Adverse Selection at its best in Maldives…

I remember one of my professors explaining to me the difference between regulating a restaurant and a bank. He says that even if five restaurants closed down within a week, it doesn’t affect much to the macro economy; however, if even one bank was to fail each week, then it sure will impact the macro economy of the country. It is because of this reason, we need an authority (an effective one), to regulate, supervise, and monitor the activities of commercial banks and other financial institutions.

The under-developed financial sector of Maldives has six commercial banks, a leasing company, and a housing development finance corporation. The commercial banks mainly rely on their lending to the tourism sector for most of their profits. According to the published statistics from the regulating authority, MMA, 59 percent of the total lending of the banks is to the tourism sector, as at end of 2009. There is an outstanding amount of over $700 million (Rf 9 billion) lent to the tourism sector at the end of 2009. According to the website of MMA, the lending rates of the commercial banks in Rufiya ranges between 8 through 13 percent, and for US Dollars it is 5.5 through 13 percent.

The banks normally think that their profits will increase if they lend at higher interest rates; as high as 13 percent. However, what they don’t realize is that at such higher rates, there will come many borrowers who do not have the intention of repaying back. There will come many businessmen, with risky projects, having very high uncertainty of recovering the investments. The banks hence face the problem of adverse selection. This is exactly what has happened to some banks in Maldives. In order to record higher bank profits, the bank managers decided to lend huge amounts to very risky borrowers, when these risky borrowers did not have the intention of repaying back, in the first place. So, we can argue that with the increase in interest rate (lending rate), the probability of repaying back falls, and the profitability of banks fall.

Another very good example of adverse selection was seen in the tourism sector few years back, when the Ministry of Tourism opened several invitations to bid for new islands for resort development. Many parties proposed incredibly high rents, and they were awarded the island. What the government did not realize was; the probability of the investor making regular rent payments; and even the probability of the investor ever being able to develop the island and open the resort, decreases with every percentage increase in the rent proposed. In other words, by selecting the party with highest rent, the government is effectively selecting the party with the lowest probability of making the rent payments, and the party with the lowest probability of ever being able to develop the island. I think the evidence we see now supports this claim. There are still more than fifty islands unable to start their operations. And one of the main reasons they are unable to attract finance is due to the incredibly high rents that they need to pay the government.

Greek and Maldives' economy

According to the data released on Thursday, the Greek budget deficit has reached to 13.6 percent of its GDP. The Greek Prime Minister, George Papandreou announced on Friday that his government was seeking to activate assistance from IMF and the European Union, totaling $60 billion as loan financing.

According to available statistics, Greece needs more than $13 billion to cover part of its debt coming due in May 2010. The total debt comes to about $400 billion, out of which $72 billion is due this year.

Because of the crisis in Greece, fellow eurozone members are worried, as a troubled Greek economy will surely pose problems to the euro economy, and the euro currency. Hence, it is in the best interest to all the member countries to salvage Greece.
We all have heard on the news that Greek authorities implemented a series of austerity measures; including tax increases, and wage cuts for government employees. This has led to demonstrations and unrest across the country. Civil servants conducted large demonstrations and strike in Athens.

All these sound familiar, right? The Maldives budget deficit was 26.1 percent of GDP in 2009, and is expected to fall to only 18.7 percent of GDP even this year. Maldives could be the country with the highest government deficit as a percentage of GDP in the whole world. We also could be the only country with the highest government wage bill as a percentage of GDP. We are spending about Rf 4 billion within a year to pay for salaries of all public employees; including civil servants, politicians, parliamentarians, and those in the independent institutions. Meaning we spend about Rf 400 million every month, only on salaries!

Our present government announced several austerity measures as well, including reduction of salaries, and reducing the number of civil servants. What followed is similar to what is happening in Greece. I say, there might come a time, when the international partners will abandon us, asking us to manage our expenses within our means. We are not Greece; there is no interest for the Europeans to save us. Our economy is insignificant to the region, and the world. Unless we manage our expenses and our economy, we will not be able to come out of this economic recession.

We need to reform IMF...?

Over the past 60 yeas, the world economy has become very inter-dependant. Due to globalization, development and crises have a contagious effect within regions. Further, as highlighted by Buira in his article, improvements in technology and communication , for example greater use of Internet and information technology has led to formation of an “international capital market".

The governing structure of IMF was formed in 1944 under the Bretton Woods Conference. However, a lot have changed since then in terms of size of economies, population of countries, share of world trade, reserves, and countries’ abilities to contribute to financial resources. Hence, it is evident that there is a need for reform of this important multilateral financial institution in order to achieve more effective financial global governance.
Here, I will highlight the main issues on the IMF Reform agenda put forward few years back.

