Friday, September 26, 2008

The Crash of Titans: Making Sense of a Financial Carnage

The current crisis in the international financial markets reminds me of a quiet sunny morning in December 2004. We were driving down NH-47 in Kerala and, as we neared Kollam, there seemed to be anxious people crowding everywhere - ambulances and police jeeps wailed to and fro; vehicles going with their headlights on in broad daylight. When we stopped to ask what happened, somebody simply said, "കടല്‍ കയറി" (the sea climbed out).

It seemed such a strange reason because we could still see the sea glinting in the evening sunshine, looking as peaceful as ever. Only when we reached home and turned on the TV did we realize the magnitude of the disaster. This was a Tsunami, a monster that sprang out of an earthquake 4000 km away, off the coast of Sumatra, Indonesia. It had killed about 20,000 people in India alone.

The recent disasters on Wall Street may not kill so many people directly but its impact is just as catastrophic. America's fourth largest investment bank, Lehman Brothers, has filed the biggest bankruptcy petition known to mankind. Just how big? - $ 613 billion. - more than three times the current annual budget of Government of India. About 30,000 people are expected to lose their jobs globally (at least 2,500 in India).

World largest insurer American International Groups (AIG) is going hat in hand to US Fed., JP Morgan and Goldman Sachs, for a $85 billion lifeline. Meryl Lynch has been bailed out by Bank of America.

Things may look sunny & peaceful in India but that is perhaps because Indian firms have not disclosed client-specific details.

How will this drama unfold? Prof. Prof. Martin Feldstein of Harvard University, puts it this way -
"Declining house prices are key to the financial crisis and outlook for the economy, because mortgage-backed securities, and the derivatives based on them, are the primary assets that are weakening financial institutions. Until those prices stabilize, these securities cannot be valued with any confidence."
Now that's quite a mouthful. Its easier to chew if you take the key words separately -

Mortgage-Backed Securities

This is the crux of the problem. Thanks to cheap credit and inflated expectations, millions of not-so-credit-worthy Americans were able to buy their own houses during the early 1990's. Banks gave them home-loans (mortgages) at special discounted rates (Sub-Prime Lending). These were "no recourse" loans, so if the home-owner defaulted the creditors could take the house but not other property or income to make up any unpaid balance.

When the home-owners started defaulting on their installment (EMI) payments, the banks had already packaged and "sold" their loan portfolio as bonds & derivatives to institutions that were ultimately owned by financial giants like LehmanBros.

People who could not pay their EMI's simply abandoned neighborhoods and cities. In Monero Valley, 60 km east of Los Angeles, about 2 million people have moved away.

Derivatives & Principal Transactions

Traditionally, financial firms were advisers and intermediaries to institutional investors (insurance cos., pension funds, mutual funds) but, over the years, they themselves got involved in "Principal Transactions" - using partners' or shareholders' money to bet on stocks, bonds and other securities.

LehmanBros' own shareholder investment was only $23 billion (2007) but it relied heavily on borrowed money ("leverage") worth almost $700 billion! So the leverage ratio here was 30 to 1 ($700/$23). Fannie May and Freddie mac, America's biggest mortgage lenders had a leverage ratio of 60 to 1!

Robert Samuelson explains the game nicely in Newsweek -

"Leverage can create huge windfalls. Suppose you buy a stock for $100. It goes to $110. You made 10 per cent, a decent return. Now suppose you borrowed $90 of the $100. If the price rises to $101, you've made 10 per cent on your $10 investment, (Technically, the price has to exceed $101 slightly to cover interest payments.). If it goes to $110, you've doubled your money. Wow."

So, in this maze of dubious bonds and baseless derivatives, nobody really knows who is holding the lemons. Thanks to this uncertainty and broken trust, few want to lend, and fewer are willing to borrow. House prices have crashed, reducing household wealth and consumer spending. Employment and salaries have come down; higher prices of food and energy have worsened matters.

American institutions are trying to prevent a complete paralysis by injecting the patient with billions worth of tax rebates and bail outs. Will it work? Everybody is watching very carefully.


