Microcredit may not work wonders but it does help the entrepreneurial poor

MICROCREDIT looks like a miracle. It involves providing unsecured small loans to poor people in developing countries whom most banks would turn away. Yet these small borrowers almost always repay their loans (and the fairly steep interest charges) on time, which suggests that they find productive uses for the money. The industry’s backers make some big claims as a result: Mohammad Yunus, the founder of Grameen Bank in Bangladesh and the father of microfinance, reckons that 5% of Grameen Bank’s clients exit poverty each year. Yet economists point out that there are surprisingly few credible estimates of the extent to which microcredit actually reduces poverty.

This would not matter too much if all microfinance funding were raised via the market (as an increasing proportion is). As long as investors were satisfied with their returns, there would be no cause for concern. Yet despite growing interest from private investors, 53% of the $11.7 billion that was committed to the microfinance industry in 2008 still came at below-market rates from aid agencies, multilateral banks and other donors. Given that there are other things that aid money could be spent on, and that the rationale for subsidising microcredit is its effectiveness as an anti-poverty tool, it is important for donors to know whether it has the advertised effects.

Measuring the impact of microcredit is complicated by the fact that the counterfactual—what would have happened to a person who borrowed from a microlender if he had not done so—cannot easily be tested. Many early studies compared borrowers with non-borrowers. But if borrowers are in any case more entrepreneurial than those who do not borrow, such comparisons are likely to overstate hugely the effect of microcredit.

Worries of this nature are not mere nitpicking. One study surveyed 1,800 families in rural Bangladesh and found that an impressive 62% of school-age sons of those who borrowed from Grameen Bank were in school, compared with 34% of the sons of non-borrowers. Advocates argued that this showed that microcredit helped increase school enrolment. But a comparison with people of similar backgrounds in villages without access to microcredit showed that the difference was because people who were already more likely to have children in school were also those who signed up for microcredit. Even comparisons between areas with and without microcredit may be misleading, because microlenders naturally choose to work in areas where their prospects of success are the greatest.

The pervasiveness of these self-selection issues has led researchers to devise experiments that allow them to ensure that participation in a programme is determined essentially by chance. Two new papers* apply this idea to measure the effect of access to microcredit. Researchers from the Poverty Action Lab at the Massachusetts Institute of Technology (MIT) worked with an Indian microfinance firm to ensure that 52 randomly chosen slums in the city of Hyderabad were given access to microfinance, while 52 other slums, which were equally suitable and where the lender was also keen to expand, were denied it. This allowed the researchers to see clearly the effect of microcredit on an entire community. Dean Karlan of Yale University and Jonathan Zinman of Dartmouth College carried out a similar exercise in the Philippines, this time at the level of the individual borrower. They tweaked the credit-scoring software of a microfinance firm so that only a random subset of people with marginal credit histories were accepted as clients. These clients could then be compared with those who sought credit but were denied it.

Broadly speaking, neither study found that microcredit reduced poverty. There was no effect on average household consumption, at least within a year to 18 months of the experiment. The study in the Philippines also measured the probability of being under the poverty line and the quality of food that people ate, and again found no effects. Microcredit may not even be the most useful financial service for the majority of poor people. Only one in five loans in the Hyderabad study actually led to the creation of a new business. Providing people with safe places to store their (small) savings may help them more in the long run.

Small and perfectly formed?

That said, microcredit did have discernible effects. In India, people in the slums that had access to microcredit were more likely to cut down on things like tobacco and alcohol in favour of durable goods (particularly items such as pushcarts or cooking pans that are used heavily by traders and food-stall owners). One reason average consumption failed to increase may therefore be that more people were diverting some of their own income into starting or expanding their businesses. Microcredit clearly allowed more people to overcome the barrier posed by start-up costs. The MIT researchers found that as many as one-third more businesses had opened in slums which had a microcredit branch. This may mean that even though there was no measurable impact on poverty during the study period, there may well be some over a longer time-frame as these businesses prosper.

Tiny loans are unlikely to be enough to allow these businesses to grow to an efficient scale, of course. But the role of microcredit in allowing people to signal their creditworthiness is valuable, especially if their success makes banks more willing to lend them larger sums and leads to even more economic activity. By being willing to take a risk on entrepreneurial sorts who lack any other way to start a business, microcredit may help reduce poverty in the long run, even if its short-run effects are negligible.