The main reforms:

1. Making surveillance more effective
According to Article I of the Articles of Agreement of the IMF, one of the main purposes of the Fund is to ‘promote international monetary cooperation through a permanent institution which provides the machinery for consultation and collaboration on international monetary problems’. In order to achieve this important mission, Article IV of the same Agreement stipulates that all member countries are required to collaborate with the Fund to assure orderly exchange arrangements and to promote a stable system of exchange rates.

However, recently the Fund has very much being criticized on its inability to influence the policies of powerful countries like USA, especially even when economies of such countries have a significant impact on the economies of developing countries.
One such criticism is that, “when the Fund consults with a poor and weak country, the country gets in line. When the Fund consults with a big and strong country, the Fund gets in line”.

As Ariel observed, ‘the world moves away from rules-based multilateral system to a power-based system’, whereby, larger powerful countries ‘go their own way based on their short term interests’ (Ariel 2005).

This was very much evident during the time when the United States Treasury responded to an IMF report, which highlighted the importance of the US current account deficit and the growing indebtedness, by stating that Treasury did not consider that a correction was necessary in its domestic policy (Ariel 2005).

In order to overcome this problem, the Managing Director’s Report 2005 recommended, ‘more incisive analysis of specific weaknesses and distortions that risk crises and contagion or hinder adjustment to gloabalization’. The Managing Director’s Report further describes various specific action plans that can be implemented to achieve the above mentioned recommendation; global surveillance, multilateral dialogue, financial market surveillance, having standards & codes, regional surveillance, country surveillance, and communications strategy.

2. Adapting to new challenges and needs in different member countries
The Managing Director’s Report outlines specific actions to be taken in terms of the Fund’s role towards the advanced, emerging and low-income countries.
With regard to advanced economies it is recommended that global implications are integrated into country specific policies.
Emerging market economies are characterized in the Report as the ones that need crisis prevention and resolution due to their high ‘risk of boom-bust cycles emanating from the volatility of capital flows’ (IMF 2005). Improving financial insurance in these countries is also on the agenda, with particular emphasis on helping member countries to ‘develop local financial markets and instruments’.
Finally, the role in low-income countries is recommended to be more focused, with more flexibility, more emphasis on the Millennium Development Goals, and having fewer procedures.

3. Helping build institutions and capacity
The Fund recognizes the need to further strengthen its ability to provide technical assistance to countries in the area of capacity building and improving institutions. The specific action recommended by the Fund is ‘to give area departments the central role in setting technical assistance priorities in the context of Article IV surveillance and Fund supported programs’. The Fund also acknowledges the need to enhance fiscal transparency and governance as they play an important role in the development of economic institutions.

Although the need for better institutions and capacity building is acknowledged and important, it is questionable how much overlapping and duplication is present in terms of providing technical assistance to member countries, between IMF and the World Bank. Hence, further reform in this area needs to consider this aspect and coordinate better with the Bank on matters relating to capacity building.

4. Prioritization and reorganization of work within a prudent medium-term budget
The Fund highlights the need ‘set priorities for the next few years based on a country-by-country analysis’.
The Fund also needs the reorganization which is necessary to implement the various components of the budget and hence recommends better organization of expert staff, departmental structure, management, executive board, and international monetary and financial committee.

5. Address the issue of fair quotas and voice
In order to achieve the mission of IMF more effectively, it needs to reallocate quotas and voting rights in order to reflect the changes that has taken place in the world economy during the past sixty years. The reallocation should be in such a way to reflect the interests and power of those countries whose share in the world economy has increased, and in general, in a way that the legitimacy of the Fund could be greater.

Concluding Remarks

The G-7 Finance Ministers and Central Bank Governors met in Tokyo on February 09th 2008 and discussed about IMF reforms, reaffirming their support on the IMF surveillance decision on exchange rate, fiscal and monetary policies. In their statement they expressed their support for the “proposal of the Managing Director to refocus the Fund’s operations on core priorities”. This is a positive message that reflects the commitment from the richest nations of the world, and is expected to have a significant impact on the reform agenda of the Fund.

