Pricing of risk.!!

Inappropriate pricing of risk is the mother of all financial crisis and its true in this recession too.Its one of the fundamental question that has been haunting the field of finance for last few decades. This topic is one of the cornerstone in the field of finance and much of the work done in this field is far from satisfactory. The traditional Capital asset pricing theorem is full of assumptions and is too simplistic to mirror a real world. Anyway, the real world is not linear as this model assumes risk return- behaviour to be a linear one.

The assumption that most of the risk in real life situations can be depicted by normal curve fails under many cases. A small difference in the real risk faced by an asset class than that shown by normal curve gets coupled with risk faced by another interacting asset class and it leads to a multiplier effect. Thus the overall risk faced by an economy can be enormous due to this multiplier effect and it leads to financial crisis when the system is stretched beyond the risk tolerance limits. This happens in the case of asset bubbles when prices increase significantly that real market valuation faces huge uncertainty.

It distorts market as it encourages speculation thus building up of upward spiral of prices which are unsustainable as they are not suported by real wealth. This huge uncertainty results in high risk to an economy as an asset bubble affects other asset classes through the financial markets. Finally the bust follows as market discovers real value of an asset and in the process a large share of investor wealth gets eroded. Thus we need an effective model which can help us to price the risk element in the financial world with required accuracy levels.A lot of work needs to be done in this field to upgrade our risk management models and replace them with better ones.

Out of recession.!!

Finally, the world appears to be getting out of the recession. Officially, France,Germany and Japan have got out of the recession as they have recorded growth in the last quarter. The pace of contraction in the US has slowed down and its expected to be just 0.5 % in present quarter with the resumption of the growth story from the next quarter. It appears that that the massive stimulus package of countries like US , china and japan has worked to save this world from another great depression. The crisis had even affected emerging economies like India, China etc .

The world has felt the aftershocks of massive finacial upheaval in the US primarily due to the integration of the world financial markets. It needs to be seen as an opportunity to revaluate our business practices .we can have a world financial stability forum which needs to advise governments about the emerging macroeconomic risks. The lessons learnt from the great depression of the 1930s has helped to lessen the impact of this crisis. This crisis has made us realize the perils of improper risk management and unending human greed. It is hoped that we dont repeat these mistakes and follow sustainable business practices for economic development.

changing power equations..!

The recent G8+G5 summit in Italy has raised doubts regarding the relevance of G8 as a body to look after the technoeconomic interests of the world. Most of the countries of G8 are marked by stagnant economies,rising deficts and ageing populations. On the other hand we have contries like India,China,Russia,Brazil etc which are still growing at a brisk pace even in this financial turmoil. These countries have young populations who can power economic growth for atleast next few decades. China and India represent close to one third of the world's population and they have huge untapped domestic markets which are being eagerly sought by western companies.

The world has realised that it cannnot fight the major problems confronting humanity without the help of these new emerging countries , be it climate change or restoring world's financial health.

India and China are no longer seen as regional powers as they have started flexing their muscles in international arenas as in the case of voting rights at IMF or Doha trade deal. It calls for the reform of major international institutions like UN security council,IMF, etc to realise the legitimate aspirations of these emerging economies. We find that it is a transition phase which will lead to a multipolar world in the next few decades.

decline of dollar.!

The days of hegemony of dollar seems to be numbered. The currency has lost its value against the major currencies of the world in the recent past. We appear to be heading to an era in which an international reserve currency would replace the dollar. Some major economies of the world like China ,Russia have already expressed there reservations against dollar and its prolonged mismanagement by the US authorities.

The US seems to be enjoying its leisure on borrowed money as most of foreign exchange surpluses of countries like india and china have been parked in the US treasury bonds at interest rates of 2-3%. These funds then in turn help the US to manage its trade deficit and thus providing resources to the government for funding its wars and in some way fuelling the private consumption story.