Source: The Economist   ( Jul 18 - 24 )

Goldman Sachs's record profits owe more to lack of competition than market recovery

TO THE survivors, the spoils. That is the cry going up at Goldman Sachs after it chalked up recession-defying—nay, record-breaking—quarterly profit on Tuesday July 14th. Minting more than $3 billion in as many months, so soon after its own near-death experience in the wake of Lehman Brothers’ demise, will enhance Goldman’s reputation as Wall Street’s overachiever. But it will also strike some as faintly obscene given the scale of public support needed to keep the firm and its peers from buckling last year.

The first half of 2009 was fertile for investment bankers as markets rebounded and companies (not least banks themselves) rushed to raise debt and equity. But none of the banks still due to report, not even a resurgent JP Morgan Chase, is expected to come close to Goldman’s blow-out performance. Having incurred smaller losses than rivals, it is still prepared to deploy risk capital where others fear to tread.

Goldman claims that most of its profit came not from “proprietary” trading, or punting its own money, but by acting as a middleman, making markets for clients in everything from bonds and shares to currencies and commodities. Such “agency” business, barely profitable in the boom years, has become a potential goldmine as competition has dwindled and bid-ask spreads (the slice dealers pocket on trades) have ballooned. A bank with the capital and daring to deal mortgage-backed securities issued by Fannie Mae or Freddie Mac can earn 10-15 times more than before the crisis.

Goldman, a dyed-in-the-wool trading firm, is grabbing such opportunities with glee, taking business from once ubiquitous but now reeling rivals, such as Citigroup and UBS. It also helps that its arch-rival, Morgan Stanley, has pulled in its horns. By contrast, Goldman’s value-at-risk—the amount it could lose on a bad day and thus a widely used (if imperfect) measure of risk appetite—hit a new high last quarter, jumping most in equities, even as stockmarket volatility fell. With spreads so high, the firm no longer needs to use as much borrowed money to get results. Its leverage ratio has fallen to 14, half its pre-crisis level—though still much higher than that of a typical commercial bank.

This windfall will eventually dwindle. Goldman and other survivors will benefit from the coming wave of debt issuance by federal, state and local governments. But dealer spreads are sure to shrink as markets normalise and those that have retreated return to the fray. This is likely to be offset only partially by a pick-up in businesses tied more closely to economic growth, such as advising on mergers and acquisitions.

Wall Street will also face tighter shackles. Regulators are on the warpath against commodities speculators. A clampdown is also coming in credit derivatives; this week America’s Justice Department joined those probing that market. America’s largest financial firms face higher capital requirements. These changes may not bring Goldman back to earth but they will clip its wings.

In the shorter term, the bank needs to worry about a possible backlash against its incongruously generous pay policies. For the year to date it set aside $11.4 billion for compensation and benefits, more even than in the halcyon first half of 2007. Its ratio of pay to revenues continues to hover near the dizzying 50% level that was the norm on Wall Street before the meltdown.

For a firm that probably would have collapsed without government capital, debt guarantees and fast-track approval to turn itself into a commercial bank (not to mention a multi-billion-dollar payout as a counterparty of American International Group), such largesse is cheeky at best, distasteful at worst. It has already drawn rebukes on Capitol Hill, even though Goldman has repaid the government’s $10 billion preferred-equity investment.

The firm’s continued generosity towards its employees may, in any case, be premature. Markets remain fragile, and even Goldman would struggle without the array of government loan facilities and other backstops in place. These are insufficient to keep some firms afloat. Officials are now working on a rescue package for CIT, a liquidity-crunched lender to small and middling companies. That they are shoring up a firm too small to pose a systemic risk betrays a continuing lack of confidence in the financial system’s ability to absorb even modest shocks. They appear to have concluded that it is better to court moral hazard than to risk setting off another round of instability.

Indeed, while a few on Wall Street are reaching for the champagne, most Main Street lenders are inclined to drown their sorrows. Credit-card losses are at a record high. Mortgage delinquencies are yet to stabilise, with supposedly high-quality “prime” loans now also souring fast and loan-modification schemes having little impact.