References / Links:

* The Economist - "The end of the dream?" Aug 14th 2008 MORENO VALLEY
* "Bubble, bubble, toil and trouble" - Martin Feldstein, Professor of Economics at Harvard University
* "Risky Business" - Robert L. Samuelson, Newsweek
* Wall Street transforms U.S. presidential race - P. Sainath, The Hindu, Monday, Sep 29, 2008
* What else could $700 billion buy? - Nancy Benac, AP / Star News Online Sep. 30, 2008


Addendum, 15 Jul., 2010

Here is another illustration of Derivatives Game from the book "The Dignity of a Nation" by the Japanese mathematician, Fujiwara Masahiko:

Originally derivates acted as a risk hedge. they were a means of avoiding the risk associated with things like product prices, interest rates, and exchange rates, whose future movements were unclear. Recently, however, derivatives have started to be used for speculative purposes.

Let us say, for example, that Mr. A thinks that the stock of Company B, currently worth 1,000 yen, will be higher in three months time. Mr. A only pocesses cash resources of 3 million yen, but by making use of derivatives, he just needs to put down that 3 million yen as margin money and he can buy the right to acquire 100,000 shares of B company at the current 1,000 yen price in three months time. With a margin payment of a measly 3 million yen, Mr. A has thus bought the right to purchase 100 million yen's worth of shares.

Let us say that the shares rose as Mr. A anticipated and hit 1,500 yen. A has the right to buy 150 million yen's worth of shares for 100 million, he has made a profit of 50 million minus 3 million yen. If the share price goes down and Mr. A does not exercise his right, he gets off with a loss of his margin deposit of 3 million yen.

Conversely, let us imagine taht Mr. A thinks that the shares of Company B will fall in value. In this instance, Mr. A can use the same margin payment of 3 million to sell the right to purchase 100,000 shares (worth 100 million yen) at the same 1,000 yen price as now in three months time. But the seller, in return for getting the margin payment of 3 million yen, cannot run away from the deal. If the share falls as Mr. A anticipates, the buyer will abandon his right with the result that Mr. A pockets the 3 million yen as profit. If, however, the share price rises from 1,000 to 1,500 yen, the privious scenario is reversed. Mr. A has to procure shares at the current value of 150 million yen and sell them at the agreed price of 100  million yen, making a loss of 50 million yen minus 3 million yen.

...With derivatives, what you are buying and selling is a right. Since this creates no immediate profit or loss, derivatives are not recorded on the balance sheet, with the result that large-size companies can go unexopectedly bankrupt.

Life On A Balcony

This year we barely got a taste of the fierce Delhi summer. Every time the mercury crossed the 40s, rain clouds would appear out of nowhere, and leave the city drenched, hot and sultry. It has been wonderful for the plants and trees, though.

Potted plants on our balcony never had it so good. Four months of regular rainfall has made us all feel like green thumbs. But the lush greenery has also attracted many guests, many of whom I have been unable to identify.

On top of the list is this caterpillar that appears only on one our two palms. Eggs are tiny (1 mm diam.), red hat like structures that break open to release red grubs that promptly cut out rectangular bits of the leaf to make themselves at home. A few days, and a few half-eaten leaves later, they reach this size (5 cm) and thread some leaves together to make a pupa.

I have never seen the creature that flies out... What could it be? - a butterfly, a moth or a dragonfly?

On the same palm, this fungus (?) turned up on a dry leaf. Does this delicate, stamen-like thing have a name?

This insect appears only on our Tulsi plant...

The last visitor is this butterfly. It seemed fresh out of its cocoon, waiting for the sun to stiffen its wings...

Can somebody help?

Answers from Shaku (University of Georgia, Atlanta) -

1) The larva (caterpillar) of a skipper butterfly - family Hesperiidae, Order Lepidoptera. I really cant identify it to species level without taking a closer look, but if it was the adult, it would have been much easier. You can identify skipper larvae by the constriction between the head and the rest of the body. And they're not usually seen in the open - they always make little cases for themselves out of leaf bits, etc.

2) I'm pretty sure they are not fungal structures, but the eggs of a green lacewing - family Chrysopidae, Order Neuroptera. Lacewing eggs are among the cutest insect structures that can be seen with the naked eye - because they are stalked!

