What Should Obama Do

What should Obama do?

Unconventional problems require unconventional measures to solve them. This is what every government on the earth is doing right now. Several of them have already announced stimulus packages while some of them are in the process of announcing yet another tranch of such packages. There are others that are contemplating such steps to bolster the economy and restore the confidence of consumers, business and the public at large. The current financial crisis emerged in the US of A which is the one of major victims of its own misdeeds. So, naturally all eyes are on the charismatic leader and President elect Barack Obama for his actions once he takes the charge after entering in the Oval Office. Experts and economist across the globe are discussing what should be his immediate priorities and are speculating what steps he should take to produce the desired results. In this report, we will discuss what challenges Mr. Obama is going to face and what he should do to tackle them? The US Fed has cut its interest rate almost to zero (0.25%). Soon the BoJ too cut its rate to 0.1%. The question is whether the zero rate regime can arrest the economic de-growth? Is it really a useful tool the central banks can use to derive the desired result? The Fed has already begun an aggressive plan of Quantitative Easing (QE) that has doubled the size of its balance sheet in just two months of time span. As of now, banks are still hoarding on the cash and credit flow is yet to resume supporting the demand. Seriously speaking, this is a perilous and precarious situation. After exhausting all the conventional measures to stimulate the economic growth being failed, the Fed is left with fewer options now. Japan which has been living with almost zero rate regimes for almost a decade recently cut its rate to 0.1%. So, what else the governments or central banks can do to bring the economy on the track? In this report, we will try to discuss what are the unconventional measures that can be taken to shore up the economy growth and whether they are effective at all?

Deepak Tiwari Research Analyst [email protected]

T: + 91 22 4063 3007

Dec 23, 2008

For Private Circulation only

1

Mr. Obama and the world One of the challenges Mr. Obama is going to face is handling current financial convulsion and terrorism. Both of them have global impact and consequences. True, this is something Mr. Obama himself cannot do on his own, as it requires a coordinated and concerted endeavor from every corner of the world. However, he will play a pivotal role and lead from the front. The success of this will depend much on how he manages the show. Some of the priorities that he will take up as soon as he takes the rein from his predecessor Mr. George W. Bush are mentioned underneath:  Designing the new fiscal stimulus program which may amount to US $ 700 billion to over 1 trillion.  Restoring and rebuilding confidence of consumers, investors and business.  Chalking out quite extensive and tougher regulations for banks (limiting their risk taking abilities and overall banking operations), consumer lending and investments.  Creating more jobs. It will be a major challenge for him because already in 2008, over 1.7 million jobs have been lost and it’s expected that it will touch 4 million in the coming year pegging the unemployment rate to over 9%.  Announcing new economic legislations where the primary focus should be on doing whatever is necessary to get the economy going again.  Ensuring balance sheet cleaning up of banks and consistently increasing funding for them.  Addressing the energy issue. The “Change” Mr. Obama will bring in will definitely change the mind-sets of regulators and great American lifestyle. It’s expected that the new regime will do whatever is necessary to stabilize the financial sector and get credit flowing once again. The previous $700 billion bailout was very badly handled. Now it’s yet to see how the Mr. Obama and his retinue would handle the next stimulus package. We expect that the primary focus would be on spending on investments that offer longterm benefits in addition to the short-term benefit of stabilizing the economy. The media reports suggest that Mr. Obama has made his first priority to sign an economic recovery package with significant focus on infrastructure projects to help boost jobs aiming at 3 million job creations over a couple of years. No doubt, few things will change for forever. Americans wont like to bank just upon credit lines and will start saving for the future. It is pertinent to mention that in US, the savings rate is in negative for several years. And the banks too will be more prudent and cautious in their lending policies.

