By W.A Wijewardena –
Public authorities: Claiming ‘no problem’ while sitting on a barrel of dynamite
The Lebanese-American finance philosopher Nassim Nicholas Taleb of Black Swan Theory fame has a wonderful observation on the experts working in governmental agencies. In his 2007 book ‘Black Swan: The Impact of the Highly Improbable,’ he has referred to those experts working at Fannie Mae, Federal National Mortgage Association in USA that refinances the residential mortgage loans as people who sit on a barrel of dynamite vulnerable to the slightest hiccup.
But, according to him, those experts will announce at the top of their voice that there is nothing to worry because the occurrence of any destructive event is highly ‘unlikely’. The implication which Taleb has not bothered to comment on is that, as history has shown, when that highly unlikely event takes place, all those who have trusted them stand to lose but they themselves manage to emerge unhurt.
Black Swan: Happening the improbable
This observation is not unique only to Fannie Mae. It is applicable to any governmental organisation from developed to developing nations across the world. The experts in these organisations with a sense of arrogance in their tone may seek to take their audiences through a guided tour that will show them what the experts want them to see. Anything else, whether trivial or significant, will be very quickly dismissed as immaterial and highly improbable.
The result is obvious: The systems will be infected by slow growing risks which one day will implode destroying everything within or explode everything out. Taleb called this ‘happening of a Black Swan Event’. The highly improbable thing will emerge on the radar just like the appearance of a ‘Black Swan’ on the horizon. Analysts have pointed out that what is happening in India, Indonesia, Thailand, Sri Lanka and even in Japan today is the appearance of the ominous Black Swan which had been dismissed by all these countries all the time as highly improbable to happen.
Looking at only winners and judging that all are winners
Taleb’s Black Swan Theory goes back to his 2001 book, ‘Fooled by Randomness: The Hidden Role of Chance in Life and in the Markets,’ which looked at the events in the financial markets. The weakness of modern humans, according to Taleb, is that they jump to conclusions too quickly without bothering to examine the fundamentals behind them.
For instance, when they look at the clouds, they may see the shapes of elephants or any other objects of their choice which are simply random formations. Then, a bias is formed in their minds to satisfy their own personal interests. When they see a lottery winner, they form the judgment that all are winners ignoring many thousands of those poor souls who have been losers.
Thus, guided by this wisdom, they over-calculate the possibility of ‘wins’ and invest in financial market products which are offered to them by crafty sellers. It enables them to make small gains. But when the real disaster hits them, their losses will be so heavy that those losses will soon eliminate them from markets altogether. Taleb equated this to ‘eating like chickens (taking small gains) and going to the bathroom like elephants (discharging heavy loads of losses)’.
Dogs seeing only the bone down there and not the stick landing on the head
Taleb’s observation of human beings concerned about only the small gain today and not about the big losses tomorrow has been a typical behavioural pattern they have shown throughout history. This has in fact been prompted by a mixture of ‘fear’ and ‘greed’ that has overwhelmed them. A popular folk saying in Sri Lanka to describe it is that a ‘dog sees only the bone thrust below its nose and not the stick that comes over its head’. This weakness has indeed enabled crafty people to manipulate not-so-smart humans to their advantage.
A good example is Kautilya, 4th century BCE Indian Guru on economics, advising the King in his treatise on economics ‘The Arthashastra’ that the King should exploit the superstitious beliefs of people to generate revenue for the his treasury. For instance, if people see some unusual spots in the sun, the King should promote those beliefs by employing his own agents and offer the people redress through various devices which are to be produced by King’s agents and sold to the affected people.
A rare event is not rare at all
In his 2007 book ‘Black Swan,’ Taleb applied the Black Swan Theory to the entire gamut of human behaviour including dictatorships. According to him, a Black Swan Event has the following characteristics:
- There are rare events beyond the expectations of human beings that will have far-reaching consequences on society once they actually occur.
- Since they are rare, people normally give a very low probability to their occurrence.
- In view of the low probability assigned, people are psychologically blinded to the uncertainty of the occurrence of the event and its massive implications on them.
Accordingly, the event under consideration is a total surprise to its observer, though it brings a major effect on him as well as the society he lives in. Thus, there is no way for people to make predictions on the event before it occurs. But, after it occurs, with hindsight knowledge, they are able to rationalise it as if it had been perfectly predicted by them. Such rare events are called Black Swan Events since the sighting of a black swan is also a rare event. It was in fact a non-event till early 17th century since the world collectively believed that there could not be swans that were black. However, after a Dutch explorer discovered black swans in Western Australia toward the end of that century, the possibility of having black swans was accepted but subject to very low probability.
Cyprus going by ‘all is good’ policy
Today’s economies and their constituent sub parts are characterised by Black Swan Events because the authorities have a tendency to reject the possibility of an economy meeting the worst end until it has been hit by an irreversible disaster. A good example from the recent past is the case of Cyprus. The Cypriot authorities rejected the suggestion that their banking system was in trouble until the system collapsed and the country became bankrupt.
India: Gradual breeding of the Black Swan
The recent events in India, according to analysts, have presented a classic example of a Black Swan Event. Indian authorities, specifically its Finance Minister P. Chidambaram, consistently maintained that the country’s economy was in good shape and it was on its march to becoming one of the leading economies in the world in the years to come.
When India was receiving a massive amount of foreign exchange flows, in some years exceeding even $ 70 billion, he expressed the satisfaction that foreign investors have placed their full confidence in the state of the country’s economy. This was when the foreign flows had caused the Indian Rupee to appreciate in the market to an unprecedented level of Rs. 38 to a dollar in 2007.
