The Fed tries to increase liquidity with rate cuts, but how much does it help homeowners?

Independent Study: GWU Summer 08

Topic: The Fed tries to increase liquidity with rate cuts, but how much does it help homeowners?

Abstract: The spiraling of the housing crisis late last year, carried over to 2008, is leading the
economy into an “almost recession” scenario. The Federal Reserve, in its attempts to
restore liquidity has cut interest rates, and introduced new lines of credit to ailing banks.
This paper attempts to examine the functioning of the Federal Reserve, leading to an
understanding of inter-bank overnight lending rates (i.e. LIBOR London Interbank
Overnight Rate, and Federal Funds rate FFR). We study mortgages tied to LIBOR and
come to understand that the bulk of home mortgages are linked to the LIBOR. An
understanding of the similarities between LIBOR and FFR leads us to compare the two
rates to determine its impact on mortgages. We analyze to see if a Federal Reserve “ratecut”
translates into lower mortgage payments for the homeowner. The media as well as
economists worldwide have been debating the various ways in which the Federal Reserve
should be tackling this problem. This paper attempts to bridge the knowledge gap
between a move by the Federal Reserve and following it up to understand how it actually
affects the economy, especially homeowners.

Download the paper in PDF

Thanks,
Sri

Masters, International Trade & Investment Policy
GWU, Washington DC

India Risk Assessment -Base Case

India Forecast Sriranjini Latha
Stable with some downside

Under the base case scenario, the UPA government is likely to settle internal disagreements over the Indo US Nuclear deal, with its Leftist coalition partners by the end of the year. The period of instability however, leads to (1) debates over India’s allegiance to the US and its future Foreign Policy (2) uncertainty in domestic financial markets. The Indo-US nuclear deal plays a big part in the stability of the current UPA government, which is attempting to solve internal disagreements through a government established committee of experts and representatives from the coalition. The economic environment continues to attract foreign inflows of cash; the economy is conducive to new investments, and growth in the core service sectors continue. The two possible downsides in economic trends is the appreciation of the rupee diluting India’s competitive advantage, and the increased short-term speculative capital inflows. The effect of the appreciating rupee without a pre-fixed band (like China), and the uncertainty that it brings to markets and exporters remain uncertain.

Stories ▪ Indo US Nuclear Deal ▪ Terrorism in Kashmir & stability of Pakistani government
▪ Export Policies & Foreign exchange risk ▪ Financial Stability (Short term capital inflows)

Political trends: (High probability, high impact) The United Progressive Alliance (UPA) led by the Congress Party, is dealing with the disagreements with the Left Communist coalition partners, over the Indo-US Nuclear deal. The left parties insist that the deal compromises the sovereignty and non-alignment policy of India because of its restrictions on nuclear testing and re-enrichment of nuclear fuel. The Left parties are threatening to withdraw support from the coalition government. If they do, that will then dissolve the UPA government, and mid term elections will be held. It is unlikely that there will be mid term elections before the scheduled date in May 2009, for the following reasons.
(1) The lack of a strong opposition party contributes greatly to the view that mid term elections will bring back the Congress to power. The Bharatiya Janata Party, BJP is the only opposition party, which now has no clear leader, and has been mired in internal conflict and corruption issues since the fall of their government in 2004. The BJP is seen as a more religiously charged party and is unable to find an agenda rooted in religious sentiment as the middle class in India is growing increasingly intolerant to such divisiveness.
(2) The Nuclear deal is seen as an elite topic to contest and people in rural areas find it difficult to comprehend, and when they do, find it hard to justify why this might be a bad deal. During the heated debate between the 2 parties, the Communist Part (CPM) decided to “take the issue to the people” by running awareness campaigns, the results of which didn’t seem to tilt in their favor, and instead turned out to be supportive of the deal or indifferent to it as it does not affect daily lives.

The above 2 reasons are big deterrents for the left parties to withdraw support. In the event that they do, polls show that it’s likely that the Congress will be re-elected to power in a coalition government along with regional parties, who are in favor of the Indo US Nuclear deal. The party that looks especially keen to join the Congress is the Bahujan Samajwadi Party in Uttar Pradesh, lead by Mayawati, in India’s most populous state with 1/7th of the seats in Parliament. Therefore, even in the event of mid term elections the deal is unlikely to fail. The top two reasons for the deal to go through, even in the event of re-elections:
(1) International implications for India. The failure of the deal means having to forgo being the US diplomatic and economic ally in the coming years.
(2) The strength and bargaining power of the leading party of the UPA the Indian National Congress will make sure the deal does not fail, through their re-election bid.