3) Those are the nymphs of the tulsi lacebug (Ocimum tingid) Cochlochila bullita (Family Tingidae, Order Heteroptera). They suck the sap from the leaves and the leaves become speckled with white and ultimately dry up. If the damage is only on few leaves, pluck those leaves and burn them. If it has affected most of the plant, give a spray of mild soap solution - take care to spray undersides of the leaves also. I won't suggest any pesticide for home garden.

4) That is most definitely the Red Pierrot (Talicada nyseus), family Lycaenidae, Order Lepidoptera. Although the common name for the family Lycaenidae is "Blues and Coppers" because most members come in shades of blue or copper, there are exceptions like this one. You can tell its a Lycaenid, from the little tail at the rear end of the wing (the orange half).

Interesting Links (nice pics, but no answers here!):

* Some Indian Butterflies - by Amber & Abha Dev Habib
* Indian Butterflies -

Tuesday, September 16, 2008

Yen Loan Projects in India

What is common between the Bhakra Nangal & Hirakud Dams, the Durgapur Steel Plant and the Metro’s at Calcutta & Delhi? -- They were all built using concessional loans under Japan’s Official Development Assistance (ODA), commonly known as “Yen Loans”.

Japan’s first Yen Loan was extended to India in 1958 in the wake of Prime Minister Nehru’s visit to Tokyo, to supplement funds for the Second Five-Year Plan. Since then the flow of ODA loans has steadily increased over the years. Last year's loan-commitment to India peaked to a record Yen 225.130 billion (~ Rs. 1000 Cr. / $ 2.085 billion).

India is now the largest recipient of Yen Loans, having surpassed China in 2003. As of 11th March 2008, 53 projects worth Yen 822.615 billion (i.e., about Rs. 30,436.75 Crores / $7.6 billion, at current rates) are under implementation with Japanese loan assistance. Cumulative Japanese ODA loan commitment to India has reached Yen 2662.56 billion (Rs. 101,497 Cr. / $ 25 billion).

To put these figures in perspective, the World Bank has 63 active projects in India, with a net commitment of about $ 12.7 billion (Jan. 2007). India's annual budget for 2008/09 is Rs. 7.47 trillion ($187.68 billion) and and its GDP crossed $ 1 trillion in April 2007.

Why does the Government of India borrow so much from a bilateral agency? How are the loan-projects selected? How is the money obtained and used? This article attempts to answer some of these fundamental questions.

Government of India has come a long way from the days when it mortgaged its gold reserves to meet a balance of payments crisis. It now sits on a pile of forex reserves worth over $ 300 billion. And yet, every year, it borrows money from the World Bank, ADB and Japanese ODA, especially for building social and physical infrastructure across the country. These “soft-loans” from multilateral and bilateral agencies are cheaper than commercial borrowings but they come with “conditionalties” that are not so easy to swallow, let alone digest. But it is precisely these conditionalities that make the loans worthwhile for the Government of India.

Loan projects are usually implemented under a tough set of guidelines that ensures the implementation of the projects using international best practices in contracting, technology-selection and project management. At the same time, they force the borrower to take a hard look at efficient management of their own institutions and resources. This, of course, is the expectation - the ground realities can turn out to be somewhat different.

Once a Loan Agreement (LA) and Project Memorandum get signed, the ‘die is cast’ and it becomes the template for duration of the project. The scope for political interference, mid-course changes, and corruption is rather limited. After all, this is borrowed money guaranteed by the State, and it has to be repaid.


The Japan Division at the Bilateral Cooperation Division of Department of Economic Affairs (DEA) at the Indian Ministry of Finance is responsible for raising and monitoring external borrowings. The DEA receives numerous loan requests every year from the states and quasi-government agencies. The proposals include detailed documents justifying the necessity, techno-economic feasibility, environmental & administrative clearances, as well as its relevance to national & state development plans.

On the Japanese side, ODA loans were originally administered directly by the Ministry of Foreign Affairs (MoFA). The Overseas Economic Cooperation Fund (OECF) handled the loans till 1st October 1999 when it was merged with the Japanese Exim Bank (JEXIM) to form Japan Bank for International Cooperation (JBIC), creating an agency with a portfolio of investments & loans totaling Yen 21.750 trillion (Rs. 870,000 Cr. / $ 174 billion).

From 1st October 2008, the yen-loan division of JBIC will be merged into Japan International Cooperation Agency (JICA). About 300 JBIC employees are expected to join JICA's existing workforce of 1400.


