Treasury Secretary

So how did Hank Paulson do as Treasury secretary?. D

-- Former CEO of Goldman Sachs till 2006 and then Treasury Secretary he completely failed to see the crisis.
Even the once revered Greenspan today admitted his ideology of self regulation was wrong and he made mistakes. He literally said in so many words that his whole world view formed over last 40 years has changed due to the crisis. Atleast credit should be given for that given for around 20 years he was GOD of the financial industry.

-- He let Lehman Brothers fail which is considered now to be biggest reason for escalation of the crisis worldwide. Given that in retrospective one can blame him but even today he doesnt agree that it was mistake. With constantly changing stances of why he didnt save Lehman it is surely fishy.

-- Bailout Bill - The first version of the bill he presented would have given him unlimited authority and pratically a blank check. He rejected all other ideas of capital injection into banks which Charles Schumer (Democratic Senator) and others had given at that time. Later after 2 weeks of playing around when Europe did capital injections he followed still not admitting he had done anything wrong.

-- Sweet Deal to WallStreet - A man from Wall Street he got the banks a sweet deal. Each of 9 big banks got $25 billion at 5% with very limited restrictions and small possibility of upside when the stock markets recover. He did not insist on cutting dividends which Europe has done. Out of $125 billion, $25 billion will go to investors as dividend next year. IS this a bailout when banks are giving money?. 5% interest rate is far lower than what Warren Buffet got for exactly similar deal it did with Goldman Sachs. He has stated clearly that he does not want to be punitive to the banks. I dont understand WHY?. Banks are in this mess because of their own misdeeds so shouldnt they be punished.

-- Implementation of the Bailout - As expected he has hired people from Goldman Sachs to mange the bailout details. Isnt there a clear conflict of interest?. How will government price securities which it buys from Goldman Sachs. The people who will runt he bailout are the same people who were part of creating the crisis and still beleive in the same ideologies which seriously failed.

Markets still throwing a tantrum

Just like a tennager who doesnt get his/her way and starts throwing tantrum - the stock markets fell 777 points the day the bill failed in Congress. Most of media said it was indication that market needed the bailout bill and how important it is for the economy or what would happen. Some others have compared this to a person pointing a gun to its head and saying if you dont do it then I will kill myself. 

Now the bill was passed under pressure for the markets and the media. Whats the result?. The teenager is still not happy with what it got and wants to throw more tantrum. The markets fell 159 points after the bill was passed .... ya after it was PASSED. So will Congress to calm the teenager put in more money and meet the markets new demands. The market want accounting rules changed, tax benefits and much more till Congress is ready to satisfy it. 

A sad day .... 

Different bailout plan

The more important concern in this crisis should be for people who have houses foreclosed. Foreclosure is a truamtic event - whole families being kicked out of houses/communities where you have stayed for multiple years and have memories, which are sort of tough to recover. If govt is spending so much money why not force banks to stop any foreclosures - govt can pay them also for doing that. Forecloursers from pure economic sense also are great losses. A typical foreclosed home is very tough to sell as most of the house is vandalized when people leave as they are angry and these houses sell for pittance even compared to prevalanet market prices of the area. Foreclosed house also reduces the value in the area. 

The second concern should be that people have access to credit to do day-to-day stuff like buy houses, run small businesses etc. This means a way so that economy does not suffer a severe recession. Other concerns include avoid job losses, save taxpayer's money etc.

Saving banks/other institutions should be a side product of these concerns. If a failing bank/institution does not materially impact the above two goals I would let it go down. 

Once we have the priorities of concerns finalized lets think about how a plan might look like.  

Govt can hold on to foreclosed houses and let family stay for a few years, renegotiate the mortgages from ARM to fixed over a longer duration, make banks share in the loss of value of houses by reducing mortgage amount, give govt guarantees for part of the amount. Bank lobbies are strongly opposed to that and so this has not come up as serious option at all. In the bailout package currently being considered banks are hoping that government will buy the mortgage securities at higher prices than they can be sold in the market and hence their balance sheets will improve. In short , banks hope that through current bailout they will transfer the losses to government which they might not be able to in the foreclosure case. Secondly republicans are strongly opposed to any foreclosure sort of plan as that would be socialism. I think US is going from so called "capitalism" to wrong type of "socialism" where its socialism for corporations/banks and capitalism for home owners/individuals (BTW this always existed but not as pronounced and in the face). 