The issue is being dealt with internally through the setting up of the UPA-Left committee on Indo-US Nuclear deal, which will discuss and allay the fears of the Left parties. The risk posed by the stability of the government is reflected in uncertainty in financial markets as well as debates over India’s future foreign policy especially toward Russia and China. Russia, almost an old friend to India, is India’s largest military supplier. India sourcing military material from the US does not go down very well with Russia. China is increasingly hostile towards India’s proximity to the US agenda, as it believes the US is looking to India to establish a foothold in the SE Asian region. This might imply a “strategic base” in India in the long term, which is certainly is not acceptable to the Chinese government. India is likely to fend off US attempts at a “strategic or military base” as the Indian government is not likely to jeopardize their economic relations with China. The upside risk however, when the deal comes through is the increased economic ties between the US and India that is hugely beneficial to both American corporations and to Indian companies and consumers.

Terrorism trends
India’s foremost military dispute is with Pakistan over Kashmir. The Kashmir dispute will remain on the radar of political debate but is not likely to escalate into a big issue, as long as President Musharaff remains in power. The conclusion of the recent Presidential elections in Pakistan, last Saturday October 6th, shows President Musharaff in a clear majority and he is to continue in office for another 5 years. This is an upside because of the stability associated with the Musharaff government and its positive association with the US government, though a potentially damaging factor for Pakistan’s democratic proponents. With the increased anti Musharaff sentiment within Pakistan, the big risk to political stability is the threat that General Musharaff could be assassinated. This could mean the return of exiled Bhutto or Nawaz Shariff or alternatively pose a dangerous threat of a new radical taking over the reigns of power. Given that the status quo continues in Pakistan, especially with India and the US government, both pushing to keep the Musharaff government, it would mean stable Indo-Pak relations. India and US’s increased influence over Pakistan, as well as strengthening of Indo-US ties, in the long run could stand in conflict with the jihadi’s and could lead to increased problems across the Kashmir border. (Low probability, high impact)


Foreign Exchange Risk, Investment Climate and Export policies
The rise of the rupee by more than 12 percent against the dollar this year is increasingly seen as a risk that is eating into the profit margins of foreign firms as well as Indian exporters to the US. Technology services exports that outsource work for American firms account for 22% of India’s exports and was the forerunner in India’s outsourcing boom. These firms face a problem because their costs are in Indian rupees while 60-80% of their revenue is in dollars. This makes them highly dependent on US customers for revenue growth. With the depreciating dollar and preset contracts in an already low margin service sector, these companies have to bear the foreign exchange risk without passing them on to clients. These suppliers attempt to stay profitable by increasing volume contracts, renegotiating existing contracts, boosting productivity in the long term, and hedging and forward contracts for the short term. The firms could alternatively, pass on the costs to their customers i.e. US firms. This scenario is plausible, in part because of the technical skills and English-speaking population that is increasingly proving to be a “comparative advantage” and not just an “absolute advantage”. This is backed by the fact that volumes of US contracts and inflow of capital has not been decreasing. Since both, absorbing foreign exchange risk or passing them on, are company level strategies it is hard to predict their collective behavior and their effects on profit margins and continued contracts with the US.

The downside indicators are proof of exports being hit: (1) In the short term the political actors within the Ministry of Commerce are implementing industry specific steps to mitigate the impact of the rise in the rupee against the U.S. dollar, examples of which were seen as waivers of export tax for jute. (2) Exports in the fiscal year ending March 31 2008 are expected to reach only $140 billion, compared to $160 billion target the government had set. With both upside and downside indicators, and specific company level strategies to deal with the situation, the potential effects of the rupee appreciation cannot be fully assessed yet. (High probability, variable impact)

Financial Stability
The current account deficit increased in the quarter ended June 30th, because of the widening trade deficit (declining export revenue and increasing import cost). On the other hand, the capital account is in surplus, mostly because of huge capital inflows into domestic financial markets. This has caused the appreciation of the rupee, and the rupee will remain up as long as the capital inflows remain strong. This exposes the currency’s vulnerability to inflows especially short-term capital. In the first 8 months in 2007 foreign institutional investors (FII) have invested $8.3 billion in Indian stocks, of which 25-30% is estimated to be from hedge funds. This number is high in comparison with China, where hedge funds are at 4% of total FII inflows. The method of investing through derivatives (Participatory notes), gives these funds easy entry and exit into the market. This also leaves the regulatory body the Securities and Exchange Board of India (SEBI) unable to track the exact inflows, as the derivatives bypass the SEBI registered route. This vulnerability is currently outweighed by the stable growth in the economy. But this situation could escalate if there is a slow down in the economy, or if speculative short-term capital is withdrawn very fast upon some perceived risk. (Low probability, high impact)

My conclusions on the base case for India is temporary political instability till the end of 2007 along with continued strong growth in the economy which will level off to about 8% GDP growth in 2008.