Once the applications are short-listed under a list of potential projects called the “Rolling Plan”and sent to the Embassy of Japan. The proposals then follow the following steps in what is broadly known as the “ODA Loan Cycle”-

  1. Appraisal by relevant agencies in Government of Japan (GoJ)
  2. Submission of a “Prior Notification” or “Pledge” by GoJ to Government of India (GoI)
  3. Loan Agreement Consultation for finalizing the terms & conditions
  4. “Exchange of Notes” between GoJ and GoI
  5. Signing of “Loan Agreement” and “Project Memorandum” – this all important document specifies the legal rights and obligations of all parties concerned, with respect to purpose, scope, content, loan amount, duration, repayment period, procurement & disbursement procedures.
  6. Implementation of the Project - Usually begins with the selection of an international Project Management Consultant (PMC) by the Executing Agency (EA-loan recipient), followed by procurement of materials and equipment required for the project.
  7. Completion / Ex-post Evaluation and Follow-up - to draw lessons for future projects.


The Yen Loans are primarily aimed at creating socioeconomic infrastructure. The present rate of interest is 1.2% for general projects and 0.65% to 0.75% for projects in the environment sector. The loans come with a “moratorium period” of 10 years and have to be repaid in 30 years (40 years for environmental projects). In effect, the repayment starts 10 years after the Loan Agreement (LA) and continues for the subsequent 20 or 30 years respectively.

Once a loan is committed, it is the responsibility of the borrower to avail the money within the agreed time frame. In order to improve the availment efficiency rate, and to discourage procrastination, a "Commitment Charge" of 0.1% (half-yearly) has recently been introduced on the undisbursed loan from the date of effectuation of the loan agreement. At the same time, the 0.1% "Service Charges" for each disbursement has been withdrawn.

Interest accrued during the implementation phase (IDC – interest during construction) gets deducted from the loan amount.

In order to ensure transparency and accountability, the borrower has to appoint a renowned international consultant to oversee the project. This consultant, in turn, helps the borrower not only in implementing the project according to the ODA guidelines, but also in generating the necessary progress reports.

Consultants are usually expensive - they get paid up to 3.5% of the loan amount. Borrowers are usually queasy about spending so much of their loan on consultants - especially when they have to be selected only through a QBS (qualifications based selection) process. But the guidelines make it amply clear that their services are required for –

  • Pre-investment studies: prioritizing projects, evaluating viability (economic, technical, financial, commercial), environmental & social matters;
  • Preparation services: detailed investigations and review;
  • Implementation services: supervising procurement procedures & construction work.

For the benefit of borrowers who may need additional help, there is a Special Assistance Facility (SAF) for project formation (SAPROF), for implementation (SAPI), for sustainability (SAPS), and for procurement management.

At the very outset, the loans are divided into “tranches”, and further sliced-up into contracts. Disbursement of the loan is linked to satisfactory implementation of the contracts through any of the following methods –

  1. Reimbursement
  2. Transfer – Direct payment to contractors on submission of attested “claims”
  3. Commitment – Forex payments through a Letter of Credit (LC)
  4. Special Account – Advance payment to borrower’s account

As soon as the moratorium period is over for each project, the Government of India starts repaying the loan through its designated bank (Bank of India) in Tokyo. All transactions related to disbursements and repayments are overseen by the Comptroller of Aid Accounts & Audit (CAAA – Ministry of Finance).

Until recently, the Indian Ministry of Finance used to pass on the loan to the recipient state government with a certain mark-up, through a complex “70-30” scheme. Following the recommendations of the 12th Finance Commission (1 April 2005), the Yen loans are now passed on to the borrowers “back to back”, at exactly the same rate that was agreed during the Loan Agreement.

A portion of the yen-loans also goes towards private sector investment, business activities in developing countries and development-related research work.


As of 10 March 2008, India has 202 active Yen-Loan agreements with the Japanese Government, aggregating to a total of Yen 2,662.56 billion (Rs. 106,502 Crores; ~ $25 billion). The earliest of the loans being repaid by Government of India is a 1976 “Commodity Loan” to DEA. It was a “partially untied” loan of Yen 7 billion (Rs. 280 Cr. today), lent at the rate of 3.5% payable over 25 years, after a moratorium or ‘grace period’ of 7 years. The range and scope of yen-loans has expanded over the years, while the interest rates have come down to the 0.65% - 1.2% range.

