twin deficits. So why are the policy makers acting as if they have been caught unawares?

Perfect vision – imperfect solution

In 2010, the ministry of commerce put out a strategy plan and a paper. The paper was titled “Strategy for doubling exports in the next three years”. In it, the ministry, assumed that near term trend growth of exports and imports would continue. Based on this, it forecast that India would have a negative merchandise trade balance of $210bn by 2013. This has proved remarkably accurate (the actual figure is $196bn). 

Interestingly, the paper also identified areas where India would have to improve to increase its exports – necessary to avoid pressure on its currency. To quote “Infrastructure bottlenecks remain the single most important constraint for achieving accelerated growth of Indian exports”.  Specifically, it identified a shortage in port capacity of 600 Million MT, 4400kms of 6 lane and 66000 km of 4 lane highways, 750 million tons of cargo handling capacity by the Railways. The other areas noted for improvement were bilateral trade agreements, lowering of transaction costs by simplifying compliance and regulatory requirements, and a stable policy environment. 

Anyone following the developments in the economy over the last few years would be aware of the lack of forward movement on most of these identified problems. In fact, significant problems have since been created, among them the uncertainty of application of tax laws to foreign investment transactions. The end result is seriously eroded investor confidence and investment climate. It is noteworthy that the likely pressure on the rupee was identified as a problem over 3 years ago, and the current blame attributed to the US Fed action is only perhaps a trigger for the inevitable. The real problem is high CAD and a decline in invisibles.

Trade Deficit worsens  while invisibles decline

 

Government focussed on “foreign money”

Of late, it is rare to hear any pronouncements from the finance ministry without it being focussed on foreign direct investment (FDI). Ignoring the findings of the commerce ministry outlined above, North Block continues to believe that all that is needed to remove the pressure on the rupee is to raise FDI limits across various sectors.  This appears a “solution” reflective of a mindset of a “command” economy. With India’s “growth story” seemingly in the past – “permission” to invest is no longer the constraint for international investors – “reason” to invest is!

Even this “liberalization” comes with micro controls. Having risked becoming a minority government by pushing FDI in single brand retail, the government has managed to ensure that there is not a single credible proposal for investment on the table.  Among the most difficult to understand requirements in this case, is that foreigners cannot invest in an existing venture. If allowed, the local entrepreneur would release capital - which would have the same effect as foreign investment in fresh capacity. For some, money is not fungible. Perhaps “our” money is not as green!

 Lack of consistency in policy and a persistent “central micro planning” mindset will ensure that the economy performs below par. Undue focus on financial markets while completely ignoring the problems of the real economy is not likely to make India an investment destination of choice. The faster our government understands this, the better for our unemployed millions.