When he was corrected by the Governor of the Reserve Bank of India Y. Reddy that such hot money flows could overheat the economy and bring in inflation causing India to sacrifice all the hard earned gains in the past, Reddy was persuaded by the top political powers in the country to backtrack his statement. But as predicted by Reddy, the Indian economy got overheated by the massive inflow of foreign exchange flows generating uncontrollable inflation within the economy.
To correct the malady, it was necessary for India to introduce a second wave of economic reforms making its economy robust, flexible and resilient. Yet, these reforms were not undertaken and the result was the silent onset of a massive Black Swan Event in the Indian economy. The Indian rupee began to depreciate in the market reversing its earlier gain and pushing its value down to Rs. 67 to the US dollar. From the peak in 2007, it is a depreciation of about 76% over a six-year period recording on average depreciation of the currency by whopping 13% per annum.
India to blame itself for the malady
What are the causes for this Black Swan Event? According to the Senior Associate Dean of the US based Fletcher School Bhaskar Chakravorti, one proximate and many long term causes have contributed the current malady (available here).
The proximate reason is the outflow of hot money from India in anticipation of the higher interest rates in USA after the Federal Reserve Bank would gradually taper off its stimulus package of buying bonds of some $ 85 billion every month from the open market and pumping liquidity to the market to keep the US economy floating above the water.
Even stimulus actions have their own limits
This massive stimulus started in 2008 has cost USA heavily bringing a Black Swan Event of its own kind to its currency. The US Federal Reserve implemented this stimulus package by printing new money and thereby increasing its asset base from around $ 800 billion in 2008 to $ 3800 billion in August 2013.
With the introduction of the package, the US real interest rates fell below zero: For instance, the US 10-year Treasury bill rate in real terms fell to minus 0.6% prompting the investors to flow their funds to emerging markets in the world in search of high interest incomes. The biggest beneficiaries were India, Sri Lanka, Thailand and Indonesia. These countries were able to live through a temporary ‘good time’ due to the massive inflow of funds which are considered hot money from abroad. At the same time, the hot money inflows obviated the necessity for undertaking immediate and essential economic reforms to sustain their economies in the long run. Thus, India and Sri Lanka in South Asia became victims of their own making.
The rising US interest rates have reversed fund flows
But these low interest rates could not be expected to prevail forever. With the Federal Reserve announcing the withdrawal if the stimulus gradually starting from September 2013, the US interest rates started to climb up gradually: In August 2013, the US 10-year Treasury bill rate jumped to 2.8% recording a real positive rate of 0.6%. Naturally, the original outward flow of funds from USA is now reversing and India alone, according to some estimates, has lost about $ 13 billion in the last two months.
A similar outflow has begun in Sri Lanka, Thailand and Indonesia too putting pressure on the respective currencies to depreciate in the market. All these outflows are beyond the control of the domestic central banks unless they go for a matching increase in domestic interest rates. But such a move may go against the economic growth objective which these central banks have pursued on behalf their political masters. So the impossible trinity – that is, a central bank cannot control the interest rate, inflation rate and the exchange rate simultaneously – is now knocking at the faces of these central banks.
India and Sri Lanka: No substitute for economic reforms
What Bhaskar Chakravorti has identified as the long term causes of the current malady in India is equally valid for Sri Lanka as well: That is, India has failed to implement the long term economic reforms in order to make that economy robust, flexible and resilient. Chakravorti has also commented that because of the policy inconsistency of the Reserve Bank of India, India’s central bank, investors have lost their trust and confidence in the Reserve Bank.
This is an important issue and this writer has emphasised the need for building trust in a central bank in order to enable that bank to attain its main objectives effectively in a previous My View that appeared in the Principles of Central Banking series (available here).
Current account deficit is the killer
According to Chakravorti, the main culprit has been the massive current account deficit of the balance of payments of India which stands at 5% of the country’s GDP. A deficit of this magnitude is a pressing problem because it need be financed out of inflows into the country by way of foreign direct investments, investments into the securities market and foreign borrowings, both corporate and government. A part of that money coming in the form of hot money to the securities market is fraught with instability because it can flow out of the country at any time in search of high returns elsewhere. This is what is happening to Asian countries today.
Sri Lanka flying in the risky region
Sri Lanka’s current account deficit standing at around 7% of GDP is not better than that in India. Sri Lanka’s authorities have consistently downplayed the risk factor arising from this massive deficit. It has to be tamed not by palliatives like inviting hot money, getting the banks and corporate sector to go for foreign borrowings and changing the country’s foreign borrowing profile from the Government to State sector banks but by painful economic reforms.
The reforms include revamping the Government budget (cutting all the inessential consumption expenditure and diverting resources from consumption to investment), reforming the loss making public enterprises, having viable and effective marketing plans for the flagship infrastructure projects which the country has already completed out of foreign borrowings effected on commercial terms and strategising the country in terms of emerging global developments.
Remittances not a blessing in the long run
Sri Lanka has taken pride in the ever-increasing remittances flow as a consolation to partially fill its widening trade gap in the past. It is indeed a consolation right now since it has enabled the country to maintain its import flow at a consistently high level to feed its import dependent industry.
However, as a researcher at the Nepal Rastra Bank Guna Raj Bhatta has reported in an article titled ‘Remittances and Trade Deficit Nexus in Nepal: A VECM Approach’ in the in the April 2013 Issue of NRB Economic Review (available here ), in countries with high proneness to imports, remittances are a curse in the long run since they increase imports and contribute to long term balance of payments problems. What this means is that Sri Lanka rupee has been saved temporarily by remittances in the past. But since they create long-term balance of payments problems, the very same saviour will become the source of instability in the long-run as well.
The ominous Black Swan has hit India, bringing enormous risks to that country today. Sri Lanka should avoid the inevitable Black Swan Event by shedding its high growth objective for the time being by raising domestic interest rates and saving its currency.
*W.A. Wijewardena could be reached at email@example.com