There should be a completely different bill, bailing out individuals/families directly rather than banks/corporations. If banks/corporations need to be bailed out then it should be highly punitive. First even now banks are giving out dividends to equity holders. I dont know how govt can talk about bailout when banks are giving money to shareholders. The bailout will give banks money but it seems they have money to give out!!!. 

In a punitive bailout plan, equity and bond holders should be wiped out. Govt should take over as was done in case of Washington Mutual and auction off things to private parties. If there are none then nationalize the entities. Otherwise do as Warren Buffett did, give loans at high interest rates with option to buy shares later at pre-fixed low prices (he did this for Goldman Sachs & now GE). Stop all dividends, fire any CEO/management who made the risky bets, create separate authority not the treasury which will doing the bailing out as was done in 1987/1930, bailout only in cases where absoutly necessary and after two years put a tax on profits of financial firms which benefited from bailout to recover costs). 

To protect from effects of job losses increase unemployment insurance duration, introduce infrastructure projects to raise employment. Finally someone has to pay for all this so increase taxes on the super rich and wall street also has to pay higher taxes in a year or so when it recovers to pay for all this and more. 

A note on costs of current bill:  what media doesnt mention is that costs are not just losses which might be incurred by govt but also opportunity cost of putting the $700 billion. Clearly, even though candidates dont say it, many of the programs will have to be scaled back or not introduced at all which has huge social costs. Because this $700 billion will be stuck for years to come govt will have to scale back funding health insurance programs, alternative energy, ...whole bunch of stuff. The costs of not acting on other issues like global warming, health insurance is as serious or higher than not acting on this bailout. Global warming is almost exactly like this issue there is unpredictability on how soon things can go bad and how bad and hence one can argue action is needed NOW (even if u agree with republican argument that global warming is not caused by humans they admit there is unpredictability in that which I can argue is with not acting on bailout of whether its necessary). Infact global warming would actually wipe human race from Earth unlike the financial crisis. 

Relief on failure of bailout package

I know that people claim the failure of the bailout package resulted in sharp losses in stocks, made it difficult to get loans for busineeses and indiviuals, reduced 401(K) portfolio of so many people ....might lead to some more institutions failing, recession, depression,...... the sky feel off, moved human race closer to extension and so on.......

There will be another package which the US Congress will pass in few days similar to the one failed, maybe even worse in some respects but even then it feels good for now that it failed atleast once. Why?

First and foremost even in the US, even now there is influence of the voters, constituents, of the person on the main street. The bill failed because many in congress got emails, letters, calls from constituents that they were angry at the package at bailing out wall street. And more than 2/3rd of representatives who are up for relection in close races voted against the bill. They were listening because they wanted votes. The media has potrayed this as negative but I find this a GREAT positive. Representatives who voted against were liberals, conservatives but that doesnt matter what matters is voter sentiments had a role to play in this. 

Secondly, strong wall streest lobbyists lost out against the voice of voters atleast for now. In media there are articles filled with how banking association lobbyists lobbied hard to get the provisions they wanted. For example: all provisions of exceutive compensation, equity stakes in banks, taxing the financial industry for any losses after five years are highly diluted in the bill to the point that they are as good as not there. So its good that bill didnt pass in its form. 

The urgency, the excessive executive authority to treasury, the non-transparency of the bill (what prices will govt pay) made it a bad bill. The urgency shown by treasury, media, president was huge. I understand that there are severe repurcussions for not acting but there were no serious alternatives considered. Why not follow the Swiss model in which Swiss govt. bought stakes in banks and shared in the upside, or the good bank model - instead of buying bad assests buy the good ones. The man leading all this is a former Goldman Sachs CEO who would be given unprecedented powers. AIG was saved by a loan to $85 billion and current CEO of Goldman Sachs was present in the meetings because it would have caused Goldman huge losses had AIG collapsed. This raises questions like did Paulson bailout AIG because of Goldman connection and not Lehman which didnt have that much impact on Goldman. Who would he hire to manage the $700 billion, people he knows in the industry which created the problem. 