Fair Trade for All - Stiglitz and Charlton

I have two cases- one to challenge the anti globalization argument and another to debate the idea of “fairness” of an agreement.

Mumbai, India 2004 – The world converged at the World Social Forum (WSF) to re-iterate the need for social justice/equity and bash that one word “globalization”, used indiscriminately through the entire 6 day conference. Having read inside-out coverage of the event and been at the heart of the almost revolution like fervor, I was left confused, till an argument came through in Pg 36 in this book. There was a particularly fiery speech by an Indian author and activist, Arundati Roy that was published center-fold in the most popular Indian newspaper, where she says “Poor countries that are geo-politically of strategic value to the Empire/Hegemon (USA), or have a `market' of any size, or infrastructure that can be privatized, or, god forbid, natural resources of value — oil, gold, diamonds, cobalt, coal — must do as they're told, or become military targets.” This is the kind of argument where people link trade or market access to political motives, which is not necessarily true. The WTO will not make countries military targets if they do not comply, a much less violent form called the Dispute Settlement Board exists.

Activists talk about unfettered and rapid globalization- none, absolutely none, of the WTO globalization efforts force developing or LDC’s to implement immediately after deals are signed. There is an internal reform process/legislation that needs to be structured and followed by each country in a phased out manner with a deadline, before they are expected to completely comply with the regulations. The answer to the long drawn verbose arguments on globalization is that the activists are more concerned about government failure than about market failure. Their diagnosis of the cause lies not in globalization but in failure of governments. This comes back to the distribution effects of globalization argument, where governments are expected to do the redistribution process, and we know the fall outs of the winners vs losers are not measurable and losers are not adequately compensated. Such bottle necks can be eased out only through an internal reform process. An important Doha reform proposal by Stiglitz in this book is called the “Market Access Proposal” where WTO nations provide free access to countries smaller than them (by GDP or per capita GDP) and get free access to WTO members larger than them, this can adjust the returns and retaliations according to size of markets. The only problem is that the most developed countries have no incentive at all to move to this type of framework.

What is a fair agreement?

My college in India witnessed huge demonstrations and street plays against India Amending its Patent Act in Dec 2004 to comply with the TRIPS agreement. Before this amendment, India patented only manufacturing processes and not the chemical molecules themselves (product patents.) After Jan 2005, they would have to legalize product patents, this would eliminate generic drug manufacturing (Generic drugs use different processes to re-engineer the same drug.) This puts life saving drugs far from the reach of the poor economies and a whole lot of pharma manufacturers into panic. Yet the margins of profit for these life-saving drugs are not high enough for Pharma companies to push for reform unless governments do. They would rather fight entry into the US market to sell the generic version of Lipitor than to fight polio or malaria antibiotics entry into LDC’s. Cipla, an Indian drug manufacturing company, manufactured generic anti retroviral treatment for under $1 a day, but is phasing out production because the governments that need it most are not buying them as they are upholding patent rights of international pharmaceutical companies. It therefore is a lack of flexibility of the TRIPS that prevents countries from getting anti retroviral treatment. Is this fair?

Its costs an incredible amount of money for a developing country firm to challenge intellectual property in a case involving a pharma firm in a developed economy. (The high costs challenge Procedural fairness in the DSB)

The Indian Government’s domestic policies in the Union budget 07-08 for the pharmaceutical industry aren’t thorough enough and sometimes inadequate. The government offered a tax exemption for pharma R&D for 5 yrs upto 2012, but the pharma R&D processes is risky and lengthy requires atleast 12-15yrs of protection, the incentive ended up being inadequate. The government also introduced customs duty on life savings drugs– this means these pharma companies cannot offer lower prices in developing markets. The government also proposed a future move from customs duty to Value Added Tax (VAT) on some pharmaceutical products (A similar change in South Africa, yielded no change in pricing or government revenue). Governments therefore might not be giving the right incentives to the right industries and when they need it.

Questions:

1. Challenging the fairness in outcome arguments- “Do we care that the argument for accessible life saving drugs is morally right and saves lives or that we have committed to patent protection so must stick by it?” How can we bring about a flexibility of policies at the WTO? And ensure they cannot be misused.
2. In the MAP, the USA for example will have to give free market access in all sectors to all those countries which have a GDP lesser than America’s, but the upward corollary of this argument does not hold. What incentives can we possibly give to developed countries in the MAP to move towards it?

