Investment Must Lead The Way For Economic Revival

The Reserve Bank of India was once again at the center of a expectations led rally -- that it would cut repo rates on October 30, while announcing its second quarter review of the 2012-13 monetary policy. Instead, RBI cut the cash reserve ratio (CRR). Here is my op-ed piece in The Economic Times, carried the next day:

The rate cut lobby should be worried for two reasons. The first one is obvious: despite their high-decibel clamour, RBI governor D Subbarao has not relented an inch. He is steadfast about holding interest rates till the rate of inflation blinks first.

In short, his message remains unchanged: interest rates won't budge till inflation does. But the second reason is far more worrisome. It depicts a state of economic stagnation that even deep rate cuts cannot remedy. The pointers lie in the second quarter review of the 2012-13 monetary policy.

Subbarao once again cut the cash reserve ratio (CRR, a mandatory provision that requires banks to maintain a fixed portion of their deposits with RBI) by 25 basis points, down to 4.25%, releasing an additional Rs 17,500 crore of funds into the system, which the central bank fondly hopes will result in credit growth to productive sectors.

This is the fourth time in the last one year that RBI has cut CRR; in fact, in the last 12 months, CRR has been pared down by 175 basis points. That is not all. Further, the central bank has cut statutory liquidity ratio, another mandated reserve that requires banks to invest a portion of their deposits in government securities, cut the benchmark repo rate by 50 bps in April and made liquidity available through export refinance schemes. Outside the policy framework, the central bank has been conducting open-market operations regularly and daily liquidity adjustment exercises.

It is, therefore, a bit surprising that despite the RBI's repeated emphasis on pumping additional rupees into the economy, attention seems to be still focused on petitioning for a cut in the repo rate, rather than worrying about drying up liquidity. And, significantly, this recurring deficit in liquidity is symptomatic of another economic crisis: slowing down of economic growth.

Apologists will argue that cutting rates is probably the only elixir for reviving growth. If that is indeed true, then the economies of US, Europe and Japan should have been growing at supersonic speeds, given their near-zero nominal interest rates. Look at the malady — the liquidity shortage — first.

The policy document of Tuesday states, "The wedge between deposit growth and credit growth, in conjunction with the build up of the Centre's cash balances from mid-September and the drainage of liquidity on account of festival-related step up in currency demand, have kept the systemlevel liquidity deficit high, with adverse implications for the flow of credit to productive sectors and for the overall growth of the economy going forward."

Data released by RBI on October 26 shows that aggregate deposits with the banking system has grown (on a year-on-year basis) by only 13.9%, compared to 17.5% growth in the previous comparable period. However, credit has grown by 15.9% (against 19.5% in the previous period).

While the wedge between deposit and credit growth seems to have narrowed during Q2 2012-13, compared to the wide gap that existed during Q1, the difference is still cause for worry. For one, the slowing down deposits growth is a direct manifestation of the slowing down savings rate in the economy. The continuing high inflation rates have dampened real interest rates, making financial instruments (such as fixed deposits) relatively unattractive compared to physical assets (such as gold).

Alower savings rate is bound to translate into a lower investment rate. It is by now common knowledge that one of the ways to kick-start growth in the economy is to rejuvenate the investment climate. In fact, some of the government's recent policy pronouncements have focused on improving the pace of investments in the economy. And, without the investment rate looking up, the savings rate is unlikely to improve, thereby worsening the feedback loop.

Therefore, the RBI policy document makes it clear that the recent spurt of feel-good announcements is not enough to warrant a cut in interest rates. The statement does not mince words, "...recent policy announcements...that have positively impacted sentiment, need to be translated into effective action to convert sentiment into concrete investment decisions."

In the meantime, the CRR cut is not only expected to boost liquidity but is also likely to have some salutary effect on lending rates as well. While the RBI is loath to directly signal lower interest rates in the system right away, lest they rekindle inflationary expectations once again, the CRR cut is an apt signalling tool: it might still induce some banks to lower their lending rates, depending on each individual bank's balance sheet. This way, Governor Subbarao can still tick both the inflation and growth boxes on his to-do list.