Lastly the claims that $1 trillion in market valuation was lost in the stock markets yesterday such a big number. Does that really matter?. See today more than $750 billion of that $1 trillion has being regained. Market valuation changes are not losses to be taken seriously, these are market fluctuations which come and go. Retirment or 401(K) accounts are not lost, markets regain value. 

Lastly business media claimed yesterday that by falling the market was giving an indication to politicans that they matter and should be taken seriously. I would advise against these fluctuations being of significant import. $700 billion is a huge amount and if govt is spending it on bailing out then it should be thought through carefully. Who is bailed out? What are the costs? How it is done? What are the alternatives? Does everybody deserve a bailout?

An alternative view to save the financial market

NY times article: This describes the plan very nicely and provides a "good bank" alternative

http://executivesuite.blogs.nytimes.com/2008/09/27/and-now-for-something-completely-different/

Some Tidbits on the crisis

Some observations.... read the previous post about crisis and frustration in general to get better understanding of where I am coming from. 

Man in Charge is Part of creating the crisis: 

Treasury Secretary Hank Paulson who will manage the $700 billion, atleast for next few months, was just about 2 years back CEO of Goldman Sachs and was involved on the corporation side in creating thecrisis. It sounds odd to me that a person with strong connections with people who created this crisis (and was part of them) be given full authority to buy stuff from them and fix it. Rarely has this being mentioned in any media reporting.

Unprecedented executive authority:

In the current bill Paulson's decision are not subject to question by any court of law and he gets overpowering authority to spend $700 billion. He decides how to price the securities he is buying (there is no market which decides on prices for these securities so nobody knows whats the price), who he buys the securities from (there are far more than $700 billion of securities ready to be sold) and other details. He only provides semi-annual reports to Congress and nothing else. Thats tooo much power. How can you trust a guy who was part of creating the crisis be able to make judgements which value things fairly?.

$700 billion number can go far higher:

The wording of the bill is tricky. Its says at any one time government can hold $700 billion of securities. So they can keep buying and selling and in aggregate buy fr more than $700 billion. This doesnt put a lid on the losses. 

Short Sellers: 

Short selling is a term used to describe a transaction when you sell something which you dont own on the hope that you can buy it later at cheaper price. So I dont own any microsoft stock and think that it will go down. I then just sell the stock today and if it goes down in some time buy it at lower price. Many have said that many financial companies like Bear Sterns, Lehman were brought down because many people at the same time short sold the stock and since there was selling by many stock started falling and then this fall became a cycle and eventually the companies collapsed. But traders, hedge funds, economists have always praised short sellers because its a way for markets to tell you in advance that something is wrong with a asset. Its claimed that its part of the "price discovery" process in the markets. Now though suddenly many of the same people have turned against it because it was their own companies which were being short sold - Merill Lynch, Goldman Sachs, Morgan Stanley and lobbied the government to impose a ban on short selling. Why is short selling at fault now when it was not earlier?

Greed: Capitalism is based on self-interest and greed is one of the self interest. According to Adam Smith the magic of capitalism is that everyone acts in their self interest and the system works for everyone. But now suddenly in the crisis "greed" is a bad word. From Mccain to   business channels everybody seems to be greed was reason for the crisis. Why has self-interest turned bad suddenly?. By that definition everyone should be against the markets and capitalism. 

Speed: Its a testament to Governments ability that it responded so quickly to the crisis. Clearly shows if government wants it can act faster than corporations and swiftly. But now Bush government, in same way as it did with Iraq war, is pushing Congress to approve the $700 billion fast. There are no details and Bush wants Congress to act fast - otherwise it says it would be BAD. I dont think that much urgency is needed. A week or so in deliberating the details is fair enough. 

The other motive of Bush is to avoid any other bailouts to homeowners which Democracts are pushing through. Clearly depicting that wall street deserves bailout but homeowners dont. Bush said "to move quickly and to resist the temptation to add provisions that, he said, "would undermine the effectiveness of the plan." Media is blaming politicians (Congress) on acting slowly.... really?. Its as if market asked govt to write a $700 billion check and government should respond otherwise suffer the guilt of killing the market. 

