Grasshopper & the Ant

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The FT columnist, Martin Wolf has come up with the all-time-favourite Aesops fable to explain the ongoing "global financial crisis".

In this version, ants are Germans, Chinese and Japanese, while the grasshoppers are American, British, Greek, Irish and Spanish.

Ants produce enticing goods grasshoppers want to buy. The latter ask whether the former want something in return. “No,” reply the ants. “You do not have anything we want, except, maybe, a spot by the sea...”

In the end...

...the leader of China’s nest tells America: “We, your creditors, insist you stop borrowing, just as European grasshoppers are now doing.” The leader of the American colony laughs: “We did not ask you to lend us this money. In fact, we told you it was a folly. We are going to make sure American grasshoppers have jobs. If you do not want to lend us money, raise the price of your currency. Then we will make what we used to buy and you will no longer have to lend to us.” So America teaches creditors a lesson from a dead sage: “If you owe your bank $100, you have a problem; but if you owe $100m, it does.”


The Chinese leader does not want to admit that his nest’s huge pile of American debt is not going to be worth what it cost. Chinese people also want to go on making cheap goods for foreigners. So China decides to buy yet more American debt, after all. But, decades later, the Chinese finally say to the Americans: “Now we would like you to provide us with goods in return for your debt to us. Thereupon, the American grasshoppers laugh and promptly reduce the debt’s value. The ants lose the value off their savings and some of them then starve to death.


What is the moral of this fable? If you want to accumulate enduring wealth, do not lend to grasshoppers.

The story is obviously an over-simplification. But it has provoked comments that are even more interesting.

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Full Article:

Wolf, Martin (2010), The Grasshoppers and The Ants - A Modern Fable, Financial Times, 25 May 2010 - http://www.ft.com/cms/s/0/202ed286-6832-11df-a52f-00144feab49a.html

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.


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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

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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.

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.

INSTITUTIONS INVOLVED

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.

THE LOAN CYCLE

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 TERMS & CONDITIONS

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.

THE PRESENT SCENARIO

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.

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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.

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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

Islamic Finance - Sukuk?

What is Islamic Finance? If Sharia prohibits lending of money based on interest, how will bankers survive?

This paradox disappears when you’re sitting on a pile of petrodollars. When you have financial assets of more than $500 million, expanding at 15-20%; when global banks vie with each other for your funds, you’d better take a closer look at Islamic Finance!

The religious view is that receiving high rates of interest on money lent to a poor debtor violated justice. Underlying this precept is the view that money was something that symbolized economic value and was significant only as a means of preserving that value. Therefore true value was preserved only if it was invested in real assets. So, under Islamic finance, transaction in real assets is based on sharing of profit and loss between the lenders and the borrowers.

This may sound Utopian fact is that there is a growing market for innovative instruments offered by Islamic finance. Some of them are –


Murabaha: Similar to installment sales contract

Istisna: A variation of Murabaha applied to housing loans

Ijara: Corresponds to a lease agreement

Musharaka: Similar to investment trust;

Takaful: A kind of casualty insurance covering capital transactions in banking, securities and insurance

Sukuk: ‘Islamic bonds’ mobilizing funds from a large number of investors


Thanks to these innovations, Malaysia now has the largest Islamic financial market in the world, surpassing Bahrain.

In the 1980s repatriation of petrodollars through the London market became a catalyst for the formation of the Eurodollar market. In 2004, FSA-UK starting pushing aggressively for repeat performance for a piece of the IF cake. Japan too is jumping into the fray using JBIC.

Restriction imposed after 9/11 have diverted money flows from USA to illiquid infra projects in the Persian Gulf through IF. Now the emerging market in India is attracting the attention of Islamic petrodollars...

I guess it all goes to prove yet again that IF there is a will, there is a way!

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Ref.: T. Maeda’s note – “A Strategic Approach to Islamic Finance”; JJ 10/07]

NOTE - 10th September 2008
According to the Economist (04 Sep. 2008), Islamic assets under management now stands at $700 billion. S&P thinks this could go up to $4 trillion. However, the Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI) has objected to Sukuk in its present form as it contravened Sharia principles. This could lead to problems...