#205 Doodh Ka Doodh, Paani Ka Paani

Anticipating the Unintended

Global Policy Watch: Bailout Pe Bailout Pe Bailout

Insights on global policy issues relevant to India

— RSJ

Where do I start this week?

Maybe with a spot of self-promotion. Pranay and I were guests on the popular Hindi podcast Puliyaabazi. I have been a long-time fan, so it was nice to be a guest there. Pranay usually co-hosts this with Saurabh and Khyati, but this time, he was on the other side. I felt a bit like Uday Chopra, who is only in the film because he is the producer’s brother. Anyway, I think a good time was had by all as we covered a wide variety of topics - Enlightenment and why it didn’t happen in India (short answer: there wasn’t any need, really), why we write this newsletter (majboori) and the usual quota of Bastiat, Smith and Rorty (showing off).

Do listen if you have time (of course, you do).

Moving on.

Here is a quick run-through of what’s gone on since my last post. Another US regional bank, Signature Bank, stared into the abyss with depositors making a run to withdraw their money as analysts looked around for large unrealised losses sitting on banks’ balance sheets. Fed officials spent their weekend hawking the other failed bank, Silicon Valley Bank (SVB), to potential buyers. But who in their right mind will buy out a troubled bank in these times? More so after all the trouble that the likes of JP Morgan Chase had buying out such banks during the financial crisis of 2009.

Running out of options, the Fed, the Treasury and the Federal Deposit Insurance Corporation (FDIC) announced an unprecedented bailout of all depositors of SVB and any other bank that will be in a similar hole in future. Simply put, FDIC will guarantee all deposits and not just those below $250,000 for which there’s insurance. To be sure, the equity shareholders and those holding unsecured corporate bonds won’t be bailed out. They will lose their shirts. So, this isn’t a repeat of the 2009 bailouts. The Fed then went a step further to address the root cause of the problem. Banks are sitting on huge held-to-maturity (HTM) losses on the securities they hold because the interest rates have moved too far up too quickly. And they have a liquidity issue if there are continued withdrawals from the depositors. If they sell their securities today to meet their commitments to give depositors their money when they ask for it, they will have to sell them at a loss. This substantial loss will mean they will need to raise capital from shareholders to keep themselves solvent as per Fed requirements. But who will give them money in this market? Uninsured depositors who play out this game-theory scenario in their minds will therefore withdraw more of their money. Ideally, if they play the scenario right as a collective, they shouldn’t. But as individuals, they will make a run on the bank. Soon, the bank will be in a death spiral, and this is what happened at SVB and Signature Banks. The last-minute solution devised by Fed was the creation of what’s termed the Bank Term Funding Program (BTFP). Here’s how Fed sees BTFP:

“The additional funding will be made available through the creation of a new Bank Term Funding Program (BTFP), offering loans of up to one year in length to banks, savings associations, credit unions, and other eligible depository institutions pledging U.S. Treasuries, agency debt and mortgage-backed securities, and other qualifying assets as collateral. These assets will be valued at par. The BTFP will be an additional source of liquidity against high-quality securities, eliminating an institution's need to quickly sell those securities in times of stress.

With approval of the Treasury Secretary, the Department of the Treasury will make available up to $25 billion from the Exchange Stabilization Fund as a backstop for the BTFP. The Federal Reserve does not anticipate that it will be necessary to draw on these backstop funds.”

If you didn’t have any background to this situation and just read the above note from the Fed, you’d be forgiven if you thought here was a central bank of a developing world economy figuring out a short-term jugaad to solve a crisis at hand. But the Fed didn’t just stop here. After all, like the Queen in Through The Looking Glass, it can believe in six impossible things before breakfast. Leaving their struggles to find a buyer for Signature Bank behind, they put together a unique Barjatya style “hum saath saath hain” deal and nudged a number of banks to do their bit to shore up confidence in the banking system: (as CNBC reports)

“A group of financial institutions has agreed to deposit $30 billion in First Republic in what’s meant to be a sign of confidence in the banking system, the banks announced Thursday afternoon.Bank of America, Wells Fargo, Citigroup and JPMorgan Chase will contribute about $5 billion apiece, while Goldman Sachs and Morgan Stanley will deposit around $2.5 billion, the banks said in a news release. Truist, PNC, U.S. Bancorp, State Street and Bank of New York Mellon will deposit about $1 billion each.