Regulation: 

Goldman Sachs and Morgan Stanley, two of "renowned" investment banks, who until now lobbied hard and succeded to avoid government regulation. Today they both begged to come under government regulation as that would give them better legitimacy and also access to government funds. This is what they have to say "We believe that Goldman Sachs, under Federal Reserve supervision, will be regarded as an even more secure institution with an exceptionally clean balance sheet and a greater diversity of funding sources". So they want regulation when it is clearly helpful. 

Job Losses:

Two unrelated events happened on the same day. Lehman Brothers went bankrupt and 25,000 jobs were put in question (though most wont lose jobs). Heweltt Packard (HP) merged with EDS and declared that it would cut 10,000 jobs. The reaction to these news events was quite different. Media was sympathetic to the workers at Lehman with press outside interviewing and feeling sad for these guys, but as far as HP goes it was praised for cost cutting and its share price rose. There was no repeated mention of HP job losses or sympthay shown for them. Why the difference?. 

Crisis, Bailout and the Frustration

I am feeling very frustrated and angry over the last two days as the events have unfolded in the financial world and the government response to it. No the frustration is not due to any sort of financial losses or sadness over the failing financial institutions (though many would lose jobs and thats sad. Hope everyone ends up getting new ones soon). A lot has happened in this last two weeks and overall in the last few months in the financial world. The sub-prime started unfolding at a rapid rate since Summer last year. Financial institutions, banks and others, made bad loans to home owners at depressed interest rates, maintained by the "Oracle" of economics Alan Greenspan. Then they sold those loans off to Fannie & Freddie Mac and other institutions around the world. This was a miracle of modern day finance - you spread the risk of the loan among everyone, so that no one would suffer. Financial world came up with new "innovative" products like securiatization, auction-rate securities, credit-default swaps (dont even try to understand what these things mean, because nobody on wall street really does). These new markets were touted as safe instruments which would help in spreading the risk and were completely unregulated. Federal Reserve chariman Alan Greenspan and the government ignored calls to regulate any of these markets and de-regulation was the mantra. Investment banks, insurance companies, hedge funds which are all very big players in the market were not federally regulated and even the regulation which were present were not enforced. This is not the fault of Bush administration alone, the Clinton administration had started the whole process. There was also a extraordinarily large amount of leverage in the system - banks and other institutions investing with borrowed money - one of the results of absent regulation. These bad loans started to fail in large numbers last year. Millions of homes are in foreclosure and millions of families will be thrown out of their homes. This has being clear since last year and happening every month. There was a stimuls package by the government to help the economy and only minor help to homeowners. The Bush Administration refused on grounds of moral hazard to bailout the homeowners who were behind in paying their loans. These last two weeks as the crisis deepend it became clearer that many financial institutions would fail. Fannie Mae and Freddie Mac, two institutions which were designed so that government bore the burden of losses while private sector enjoyed all the profits, were completely nationalized by the government. Then Lehman Brothers, one of the stalwarts of Wall Street, went bankrupt - government this time allowed it to fail. Then AIG, the worldest largest insurance company, which is not regulated by the Federal government was nationalized and saved by the government by giving a bridge loan of $85 billion. The Federal Reserve has pumped hunderds of billions into the market to stablize it. 

Until all this happened it was ok but now there is a plan to create a big fund by government which would buy all bad loans from everyone and virtually bail everyone on wall street out at estimated cost of $800-$1 trillion with other countries Russia, China, UK and others coming out with their own mini-bailouts. There were reports in the Indian Press that Indian governement a few weeks back was planning a bailout for the airlines industry in India which has being hurt by the high petrol prices. This is really frustrating and angers me. Why?. Because I am a pure free market guy and dont like the intervention by the government. NO (Milton Friedman might fall in this category). Because government is spending tax payers dollars wastefully putting the money at risk. NO (I am not that concerned about this). Then Why?. I applaud and appreciate the work done by people within the government over this. Look at the efficiency, within a week government officials have chalked out a detailed plan on how to save the economy and the world in a infinitely complex financial universe. Who says government cant be efficient. The frustration lies in the injustice. Why does Wall Street deserve a bailout, created as a result of their risk taking and mistakes, but people in New Orleans dont. Government today announced that it will retroactively insure all money-market funds. This means that all money invested in these funds is safe, no matter how bad the managers of the fund have screwed up. Why didnt the government retroactively provide flood insurance to all houses in New Orleans after Katrina. That would surely have saved a lot of pain. 