The reforms outlined above are those highlighted in the Managing Director’s Report, 2005 and in addition to these, there are few other areas that need attention.
Some of them include, making the work of the Fund in the member countries more ‘demand-oriented’ taking into account the local circumstances and needs of the countries, rather than being ‘supply-oriented’ by the replicating what is being done in many other countries. In some countries, some of the new projects or policy recommendations are suggested and being ‘forced’ to be developed into loans, even though such loans are not diverted to the most efficient use or sector. In the meantime, there are many other areas that need special attention and assistance, but unable to attract the attention of the Fund or the Bank, as the officials of these institutions do not feel that they are important.

Finally, it has to be emphasized that rich and powerful countries need to be brought on-board in understanding the importance of global financial governance, and the relative effects of global integration, and thus adapting policies that can have positive impacts on the world economy.

In order to achieve ability to force corrective action on its members, the Fund needs reorganization and reallocation of its quotas and voting rights. Reallocation of quotas is also important in order to improve the legitimacy of the institution and hence, achieve the core objectives of the Fund.

Foreign Aid - Is it free?

Foreign aid has attracted a bit more attention lately, but it has, since its inception in 1950, been a controversial issue. Recently a book by William Easterly (Title: The White Man’s Burden: Why the West’s efforts to aid the rest have done so much ill and so little good. Publisher: Penguin Press, 2006) has set off a new round of discussions and questions and polemics. So I thought that I would join in.

I will concentrate on Official Development Assistance (ODA), essentially aid in the form of funds given by the rich countries to the low and middle GDP countries of the world. ODA is the largest of the various aid categories. I may try to discuss other categories, especially technical aid, in a later post.

Official Development Assistance has been of significant size. In the year 2006, for example, it amounted to $120 billion in current prices. (This is the world total.) This seems to me to be a sizeable figure, but it is a small proportion of the West’s Gross National Income, and it was spread over many countries, not necessarily on the basis of need or the ability of a country to use it productively.

This foreign aid of course is meant to provide a country with resources in addition to those of its own. Aid then is a supplement to domestic saving. Government can then do things it could not have done without the aid. This is obvious of course. Suppose a government is using its own resources effectively, and then gets some aid. It can then do more–can build more elementary schools, can improve or maintain more roads, can guarantee farmers a good price for their crops, and so on–than it could in the absence of aid. Aid obviously can be of great help in the development of a country. Why are there doubts?

There are several reasons that have been mentioned by opponents of aid. It breeds corruption, it is wasted on pet projects pushed by some government officials, it enables the continuation of harmful policies, it makes exchange rate management more complicated, it dampens pressure on domestic resources to seek productivity gains, donor countries often put damaging restrictions on the use of aid funds, and so on and on. These doubts are real and there are many examples that one could cite of their impact. At the same time there are many examples of aid having a very favorable effect on a country’s development effort. Botswana and Korea are examples of aid working in an effective way.

For aid to be effective the overall economic policy of a country must be in order. The country must understand how its economy functions. As noted above the aid receiving country must be using its own resources effectively and to appreciate how it can use additional resources in an equally effective way. This is not an easy thing to do. And it is not surprising that aid is often misused, not because of corruption or selfish government officials, but because the understanding of the aid receiver’s economy is so limited. Thus foreign aid is beneficial where those who manage the economy understand how their economy in fact works. Where the donor imposes conditions for its aid that the recipient believes to be inappropiate, aid must be rejected. Do not think because it is aid it is free, and doesn’t matter. The costs may be high. There is no such thing as free aid, as there is no such thing as a free lunch.

What the government and the civil servants need to understand on the issue of salaries

The government announced pay cuts for civil servants during the last quarter of 2009, and revealed plans for gradually reducing the number of civil servants. On various occasions, the president has tried to explain his strategic economic reforms, and overall macroeconomic policies adopted by the present government. He’s outlined the reasons for his drastic measures of reducing government recurrent expenditure on salaries, and increasing electricity tariffs and stop subsidizing the State Electric company.

The years following 2004 tsunami, the macroeconomic management can be best described as ‘stupid’, ‘politically-motivated’, and mostly unsustainable. Government’s current expenditure hiked to unsustainable levels, mostly through increasing salaries, and huge promotions. This was followed by formation of many independent commissions and institutions, again with huge salaries. Meanwhile, salaries of the Parliamentarians, and ministers also increased drastically. All these led to extremely high government budget deficit, that was financed through printing Rufiyaa. This led to increasing inflation, as equivalent goods and services were not produced, and the productivity in the economy did not improve.