Hormones And The Trading Floor

Here is the review of an interesting book that I wrote for Business Standard. The book is titled "The Hour Between Dog and Wolf: Risk-Taking, Gut Feelings and the Biology of Boom and Bust" and it's been written by a Wall Street banker turned neuroscientist, John Coates.

Folklore is full of stories about shape shifters, men turning themselves into wolves or other fierce beasts at the stroke of midnight on a full moon night. What probably gave birth to the myth was the chilling sight of vicious, bloodthirsty marauders on the rampage in ancient times. These intruders often wore wolf skins (or bear skins in some cases) for protection against the cold — and, maybe, to generate a sense of dread. Whatever it was, the ploy seems to have succeeded and a horror story was born, giving rise to a cottage industry of books and movies about imaginary werewolves.

A link was created between the shifts in lunar patterns and changes in physiognomy. While the apocryphal might seem absurd to the untrained eye, there is a whole lot going on just below the surface. The symbolism of man turning into beast has held the interest of assorted scholars for centuries. At the same time, philosophers and scientists began to peer inside the mind, trying to figure out whether the brain had any role in all this.

And now Wall-Street-trader-turned-neuroscientist John Coates comes racing down these old, familiar neural paths with a new gig in town. He shows how human beings think with their bodies in addition to their brains. Using the familiar setting of a bank’s dealing room, Mr Coates explores the impact risky situations can have on the mind as well as on the physiology. He shows how, when confronted with the threat of risk, biology takes over and transforms us into different people. Hence the analogy between dog and wolf.

Mr Coates shows how there is feedback loop mechanism between the body and the brain, and the two act on each other to prepare the entire being for responding to different situations — elation, depression, fear, grief, rage and so on. Using the events that led to the financial crisis in 2008, Mr Coates tracks the different desks and their dealers on the trading floor. The sequence of events and the reaction of the traders – we do not know for sure whether they’re real or fictional – set the stage for him to build his hypothesis.

Ask anybody on the Street about the reasons behind the 2008 financial crisis, and nine out of ten will probably tell you that untrammelled greed caused it all. Mr Coates, however, has a different take. He argues that the frequency of financial meltdowns has increased over the past few decades. One of the reasons is the fundamental change in the nature of the markets — deregulation, opening up of new markets across the globe (especially Asia), lower interest rates, relaxed margin requirements and easy liquidity. But there is another pressing reason: traditional partnerships on Wall Street and London have been replaced by corporate structures that have (supposedly) shifted the priorities from long-term stability to short-term profits.

But, importantly, the market volatility ensuing from these changes has been heightened on both sides of the curve, primarily due to the traders’ biological reactions to enhanced opportunities and threats that occur far too frequently now than in the past. Mr Coates believes that the risk curve might have been amplified because of hormonal build-up in the body of the traders, thereby shifting their risk preferences to extreme levels.

This is what he says: “...under the influence of pathologically elevated hormones, the trading community at the peak of a bubble or in the pit of a crash may effectively become a clinical population. In this state it may become price and interest-rate insensitive, and contribute greatly to the violence and intractability of runaway markets...”

Therefore, the familiar exercise of risk modelling now needs to add another important variable to the stew pot — the clinical state of the trading community under extreme scenarios. This leaves room for a sequel: how to assign values to different emotional states.

It’s an interesting book written from an interesting perspective. Given the huge success of books attempting to decipher what’s going on inside the skull – the popularity of Vilayanur Subramanian Ramachandran’s books (Phantoms in the Brain, for example) is ample testimony to this phenomenon – Mr Coates has a novel approach. He has married his two familiar stomping grounds, the brain and the trading floor. But then, the thesis accords a secondary role to another critical ingredient in the mix: the role of perverse incentives. Seen in that context, it might be a bit too glib to explain away all that has happened to only hormones and changes in the body’s chemical balance. There is one way to test this hypothesis: try explaining it to those in the manufacturing sector who have lost their jobs because of the excesses in financial services.