The loan projects vary in size and scale. The smallest loan now is Yen 84 million (Rs.3.36 Crores in 1990) towards engineering services for the Indira Gandhi Nahar project, and the largest single Loan Agreement(LA) so far has been for the Delhi Metro – Yen 59.296 billion (Rs. 2372 Cr., 2004).

The top five projects, in terms of amount committed, are –

  1. Delhi Mass Rapid Transport Project (V) – Yen 59.296 billion (Rs. 2372 Cr., LA-31/3/2004; RoI 1.3%)
  2. Anpara B Thermal Power Station Construction Project – Yen 49.801 billion (Rs. 1992 Cr.; LA 23/01/1991; RoI 2.5%)
  3. Bangalore Metro Rail Project – Yen 44.704 billion (Rs. 1788 Cr., LA 31/03/2006; RoI 1.3%)
  4. Gandhar Gas Based Combined Cycle Power Project (II), NTPC – Yen 42.599 billion (Rs. 1704 Cr.; LA 09/01/1992; RoI 2.6%)
  5. Hyderabad Outer Ring Road Project Phase-I – Yen 41.853 billion (Rs. 1674 Cr.; LA 10/03/2008; RoI 1.2%)

Even a cursory glance at the projects reveals that some states are better than others when it comes to wooing external lenders. Presently, Uttar Pradesh leads the pack with 17 projects, taking 13.77% of the loan-pie. UP is followed by Andhra Pradesh (12.95%), Delhi (11.96%), West Bengal (9.37%) and Karnataka (8.52%).

The distribution of loans is closely linked to the priorities of both governments, as well as the ability of borrowers to make convincing, competitive packages of their loan requirements.


Note 1: Exchange rate used - Yen 100 = Rs.40; $1 = Rs.40
Note 2: Japanese ODA & China - Even though net ODA to China has been declining since 2001, China continues to top the list of borrowers. As of December 2007, China had 365 active yen-loan projects, worth Yen 3316.48 billion (Rs. 132,660 Cr. / $ 34 billion) - about $10b more than India.


References / Links:

* Indian Ministry of Finance - Department of Economic Affairs (DEA) – Japan Division
* Outline of Japan’s ODA to India - Ministry of Foreign Affairs (MoFA), Japan
* “Japan’s ODA Loans – 50 Years in India” – Booklet printed by JBIC in 2008

* “World Bank to Help India Achieve UN Goals”, IANS/IndiaPRwire, 12.02.2007

* Message from the JBIC Governor – Hiroshi Yasuda, JBIC Review (PDF)
* JBIC Financial Statement FY ending March 2008 - JBIC Homepage

* JBIC Homepage- Economic Cooperation (ODA) Division
* JBIC - Types of Japanese ODA Loans
* ODA Project Cycle
* ODA - Special Assistance Facility
* "Japan Cutting Yen Loans to China" - Reuters - 6 March 2007
* Overview of Japan's ODA to China : MoFA-Japan
* Country Assistance Program for India (2006): MoFA-Japan

* Aid Audits & Accounts Division, DEA, Ministry of Finance (India)
* "What Caused the 1991 Currency Crisis in India?" - IMF Staff Papers

* JBIC-Watch - An NGO network for monitoring Yen-Loan projects

Friday, September 12, 2008

The Downside of "Kerala Model"

I've often wondered why the much vaunted "Kerala Model" of development is mocked by the people of Kerala themselves.

"You call this development?", they ask, "We get our foodgrains from Andhra Pradesh, vegetables from Tamil Nadu, our shops are stocked with goods made elsewhere and our politicians flail helplessly, taking the state from one financial crisis to another".

It turns out that the one of the biggest achievements of the Kerala Model - land reforms - is exactly what led to a steady decline in food production in the state. Land reforms had been implemented as a means to redistribute land, not to raise productivity. Instead of leasing out land to prospective tillers, the people who received the land, the erstwhile tenants, were not required to cultivate the land given to them. These tenants were merely the intermediaries between the landlords and the laborers.