“This action by America’s largest banks reflects their confidence in First Republic and in banks of all sizes, and it demonstrates their overall commitment to helping banks serve their customers and communities,” the group said in a statement.

“This show of support by a group of large banks is most welcome, and demonstrates the resilience of the banking system,” The Federal Reserve, Treasury Department, Federal Deposit Insurance Corporation and Office of the Comptroller of the Currency said in a joint statement.”

Remind me now, sometime in the past, I have accused Indian policymakers of what’s called isomorphic mimicry. It is a concept developed by Lant Pritchett et al to explain the tendency of governments to mimic other governments’ successes, replicating processes, systems, and even products of the “best practice” examples without actually developing the functionality of the institutions they are imitating. Policymaking in developing countries often falls prey to this. A good example of this is imitating the green energy policies implemented in Sweden (a $60,000 per capita economy) in India (a $2000 per capita economy) which has neither the state capacity to implement nor the public readiness to accept such policies.

Why am I bringing up isomorphic mimicry here? Well, because I never imagined a day shall dawn when the US policymakers take a leaf out of what India did when faced with a crisis. What the Fed did to save Signature Bank is isomorphic mimicry flowing the other way. To refresh your memory, here’s a Business Standard report (Mar 13, 2020) on what the Finance Ministry and RBI did to save Yes Bank in 2020:

“Hours after the Cabinet approved reconstruction scheme for YES Bank, private lenders ICICI Bank, HDFC, Kotak Mahindra Bank and Axis Bank came to the cash-strapped bank's rescue. While the SBI had earlier announced its decision to purchase 49 per cent shares, both ICICI Bank and HDFC are set to invest Rs 1000 crore each with Axis Bank pouring Rs 600 crore to pick up 60 crore shares of the troubled lender and Kotak Mahindra infusing an equity capital of Rs 500 crore under the RBI's bailout plan.

The developments took place soon after Finance Minister Nirmala Sitharaman said that other investors were also being invited.”

I guess one way to look at this is if you let fiscal dominance become the central canon of how you manage your economic policy, you will eventually reach the same place as other economies (mostly developing) that have indulged in the same for years. The monetary authorities in the U.S. have been accommodating the fiscal profligacy of the treasury for years. This was accentuated during the pandemic. Trillions of dollars were pumped in to save the economy. I’m not sure how much the economy needed saving then. But that bill has come now. First in the shape of inflation, followed by rapid, unprecedented rate hikes and the inevitable accidents that are showing up now. Almost certainly, a recession will follow. Isomorphic mimicry of Latin American monetary policy indeed.

Anyway, that was not the only bailout of the week. We also had Credit Suisse almost going under in a bad case of deja vu to those who have seen 2009. Here’s CNBC on this:

“Credit Suisse announced it will be borrowing up to 50 billion Swiss francs ($53.68 billion) from the Swiss National Bank under a covered loan facility and a short-term liquidity facility.

The decision comes shortly after shares of the lender fell sharply Wednesday, hitting an all-time low for a second consecutive day after its top investor Saudi National Bank was quoted as saying it won’t be able to provide further assistance. The latest steps will “support Credit Suisse’s core businesses and clients as Credit Suisse takes the necessary steps to create a simpler and more focused bank built around client needs,” the company said in an announcement.

In addition, the bank is making a cash tender offer in relation to ten U.S. dollar denominated senior debt securities for an aggregate consideration of up to $2.5 billion – as well as a separate offer to four Euro denominated senior debt securities for up to an aggregate 500 million euros, the company said.”