Losses are also accelerating in commercial property, on which banks of all sizes loaded up in the fat years. This was the biggest stain on Goldman’s ledger, accounting for more than $700m of mark-to-market losses. Unnervingly for other banks, many of which carry their commercial-property loans at close to par value, Goldman marks its portfolio at half that. A Federal Reserve financing programme was recently extended to commercial mortgages but many are or will become ineligible under its present rules because of ratings downgrades. Meanwhile, a public-private scheme to take troubled loans off banks has stalled, partly because of accounting-rule changes that give the banks more leeway in valuing them, reducing pressure to sell—though a $40 billion sister programme for toxic securities finally got going last week.

Small wonder, then, that David Viniar, Goldman’s chief financial officer, admitted to analysts that “we are way far away from being out of the woods”. The firm may be scooping up market share at quite a clip. But the bigger picture is still far from pretty.

Source: The Economist   ( Jul 18 - 24 )

Investors may be too complacent about the outlook for property

TWO bear markets in the past decade have made many investors reconsider their attitude towards equities. The argument that shares are the best investment for the long run no longer sounds quite so convincing. Property is not yet the subject of such disillusionment. Already, in the British residential market at least, estate agents are talking as if the crisis is over. Many people seem to assume that once the recession has finished, property prices can resume their traditional upward course.

But if equities are doomed to struggle, property will surely follow. The terrible performance of the Japanese equity market over the past 20 years is well known. It is easy to forget that property prices have suffered almost as much. Japanese land prices are still 58.5% below their 1991 peak, and indices of residential and commercial property are 44.3% and 73% below their highs respectively.

One should expect a rough link between equities, property markets and economic growth. Neil Turner of Schroders, an asset-management group, says a simple model suggests that property returns should equal the starting yield plus rental growth. In turn, rental growth is linked to income growth and thus to nominal GDP. On the same basis, equity returns should be equivalent to dividend yield plus dividend growth, with the latter linked to GDP.

Over the past decade, however, property seems to have performed much more strongly than equities. Only in 2008 did the IPD index of global commercial property show a negative return. But the 10.1% fall (in dollar terms) was a lot better than the 40.3% plunge in the MSCI world-equities index. Over the previous decade, from 1998 to 2007, an investor who put a notional $1,000 in the IPD index would have trebled his money (assuming he reinvested his income) while an equity portfolio tracking the MSCI index would have merely doubled.

Part of that outperformance may be the result of the stratospheric valuations on which equities traded in the late 1990s. Property values started from a much more reasonable base. But property’s relative stability may be an illusion caused by an illiquid market; values have simply not been marked down as much as they should have been.

The fact that British property returns were the second-worst of all countries in the IPD database in 2008 was not just down to a lousy economy. It was because British companies tend to be quicker to adjust values to reflect recent transactions. Other countries are slower to act, but the mask occasionally slips. Earlier this year the John Hancock tower, a Boston office building, was auctioned for $660m. It had been bought for $1.3 billion in 2006.

The Hancock deal was a distressed sale, of course. But other such deals will surely follow. In a recession vacancy rates rise, rental income stagnates or falls, and financing is both more expensive and harder to renew. David Skinner of Aviva Investors, a fund-management group, says that property prices since 2000 have been driven not by fundamentals but by the availability of credit.

Property was indeed a great investment at a time when financing was easy and recessions were occasional and mild. But that world has disappeared for a while. Even low interest rates may not help, as the Japanese example has illustrated over the past 20 years.

The naive belief that American house prices could not fall at the national level has been exposed by the current crisis. The belief that property prices must rise over periods of a decade or more may also prove to be false. Figures from Robert Shiller of Yale University show that real American house-prices were lower in 1945 than they were in 1900, for example. In a world of low inflation that means they could easily fall in nominal terms.

What about the argument that the result of this crisis will inevitably be inflation? Surely property would be a good hedge against such an outcome, as rents would be expected to keep pace with higher prices in the long run?

It sounds good in theory, but in practice the result of inflation would probably be a one-off rise in rental yields caused by a sharp fall in property prices. The 1974-1976 inflationary downturn in Britain saw cumulative commercial-property losses of 45%; yields rose from 5.7% to 8.7% between 1973 and 1975. Any increase in inflation would also lead to higher interest rates, causing further problems for leveraged investors. A strong economy is a far better backdrop for property than inflation ever could be.