Book Review - Food Fights over Free Trade, Christina L Davis

“Farm Politics” – despite having studied trade for a while, it struck me when I saw this phrase how complicated, twisted and ironical agricultural negotiations can be, and this phrase “farm politics” seemed to sum it all up. A progressive reduction in agricultural subsidies will have an almost immediate impact on poverty elsewhere and like a senator put it “can mean life and death somewhere across the world.” The book has a thorough lay down of facts, evidence, arguments as well as a humanitarian face to things. I found the book “Food fights over free trade” a tough book to plough through initially, but one that leaves you feeling like you understand the political, economic and diplomatic complications of agriculture much better.

Davis’ argument on cross sector issue linkage- especially that between agriculture and industry can be weighted as successful if the linkages are highly correlated, then one can be effectively weighted against the other. But agriculture has always been a sector that lobbies independent of other sectors and it’s very hard to find a sector linkage strong enough to be compromised for decade-long agricultural subsidies, and you see how most agricultural negotiations end up being bilateral or a single issue negotiation. The “politics of negotiation” is captured in the agricultural sector as it captures the sentiment of the general public and are large vote-banks. Therefore the sector has a lot of political leverage. At the negotiating table nobody is benevolent- if you can give them incentive enough to switch, they will. But as in the case of most negotiations- a little crack of light needs to be found in order to further expand the scope of agricultural negotiations.

When looking at the course of trade negotiations through history- it is evident that the WTO’s organizational structure, its enforceable authority, and its various dispute settlement bodies, and their use of reputation costs to deter violators has worked better than the GATT system. By signing in as a member of the WTO domestic governments are tying their own hands against passing unilateral trade policies and changing existing tariffs. (EU in the hormone beef ban case violated this and could not do this for long) If not for this international carrot and stick policy- each time an industry lobby favored government party comes into power that industry would expect to get protected through tariff or non tariff barriers. A tangent to the argument about collective action problems is that of lack of awareness of the WTO redressal process and lack of communication of importers to their respective government agencies of countervailing or antidumping.

The US market size allows for a great deal of autonomy and bargaining power at the table- but sometimes the US is on the receiving end, as in the case of China. China refuses to revalue the Yuan despite immense pressure from the US government. This is because for one, the US is not China’s biggest importer, therefore the US does not have the “monopsony power in trade” Second, the huge number of dollar reserves that the Chinese government holds can cause serious currency value fluctuations if they decided to sell. It goes to prove that all negotiations have power and interests, both of which change over time and therefore need to be reprioritized as the balance of power and interests change between the parties involved.

A key summary of the issue, though can be easily missed, is the assumption of the state being a unitary actor- this means that domestic concerns should not theoretically play a part in international trade laws. Its failing, in cases like the Diet in Japan’s vehement opposition of importing “one grain of rice” – ultimately goes to say, we understand that the assumption of unitary actor does not hold. With strong international pressure in the Rice ban, hormone beef ban as well as CAP, it is fascinating to see how ultimately domestic interests “aggregate” towards liberalization and equilibrate the market.

The author also chronicles some significant but smaller incidents in the midst of negotiations such as the US bashing of Clayton Yuetter- him having rejected the US farmer petitions twice over, on grounds of straining US-Japan relations. Those on the forefront of such diplomatic talks realize how seemingly “right” it would have been to accept the petition but that would’ve made it so much easier for Japan to have shut itself off from negotiations all-together. Having come from India, a country where there are bilateral negotiations all the time with Pakistan, you realize how one comment or seemingly “right” decision to you might be a very sensitive issue for the other party in the negotiations- leading them to turn hostile. At the end of each of his chapters/parts the author gives us empirical evidence to make clear which of the negotiating structures or hypotheses have worked in the real world.

The conclusions of the book lie modest, yet insightful – the difficulties of saturation of cross sector linkages, where nothing in the newer industries can entice the countries to come to the table is a very pertinent difficulty in the long run. Adjudication is increasingly seen as a means to settle trade disputes, yet it can’t work always, and there must be a negotiating structure formulated to the specific circumstances. The formations of G-20’s G-8’s to resonate the developing country voices is a good proposition for the success of the Doha round. It is also dangerous – the combined bargaining power might lead to failed talks repeatedly and negotiations increasingly move towards bilateralism, which is not in-line with the WTO consensus approach. Multistage negotiation analysis gives us an understanding of how exactly to structure negotiations – first, a series of bargaining or should they raise only easy issues in the GATT rounds?

The strategic and negotiation studies of international relations, comparative politics and sometimes a long drawn out series of interests and threats are necessary to tip the balance and solve any issue as complex as agricultural issues.