What’s that word that starts with C and was used a lot during the pandemic? Well, that C word is knocking at the doors of global finance right now. It is not a contagion yet. But the odds of it happening have significantly gone up in the past week.

I will close this by covering the two discussion themes emerging from these events.

First, what happens to the hawkish stance the Fed had taken a couple of weeks back on more rapid rate hikes in the light of inflation being sticky and inflation expectations being anchored? This, as I have written earlier, is of real interest to India and its policymaking stance. The Fed is in an absolute bind now before its meeting on Wednesday to take a call on rates. A rate hike in the current environment will make the weak banks look even more vulnerable despite the deposit backstop and the additional liquidity available from BTFP. And who knows what other accidents are lurking that will show up as the rates go higher? Does the Fed want to risk financial instability? On the other hand, inflation is real, and it is an election year. Runaway inflation will mean the eventual taming of it, and the recession that will follow will be hard and long. Who wants to preside over that? I see almost zero chance of a rate hike in this cycle. The Fed might wait till May to resume raising rates after it has weathered this risk of banking contagion and waiting for the April inflation data. But even then, the core problem remains. Further rate hikes will expose weak players, and that will mean we will have accidents. So long as they are small and contained, it is worth the risk of raising rates. But who can predict the nature of the accidents?

Second, there’s some kind of war that’s broken out on social media on who is responsible for the collapse of SVB and Signature. There are those who believe it is the Fed whose actions over the past three years are solely responsible for the situation we are in now. The crux of the argument is that the Fed forecasts the interest rate and then it sets the rate. Banks take bets on long-term securities based on these forecasts. This is called duration risk. If the Fed then sets the rate that’s so far removed from their own forecasts, what do poor treasury folks in Banks do? Plus, it is the Fed that has been making the rules since the GFC to direct a whole lot of bank liquidity into the purchase of long-term government bonds. The whole system is rigged by the Fed, and when things go wrong, it cannot pontificate on the risk management practices of banks. The counter to this is that the Fed only puts out an interest forecast based on the data (esp on inflation) that’s available. When the incoming data changes, its forecast changes. This deviation is in a narrow band in usual times. In unusual times like what we’ve been through in the past two years, you may have a bigger variance. Banks have multiple ways to hedge duration risks. Instead of looking at the Fed to apportion blame, one should look at how conveniently the depositors of SVB - the VCs, startups and other cool people - jumped ship at the first sign of trouble when they know such a collective deposit withdrawal will make the situation worse. It is incredibly stupid of this deposit base that prides itself on its ability to see further, take long-term bets and dimension risks better than others, that it could not have the patience to stand by a bank that has served them well. The problem of SVB bank, according to this lot, is they were over-reliant on a lopsided deposit base, and that deposit base acted most stupidly.

I think both these debates are going to rage on for some time. The Fed has slipped down the path where it has allowed fiscal dominance to overrule prudent policymaking. It is quite difficult to retrieve ground from there unless you have a Fed Chair with the intellectual heft and drive to restore balance. Equally, asset liability matching (ALM) is a core responsibility of banks. They are supposed to diversify their base of customers, monitor duration risks, and stress-test their balance sheet. All the strutting around as a cool disruptive bank or hanging out with your clients should not distract you from that fundamental truth.

You take your eye off it, you veer off the road.

Advertisement: Admissions to Takshashila’s Post-graduate Programme in Public Policy (PGP) are now open. This is a fantastic opportunity if you want to dive deep into public policy while pursuing your work responsibilities.

India Policy Watch: Milking Consumers and Producers, All at Once

Insights on burning policy issues in India

— Pranay Kotasthane

We harp on Hayek’s paper, The Use of Knowledge in Society, in this newsletter. Price is a vital signal, a decentralised coordination mechanism between producers and consumers. And so, when governments prohibit its functioning, bizarre things happen. Let’s analyse the consequences of price distortion using an ongoing situation — the milk shortage in Karnataka.