Source: The Economist   ( Jul 18 - 24 )

Burgernomics points to uncompetitive currencies in continental Europe

Data- http://ronaldecon.blogsite.org/image/big_mac_Jul_09.gif

WHEN demand is scarce and jobs are being lost, no one relishes a strong currency. A country with an uncompetitive exchange rate will struggle to sell its wares abroad and will also cede its home market to foreign firms. A weak exchange rate, by contrast, encourages consumers to switch from pricey imports to cheaper home-produced goods and services. So which countries has the foreign-exchange market blessed with a cheap currency, and which has it burdened with a dear one?

The Economist’s Big Mac index, a lighthearted guide to valuing currencies, provides some clues. It is based on the theory of purchasing-power parity (PPP), which says that exchange rates should equalise the price of a basket of goods in each country. In place of a range of products we use just one item, a Big Mac hamburger, which is sold worldwide. The exchange rate that leaves a Big Mac costing the same in dollars everywhere is our fair-value benchmark.

The dollar buys the most burger in Asia. A Big Mac costs 12.5 yuan in China, which is $1.83 at today’s exchange rate, around half its price in America. Other Asian currencies, such as the Malaysian ringgit and Thai baht, look similarly undervalued. Businesses based in continental Europe have most to be cheesed off about. The Swiss franc remains one of the world’s dearest currencies. The euro is almost 30% overvalued on the burger gauge. Denmark and Sweden look even less competitive.

Care is needed when drawing quick conclusions from fast-food prices. The cost of a burger depends heavily on local inputs, such as rent and wages, which are not easily arbitraged across borders and tend to be lower in poorer countries. So PPP gauges are better guides to misalignments between countries with similar incomes.

On that basis, the markets have been kindest to British exporters. A year ago the pound was overvalued by more than a quarter on the Big Mac gauge. Now it is close to its fair value against the dollar and looks cheap against the euro. That shift has upset some other EU countries that had relied on selling to spendthrift British consumers. But after years of struggling with an overvalued currency, British firms will feel they deserve a little mercy.

Source: The Economist ( Jul 18 - 24 )

Extended reading: http://ronaldecon.blogsite.org/index.php?id=467

Are investment banks run for employees or shareholders?

IT WAS once famously asked of Wall Street: “Where are the customers’ yachts?” Shareholders of investment banks have not seen much of the spoils either, given the events of the past two years. As business booms once more, rather than reward their owners with an extra big chunk of profits, most investment banks seem likely to favour their employees again. In the case of Goldman Sachs, shareholders received $4.4 billion of profits during the first half of this year while staff were allocated $11.4 billion in pay and bonuses, equivalent to about half of the firm’s net revenues.

Banks defend their model by arguing that they have to pay top dollar to secure the best employees, who maximise profits for shareholders. If they paid less, profits would be lower. For Goldman there may be some truth in this. In the first half of 2009 shareholders still earned a healthy return on equity of 19%. And over the decade to the end of 2008, even though cumulative compensation was double profits, return on equity averaged 20%. Furthermore, since a chunk of bonuses are paid in stock and staff cannot sell their shares immediately, their interests are to some extent aligned with those of shareholders.

There are several holes in the industry’s argument, however. One is that when investment bankers owned the banks themselves, partners demanded higher returns on their equity than public shareholders now get. In the three years before the bank floated in 1999, Goldman partners earned returns on their capital of about 50% each year.

More importantly, the industry-wide practice of paying out about half of net revenues to employees looks a lot less palatable for shareholders once mediocre or bad banks are taken into account. This is a risky industry: two of America’s five big stand-alone investment banks collapsed during the crisis. And when things go wrong employees do not always take their share of the pain.

Lehman Brothers made losses in the two quarters before it collapsed yet continued to accrue a compensation pot not far off the levels of 2007. Shareholder returns over the entire cycle look a lot worse when the failures are included. Lehman paid out $55 billion to employees in the decade to the end of 2008. Shareholders earned cumulative profits of zero, including the loss of all of their capital when the firm failed (see chart).

Banks pay low dividends, and when they get into trouble the capital that shareholders have retained in the firm typically gets wiped out. Employees have taken money out of their firms each year. It may be time for the owners of banks to mutiny over the bounty.

Source: The Economist ( Jul 18 - 24 )