Since there was no economy of scale in tilling small plots of land, they merely treated it as a piece of real estate that was quickly sold off when Gulf-jobs beckoned in the mid 1970s.

"Imagining an Economy of Plenty in Kerala" - Pullapre Balakrishnan, EPW, 17 May 2008

Tuesday, September 02, 2008

Notes From Kangra Valley

How things have changed in a decade!

The valley is now crowded with buildings, the roads looked like they had not been mended since my last visit. At McLeod Ganj, the vendors along Jogibara & Bhagsu roads selling sun-dried pork had been replaced by swank pizza joints; Mrs. Naoroji's shop had been reduced to an empty showpiece and strange new rules restricted the flow of public transport after dusk.

Tsuglagkhang Complex, McLeod Ganj

Is the public display of rage linked to the price of vinyl posters? It certainly seems so at the 'Tibetan Capital-in-Exile'. Huge banners and posters now dot the streets and chowks of McLeod Ganj, listing the brutalities committed by the Chinese in Lhasa; pamplets pasted on the lamp-posts and walls urge the world to boycott the Beijing Olympics.

Inside the Tsuglagkhang complex, it looks like a mini India now. People in a wide range of costumes and languages pay their respects at the Dalai Lama's shrine. It is difficult to make out who is Tibetan and who isn't.

Club Mahindra Kangra Valley, Dharamsala

If you've already seen other Club-M properties, this one is a clear let down. "Club Mahindra Kangra Valley, Dharamsala" is actually 14 km away from Dharamsala, closer to Yol, on the on a road to Palampur-Mandi. After having seen the spacious gardens and neat cottages at Binsar and Coorg, this place looked like an isolated, pathetic hotel along a dusty, noisy, state highway.

The building itself was unremarkable - just the usual tinted glass windows on the outside; a small cemented parking area; a foyer at two levels shared by a restaurant, bar and reception desks. A wooden staircase connected each of the four floors that housed 8-10 rooms.

If there was one thing that reminded you that you were not at another dodgy hotel but at a Club-M property, it was the staff. All of them, without exception, were smart and well groomed. A couple of them manned the reception area, a few were busy with housekeeping and room-service, and most of them were outside enjoying a game of cricket on the sunny lawns.

But what about the guests? The front-desk had claimed 70% occupancy but there was no sign of anybody. The parking lot was practically empty, the rooms were silent (no sound of kids, TV) and the dining hall at lunchtime was full of empty chairs. Perhaps all the guests had gone elsewhere in search of "family-fun-forever".

Our room reasonably spacious. It was not the 'studio apartment' we expected (no kitchenette, no balcony, no carpets). It had chunky furniture and a badly designed bathroom (the "exaust fan" actually blew air inwards) but the view from the windows was almost priceless. 'Almost' because you only had to ignore a few ugly buildings located next to the resort, to let your eyes sweep across the little emerald-colored rice fields and orchards, up the slopes of the nearest hills, past the fluffy clouds, up the sheer cliffs of the Dhaula Dhar Range, until you caught a glimpse of the Manimahesh Kailash peak (5656m).

You could sit by the window all day, watching the clouds romancing the mountains; imagining the panorama that would unfold if you were with the eagles flying high above...If you went soaring through the thermals over Kangra valley, just across the mountains lay Chamba valley - just 20km away. Or if you flew eastwards, road connecting Manali to Rohtang La was just 60km away. No wonder so many hang-glider's come to Bir!

Getting There: We took an overnight train Jammu Mail to Pathankot (~484km, 10 hours, Rs. 500, ) and from there, by taxi (90km; 4 hours, Rs. 2000!) to Kangra Valley. A better option would have been to take the overnight HRTC volvo-bus service from Delhi (11 hours, Rs. 660). The buses would have allowed us to completely bypass the taxi unions and their obscene rates.
There is a brand new airport at Gaggal but it is serviced only by Deccan and an unfamiliar company called MPLR Airlines. Flights from Delhi cost about Rs. 4500.

Getting Around: If you have a choice, come in your own car. If you have the time, stick to the local buses and "share-cabs" . The local taxi union sincerely believes in fleecing the tourists, so a one-way, 14 km drive from Sheela Chowk to McLeod Ganj will set you back by Rs.350. A bus-ride will cost you Rs. 20, at the most.