A bit of background to set things up. Milk is an ‘essential’ commodity. Its essentiality is not just a matter of fact or reason but also a carte blanche for Indian governments to regulate the production, supply, and distribution of any commodity that is classified as essential under the Essential Commodities Act (ECA), 1955. In practical terms, it means that the government fixes procurement prices, caps consumer prices, and often owns and runs everything that lies between these the producer and the consumer.

So is the case with milk in most states, including Karnataka. The Karnataka Milk Federation (KMF) is a dairy cooperative under the Department of Cooperation, Government of Karnataka. It procures nearly 50 per cent of all the milk that is produced in the state. It sells products under the brand name Nandini. Nearly 50 per cent of its consumption happens in the capital, Bengaluru.

Government ownership complicates and comicalises the situation in a way that can only be equalled by a Priyadarshan comic flick. See, for instance, what has happened due to a milk supply chain disruption over the last few weeks.

As the summer began early this year, the demand for milk rose sharply. A glass of majjige (buttermilk) or lassi is a wonderful refresher in the heat. Simultaneously, the supply drops in the summer months. Natural adaptation dictates that animals produce less milk than usual in the heat. A bout of lumpy skin disease has further exacerbated the gap between demand and supply this year.

For an ordinary product, a rise in prices would iron out this demand-supply gap quickly. With an increase in prices, consumers will rationalise consumption, while the producers will work harder to increase the supply. But when governments own the supply chain, price rises are defenestrated, and a chain of bizarre events emerges.

First, electoral concerns circle over pricing decisions like vultures. In this particular case, the government will not touch the price caps with a barge pole because the Karnataka elections are due in May. So the government tries to increase prices in a roundabout way: increase the maximum retail price (MRP) but offer a reduced quantity of milk for the same packet price.

Second, shortages abound. Since the administered price rises have not done enough to make the demand-supply gap go away, milk shortages have emerged. The rich can well afford to buy premium milk at higher prices from other suppliers. But for the poor, the milk packets disappear. Instead of paying a slightly higher price until the supply rises again, the less-privileged consumers are left only with an empty glass.

Third, the government resorts to blaming private businesses. Someone has to be blamed, and as so often happens in India, businesses get the flak. See this report in The Hindu, which casually places the blame on private players who are now willing to offer higher prices to the dairies and farmers. The report says:

“Private players purchasing milk from the retail market to sustain their businesses in milk products is said to be causing a disruption…

“He also said private dairies were procuring milk directly from farmers in rural areas by offering a higher price, thus reducing the union’s procurement.”

We should have been celebrating private players that are offering a better deal to farmers, given the scarcity. Instead, they have become villains.

And fourth, a quotidian issue becomes a front for inter-state tensions. The Karnataka government blames dairies in Maharashtra and Tamil Nadu for offering higher prices to farmers within Karnataka, while the Tamil Nadu government is blaming private companies from Andhra Pradesh!

Funny, the kinds of things that happen when the government enters and obstructs a control system called “prices”.

Even as this satire unfolds, the root cause of the milk shortages isn’t even being talked about. The Bangalore Milk Union president admitted that “many small milk producers have given up on rearing cows as it has become unsustainable”. Though he doesn’t mention the underlying reason for this change, the bans on cow slaughter and recent attacks on people transporting cattle surely have reduced the incentives for farmers from stepping into this minefield called milk production.

HomeWork

Reading and listening recommendations on public policy matters

* [Newsletter] Economic Forces is a must-read newsletter for all public policy enthusiasts.

* [Paper] This paper on the effect of a landmark policyWTF called the Freight Equalisation Scheme explains how good intentions can sometimes produce terrible policies.

This is a public episode. If you would like to discuss this with other subscribers or get access to bonus episodes, visit publicpolicy.substack.com