Why do millions suffering from the food crisis world wide dont deserve a bailout while Wall Street does?. Since 2003 cereal prices have increased more than 250% resulting in widespread hunger across the world. Millions are on the verge of famine in Eastern Africa according to a recent UN report. The reason of the crisis are multiple - increasing meat consumption in China and the developed world, ethanol policy in US and Europe, drought in places, weak dollar, increasing oil prices, neglect of agriculture, unfair trade policies, decreasing purchasing power of the poor and the increasing inequality around the world. None of the reasons are due to mistakes/risk taking on part of the poor - who are the worst sufferers - as is the case in Wall Street crisis. But what has the response of the world to this being. There were calls for increased aid, big conferences were organized by World Bank and the UN and a paltry sum of $700 million raised in emergency food aid by the World Food Programme. Today UN issued an emergency appeal for $700 million more to avert famine in East Africa. But who is listening with the media screaming wall street ...

How is bailing out wall street institutions ok, while bailout of farmers in India lead to calls that India was being populist (as if that is bad) and moving away from the path of reform (Economist). How is bailing out Wall Street ok, when during the Asian crisis IMF (which follows US policies) gave loans to Korea only after it got assurances from the government that it wont bailout Korean banks. How is bailing out Wall Street and spending hundreds of billions ok, when US, World Bank and IMF have criticized developing country governments for giving food subsidies. 

How is this free market capitalism, which is dead against government intervention when times are good and everybody is making money and all for government bailout when times turn bad due to risks and mistakes which capitalist made. Explain to me how? ........

I am not against government bailouts in all cases, there are cases and this crisis might be one where they are completely justified but there have being others equally or more deserving crisis - Katrina, World Food Crisis, Indiviual homeowners in the US ......Why not them?. 

Criticism/comments/clarification welcome!

The Economic Lives of the Poor

The Economic Lives of the Poor
Abhijit V. Banerjee and Esther Duflo
October 2006

An interesting paper with data showing what do the poor do in economic lifes - where they spend their money, where their earn their money from, whats the infrastructure and assests they have. It also tries to postulate some reasons for the patterns see. They do this for 13 countries through analysis of survey data. For India they did a survey in udaipur whose results are presented:

In udaipur poor (defined as below $2 a day - in the paper they seperate this into two categories below $1 and $1-$2) spend around 60% on food and 14% on festivals, in UP/Bihar expenditure on food is around 75-80%. An analysis of food expenditure shows that for every extra income only between 1/4th to 2/3rd is spent on food - saying that increasing income by $1 doesnt mean that all additional money goes to food. Even among the type of food more expensive and less calorie food is preferred ( preference for wheat/rice which are expensive over millets).On average there is 5% expenses on tobacco/alcohol, 5-6% on health and 1% on education. Expenses on education are 5% in Hyderabad among the poor. Majority of the poor are involved in multiple occupations - agriculture, labor, enterprenial work. All occupations lack scale and poor dont generally gain skills as they move from one job to next. There is temporary migration - but usually poor dont migrate for long. Access to credit, insurance are almost absent. Savings are also absent. In explaining lack of savings the paper postulates - even in cases where poor have money to save - lack of resistance to temptation to spend is one reason (temptation to spend on that extra sweet which the child wants, which might be taken for granted for us but not for the poor) and also
"one senses a reluctance of poor people to commit themselves psychologically to a project of making more money. Perhaps at some level this avoidance is emotionally wise: Thinking about the economic problems of life must make it harder to avoid confronting the sheer inadequacy of the standard of living faced by the extremely poor."

http://econ-www.mit.edu/files/530

India shining, Bharat Drowning

Summary: This paper uses student answers to publicly released questions from an international testing agency together with statistical methods from Item Response Theory to place secondary students from two Indian states -Orissa and Rajasthan -on a worldwide distribution of mathematics achievement. These two states fall below 43 of the 51 countries for which data exist. The bottom 5 percent of children rank higher than the bottom 5 percent in only three countries-South Africa, Ghana and Saudi Arabia. But not all students test poorly. Inequality in the test-score distribution for both states is next only to South Africa in the worldwide ranking exercise. Consequently, and to the extent that these two states can represent India, the two statements "for every ten top performers in the United States there are four in India" and "for every ten low performers in the United States there are two hundred in India" are both consistent with the data. The combination of India's size and large variance in achievement give both the perceptions that India is shining even as Bharat, the vernacular for India, is drowning. Comparable estimates of inequalities in learning are the building blocks for substantive research on the correlates of earnings inequality in India and other low-income countries; the methods proposed here allow for independent testing exercises to build up such data by linking scores to internationally comparable tests.