Dec 23, 2008

For Private Circulation only

2

Unconventional monetary measures After exhausting all the conventional measures to spur the demand and stimulate the economic growth being failed, the Fed is left with fewer options now. It is expected that the Fed will take some exceptional measures like Quantitative Easing (QE) which is a tool of monetary policy also known as printing money mechanism. This is used usually to fight domestic deflation. Deflation is a persistent decrease in the general price level of goods and services only when annual inflation is below zero percent resulting in an increase in the real value of money - a negative inflation rate. All developed economies are in recession and are expected to see deflation by the second half of the next year. Inflation in the US has pegged at 1.1%, in Japan 1.7% and in the Europe area at 2.1%. The classic example is Japan which has experienced unprecedented recession and deflation for more than a decade. The Bank of Japan has been maintaining shortterm interest rates at close to their minimum attainable zero values since 1999. However, it’s still debatable how these measures are effective to such deflationary situations. Under Quantitative Easing (QE), the central banks inject commercial banks with excess liquidity to promote private lending, leaving them with large stocks of excess reserves, and therefore little risk of a liquidity shortage. It also involves reducing the reserve requirements and buying treasury bonds for cash to offset the reduction of money supply in the private sectors due to the collapse of credit through "open" market operations. Moreover they buy asset-backed securities, equities, and extend the terms of its commercial paper purchasing operation. How the QE is effective in buoying the economy? The Bank of Japan’s QE policy was introduced in March 2001 and terminated in March 2005. The policy was introduced with the intention to open-up a new possibility for further monetary easing when the interest rate was already as low as zero. The policy was unprecedented and was an ambitious experiment by itself. The effectiveness of it has been a point of great controversy since its introduction. Several empirical studies have confirmed positive macroeconomic effect of the QE and have found out that the increase in the excess money led to the increase in aggregate demand and helped the economic recovery since 2002. However, no effect has been established on expectations and portfolio rebalancing by investigating the increase in Current Account Balance (CAB) targets and increase in government bonds purchases by the central bank. It’s very cumbersome exercise to quantify the exact effect of such measures but the consensus is that they have positive effect on the economy.

Dec 23, 2008

For Private Circulation only

3

Japan: A case study To understand the effectiveness of the QE we need to examine whether the change (increase) in the Current Account Balance (CAB) is really possible. Demand for the CAB depends on the nominal interest rate, which is the opportunity cost of maintaining the CAB. Therefore, to increase the CAB, generally we need to decrease the interest rate. As the interest rate is already almost zero, increasing the balance seems difficult. In reality, the CAB has increased greatly. Two reasons are possible: 1. Telecommunication expenses and various costs associated with funds transactions may not be paid as the market interest rate is very low. So, private institutions cannot invest funds held at the BOJ's current account into money market instruments. 2. Financial institutions feared that obtaining capital from the short-term market would become difficult because of the unstable financial markets. How does the increase in the CAB affect interest rates and other asset prices viz. equity, government and corporate bonds? The short-term interest rates are theoretically expected to decrease in response to an increase of the CAB. Similarly, stock prices would rise and the yen would depreciate. However, the influence on interest rates and stock prices largely has not been realized. The main reason is that there was no room for short-term interest rate to decline. For the exchange rate, the Japanese yen actually depreciated from 116.44 yen/$ to 133.89 yen/$ (between February 2001 and February 2002), but this is mainly because of the economic recovery of the US and the instability of the Japanese financial system. Furthermore, it is noted that the depreciation of yen would end deflation but it is costly to Japan. How does the policy affect the depository institutions? Theoretically, the portfolio rebalance effect exists. In general, financial institutions consider the changes of interest rates and construct their optimal portfolios by increasing or decreasing loans, bonds, stocks, and other assets. When the short-term interest rate drops, banks expect to increase their lending activities. However, the interest rate seemed not to have a strong influence on banks' behaviors. The reason is that the interest rate in Japan was near zero, and Japanese financial institutions could not increase their risk-taking because they had large (non- performing loans) NPAs. Thus, the portfolio rebalance effect was not realized. The quantitative easing effects on the economy It is important to consider the movement of the monetary base, money supply, and GDP. These three indices exhibited similar trends around 1995. Since then, the increase of the monetary base has been remarkable; on the other hand, the increase of the money supply was not so large, and the GDP leveled off. Raising the reserve target may have been perceived as a signal indicating the BOJ's accommodative policy stance. Most economists also argue that the QE policy has contributed to financial stability. However, the above-mentioned brief evidence may suggest that the QE has not been very effective. In addition, many Japanese economists have stated that the recent economic recovery is not due to the QE policy. However, there is some possibility that the "time duration effect" is effective. References: 1.

Research reports by MIHIRA, Tsuyoshi (Toyo University), YAMASAWA, Nariyasu (Atomi University), SEITANI, Haruki and SAITO, Jun (Economic and Social Research Institute). 2. International Journal of Business, Winter 2006 by Kurihara, Yutaka

Disclaimer: This document has been prepared by Arthaeon Financial Services and is meant for sole use by the recipient and not for circulation. This document is not to be reported or copied or made available to others. It should not be considered to be taken as an offer to sell or a solicitation to buy any security. The information contained herein is from sources believed to be reliable. We do not represent that it is accurate or complete and it should not be relied upon as such. Arthaeon Financial Services and/or its affiliates or employees shall not be liable for loss or damage that may arise from any error in this document. Arthaeon Financial Services may have from time to time positions or options on, and buy and sell securities referred to herein. We may from time to time solicit from, or perform investment banking, or other services for, any company mentioned in this document.

Dec 23, 2008

For Private Circulation only

4