But the recent quantitative easing in the US have cast doubts about the credibility of dollar resulting in the loss of the investor's faith. The US seems to have found a way to get rid of its foreign debt by debasing the real value of dollar which has made countries like china quite jittery. Such events have contributed to the viewpoint that time has come to evolve a global currency which can replace dollar in due course of time.

The futile act of prediction

Mankind has  been the most intelligent creation of nature but it does mean that we start assuming the supernatural powers of God and start predicting things. We have been able to develop fairly advance  forcasting models through our achievements in science and technology but they are still limited by our limited rationality i.e whether we have really been able to decipher the laws of nature or it might be that our theories are only able to explain some observable phenomena without coming up with the ultimate truth. We find most of them correct as they fit with our limited rationality and in some cases we force ourselves to such hitherto sacrosanct principles.

                                     In late 2007,Goldman Sachs had made a prediction that crude oil is going to touch $200 per barrel and now its currently trading at $50  per barrel. The intention is not to doubt their econometrics model but its high time they realise that systemic problems with their model and stop behaving like God about predicting future events. In early 2008, one reputed organization had made a prediction that rupee is going to appreciate to the level of 35Rs /$ by the end of 2008. Now,its currently trading at 50 Rs /$.  IMF is itself not sure how many times its going to release growth forcasts for different parts of the world with its figures appearing to be some random numbers generated from its model.

                                  We must relise that this is not a linear world where future outcomes can be predicted by the summation of different incremental inputs. We live in a world where there are possiblly infinite number of factors with the magnitude of  effect of each factor depending upon the outcomes of some other input. It does not mean that we should not  have some estimate of likely events which may happen in future but the business of predicting future is highly dangerous . It distorts market by encouraging speculation and in some cases may lead to undue euphoria or pessimism.

Quantitative Easing..!

Finally, this crisis hit world has decided to use the most potent weapon in its arsenal. Its nothing but quantitative easing. Most of us might not be aware of the reason behind the coining of this fanciful term. Basically, it stands for monetization of debt i.e printing of money by the central bank of a country to finance huge fiscal deficit and to increase liquidity in the market when other instruments of financial policy like monetary policy have been exhausted.
Recently, the US Fed has announced that it would buy the US treasury bonds amounting to close to $1.2trillion which would be financed by printing money. Similar indications have been made by the bank of England. Till now, india has resisted the temptation to use this instrument. But, the finance ministry seems to be mulling this option for a while and our government may go for restarting the printing presses which had been lying idle for quite some time .
Quantitative easing results in the devaluation of a country's currency against a basket of foreign currencies besides resulting in inflation in the long run. It was a normal practice in india prior to 1991. However with the implementation of economic reforms ,some restrictions were placed in 1997. Finally, when the UPA came to power in 2004,it passed the FRBM act by which the government could not directly approach the RBI for funds beyond 1st jan 2006. It was decided that this policy measure would be used only in situations akin to economic emergency.
However, the present situation calls for extraordinary measures to tackle this extraordinary situation and we should not be myopic to restrict ourselves to the textbookish approach in this situation where growth rates have fallen significantly, coupled with huge fiscal deficits and the accompanying spectre of the vicious cycle of deflation. Finally ,we conclude that no policy instument is untouchable and decisions should be made depending on the unbiased analysis of a situation rather than some fixed traditional approach

a paradigm shift..!

The global meltdown has put an end to growth model based on consumption as in the case of America and one that is entirely driven by exports as in China. The culture of excessive consumption in western contries due to easy availability of credit has resulted in low private savings rate. The problem is not too different at the government level as the US has been running a deficit budget for last few years. This mess in the financial system could have led to another crisis,had it not been for the cheap capital provided by developing countries, manly china in the form of deposits in the US treasury.
Now,this dual core engine of world growth based on consumption and exports has failed miserably. It should be seen as an opportunity to develop an alternate model based on high savings rate and a strong R&D culture resulting in the production of goods with high value addition instead of spending money on unproductive activities.
Moreover,the curbs on the flow of capital should be removed so that capital could finds its way to the country where the returns are maximum ,thus homogenising global growth in a fairly equitable manner.