http://www-wds.worldbank.org/external/default/WDSContentServer/IW3P/IB/2008/06/06/000158349_20080606082618/Rendered/PDF/wps4644.pdf

Underweight Prevalence Across States in India

Using GIS maps and data from National Family Health Survey-III (2005-06) I put this map together. (Click on it to get a bigger view) On average 46% of Indian children are malnourished. Imagine that - One in two children in India are malnourished. The map shows % of malnutrition prevalence across states in India. There are some patterns. Obvious ones are that northern belt the BIMARU states have high prevalence of malnutrition. But not so obvious ones are the extent of malnutrition in Gujrat and Maharastra - two of the most industrialized and richest states in India.

Cost of Capital Inflows into India

Large capital inflows in last few years have posed extraordinary challenges for the conduct of monetary policy for the Reserve Bank of India (RBI). Appreciating rupee, increasing sterilization cost, overheated asset markets, increased potential of crisis are some of the direct consequences of these flows.

Capital inflows into India have skyrocketed in the last year. Portfolio flows have picked up strongly on account of Foreign Institutional Investors (FIIs), amounting to Rs.70940 crore during 2007 as compared to an inflow of Rs.31289 crore in 2006. During the period of April-July 2007 FDI inflows were placed at US $ 6.6 billion as compared with US $ 3.7 billion in 2006. Also, there has been a 63 per cent increase in external commercial borrowings made by Indian companies during the first seven months of fiscal year 2007-08. Though large proportion of inflows are non-debt creating they are dominated by Portfolio flows which tend to be volatile and short term.

Exchange Rate

One of the most visible impacts of the flows has been rupee appreciation. The Indian Rupee has appreciated 16% since July 2006 against the US dollar (from 46.85 to 39.33 per US dollar). The 36-currency NEER and REER of the Indian rupee, on an average basis, appreciated by 12% and 12.86%, respectively, between July 2006 and September 2007. This indicates that Rupee has appreciated not only against the dollar, which has depreciated against almost all major currencies, but also against currencies of many of India's trading partners.

Export Competitiveness

Exchange rate appreciation is affecting the export competitiveness of Indian Industry as Indian exports become expensive in foreign markets while imports get cheaper. Some initial indications of the slowdown are reduced growth rates of exports (18.2% in 2007 vs. 27.1% last period) and increased growth rates of imports (non-oil increasing 44% in 2007 vs. 10.9% last period). The Mid-Year Review presented by the Finance Ministry shows that sectors such as textiles, handicrafts and leather, that have low import intensity, have experienced low export growth. The current account which saw a surplus from 2001-04 is predicted to face a deficit of 2.1% in 2007 and 2.6% in 2008 as per the IMF World Economic Outlook, 2007.

Reserves

The biggest challenges in the management of capital flows are the attendant implications for liquidity and overall economic stability. In order to limit the rupee appreciation due to the inflows RBI has been mopping up dollars in the foreign exchange market through interventions. In 2007, the Indian Foreign Currency Reserve accumulation was more than US $100 billion, making India's reserves fourth largest in the world at $266 billion after Japan, China and Russia.

In order to control inflation caused by the increased liquidity RBI uses several monetary instruments. These include issuing bonds under the Market Stabilization Scheme (MSS), absorbing liquidity through net reverse repos under the Liquidity Adjustment Facility (LAF) and increasing Cash Reserve Ratio (CRR). The total amount of issuances under the MSS has gone up by 159 per cent over the March 2007 level. In addition, liquidity absorbed in the form of net reverse repos under the LAF in 2007 was five times the amount in the corresponding period of 2006. The Cash Reserve Ratio (CRR) was raised by 150 basis points during April 2007-October 2007 to 7.5% over and above the cumulative increase of 100 basis points during December 2006-March 2007.

All these instruments have both direct and indirect costs; either as direct fiscal costs due to interest payments on the bonds or as indirect costs due to inefficiencies they introduce in the banking system. The interest rate paid on the MSS bonds is far higher than one received on the foreign currency reserves, which are mostly invested in US treasury bonds. This interest rate differential is a rough estimate of the cost borne due to MSS. As per Mid-Year Review 2007-08 estimates, the fiscal cost of sterilization would be around Rs. 8200 crore for fiscal year 2007-08.

Equity Markets
FII investments in equity markets have lead to a whooping increase of more than 200% in the BSE sensex since January 2005. Last year also saw the highest-ever mobilization of Rs.45,137 crore through public equity issues, comprising both IPOs and FPOs, according to Prithvi Haldea,CMD of PRIME, the premier database on the primary capital market. This is 83 per cent higher than the previous year. Though markets have sky-rocketed, the volatility in markets has increased.

Source: Security and Exchange Board of India (SEBI)

As seen in the corresponding graph, FII investments fell abruptly in Feb 2007 along with the collapse of global markets caused by drops in the Chinese markets. The end of summer and late December FII flows turned negative due to renewed concerns about the US financial crisis. Although there was no fundamental change in or related to the Indian economy, each of the aforementioned occasions have resulted in a nose-dive drop in the Indian stock markets. A shock in an unrelated emerging market economy or shocks in developed countries, that makes investors reassess risk and flee to safety, can cause inflows in India to dry up. Given the prolonged rally in the Indian markets and financial crises in developed countries, such risks have increased exponentially. Such a halt in inflows can lead to higher exchange rate fluctuation (even a significant depreciation of the Indian currency), stock market collapse, current account imbalance and affect India's long term growth prospects.

In the 1990’s East Asian countries like Malaysia, Thailand, Indonesia experienced high growth rates and huge capital inflows. Despite a lack of significant or fundamental change in the economies of these countries in 1997 the inflows suddenly stopped and even reversed, resulting in severe recessions in these countries. Several Latin American countries have witnessed similar episodes of sudden discontinuation of inflows and recession. There is no evidence suggesting that India is immune to similar events. To avoid such economic depressions and tribulations, India needs to manage its flows carefully.

The Reserve Bank of India and the Government of India have tried unsuccessfully to reduce capital inflows. In its Annual Policy Statement for 2007-08 and Mid-term Review of Annual Policy, RBI announced a host of measures to liberalize overseas investments such as; enhancement of the overseas investment limit for Indian companies to 400 per cent of their net worth from the existing limit of 200 per cent; increase in aggregate ceiling on overseas investment by mutual funds to US $ 5 billion from US $ 3 billion; enhancement of the limit for individuals for any permitted current or capital account transaction from US $ 50,000 to US $ 200,000 per year. In August, 2007 RBI also put end use restrictions on External Commercial Borrowings (ECB's), which required borrowers raising more than USD 20 million to park the ECB proceeds overseas for use as foreign currency expenditure. However, none of the measures have helped. Outflows remain a small fraction of the inflows and ECB's continue to rise.

Given the increasing cost of inflows indicated by lower export competitiveness, rising fiscal costs due to sterilization and increased risk of crisis, the Finance Ministry and RBI should take more concrete measures to manage India's inflows. In the Mid-Year Review and various public statements, the Finance Minister has acknowledged the costs and risks to growth due to the inflows. However, the Ministry has been reluctant to impose any form of capital controls or limits on inflows. RBI Governor Y.V. Reddy has hinted that he would be ready to take a more flexible approach and even consider some controls.

While some Latin American countries that have faced similar patterns in capital inflows have experienced recessions in the past due to sudden stops, others have found better ways to deal with such inflows. For example, various economists, including Nobel Prize winner Joseph Stiglitz have praised the Chilean government for managing its flows by using reserve requirements. Chile's strategy of has been succesful at discouraging short term flows, with no affect on long term flows. Chile accomplished this by placing reserve requirements on all inflows for a short time period (a percent of inflows were deposited with the central bank, with no yield or returns to the investors). The reserve requirements’ then were changed depending upon the amount of flows.

India should learn about the cost of its capital inflows, from other countries that have witnessed similar patterns of growth and the unforeseen decline that tends to follow. At the least, India should learn from countries like Chile and figure out ways to manage its inflows in order to avoid similar economic catastrophes.