International financial institutions like IMF, World Bank, and Asian Development Bank, all advocate reducing government deficit and stop printing Rufiyaa to finance the deficit. (http://www.imf.org/external/np/sec/pr/2010/pr1013.htm)The government expenditure has to be financed through revenue collected from taxation. Not by any means through printing Rufiyaa. Whenever we print Rufiyaa, we’re adding up to our problems, as it’d lead to higher inflation, and difficulties in obtaining US dollars. These financial institutions who provide assistance to us, have been advising us to reduce the redundant civil servants, stop subsidizing STELCO (by increasing the electricity prices), and reduce the government wage bill.

The rationale is: we cannot continue paying higher salaries to many staff who do not add any value. In other words, we pay salaries to government employees in order to provide some services to the public. We need to reduce the number of government employees, so that redundant, or unnecessary staff are removed, so that they can get employed elsewhere. Regarding the salaries, it is common sense that anybody, even if it’s the government, cannot continue to pay higher salaries, if it cannot raise enough revenue to pay for that. So, reducing salaries would be the best option in order to reduce government expenditure and deficit. If not, deficit will have to be financed through borrowing or printing Rufiyaa, both options being bad for the economy.

Reducing salaries of civil servants, reducing the number of civil servants, and increasing electricity prices, are all political suicides for a president or a government. However, the current government was forced to take these steps, as it was recommended by the IMF, and many other donors. Further, the assistance package provided by IMF requires government to reduce the deficit levels to certain levels or targets, and for such conformity, these steps have become necessary. So obviously, the government’s policy and decisions are for the future benefit of our country.

But, why are the civil servants, and the civil service commission still protesting, and demanding higher pay? Answer is simple; although the government’s economic plan is prudent, and is necessary for the country, the sincerity of the government is being questioned by the civil servants and the public. Why do I say that?

If there were same principles applied to all employed staff of the state, including, civil servants, political appointees, staff of independent commissions, and parliamentarians, then, it is more likely that the civil servants would have accepted a lower pay even for the whole year. However, what we see is that political posts keep on increasing, and the salaries of parliamentarians and some of the independent institutions were not reduced.

The IMF and those institutions advise to reduce the total wage bill. The total wage bill includes the salaries of all political posts, parliamentarians, and civil servants. So, if we are talking about reducing the number of civil servants by laying off redundant workers, then the same principle needs to be applied to political appointees as well. Redundant political appointees need to be laid off. Just like civil service staff are hired and employed based on their performance, need, and productivity; even political appointees should be appointed and employed based on the need, their performance, and the productivity. The salaries of political appointees and the civil servants, and even the parliamentarians are paid by the same budget; the state budget. Hence, in order to show sincerity, and commitment to reducing government expenditure and deficit, government needs to apply same principles, and treat everybody impartially. Government needs to lead by example.

don't worry...be happy.. :-)

Recently I opened a poll to obtain an idea about how the readers of this blog feel about their life. Whether they are happy, not very happy, fairly happy, or not happy at all. An overall index closer to 4 would mean that our society is a fairly happy society. From the results of this short survey, the happinness index comes to 2.4. Ofcourse this is not a representative result of the whole society. In order to determine the happiness level of Maldivians, we would need to conduct a comprehensive survey, covering a significant sample of the population.

Talking about happiness, it could be the case that different people interpret happiness in different ways. For me, happiness means feeling good, enjoying life, and think to myself, “What a wonderful world”! Happiness has many dimensions; we feel different at different times of the day, when we are with different people, and when we are doing different things. A study done in 2003 by Kahneman et al, in which 1000 working women in Texas were asked how they felt at different times of the day. The results are reproduced here.

According to the results, Americans felt least happy while commuting, and the highest index is for sex. This could obviously vary for different societies, and I don’t know which activity makes Maldivians happier.

The same study determined, how happy they were spending time with different people, and showed that they were happiest while spending time with their friends (3.3), and least happy while with their boss (2.0).

Individual happiness levels, according to Layard of London School of Economics, depends to a large extent on how happy others are. If your neighbor earns twice your income, any income raise that you get may not make you happier, as still others’ incomes are much higher than yours. Well, incomes are only one of the factors that makes us happy.

Layard raises an interesting point, that people in the west have become much richer, work much less, have more holidays, travel more, live longer, are healthier, but, still they haven’t got happier. So what shall we do, to make us happier?

10 things I hate about MONEY

Money may come easily for some, but there are ways it can go easily as well. So, here are some things advised by experts on being rational or sensible about money.

1. Live within your means and monitor how you spend your money
2. Save a portion of your income before spending the balance. Aim to keep six months of income for emergencies
3. Make use of credit cards wisely and settle debts promptly to minimize interest charges
4. Gather information and shop around before buying any financial product
5. Buy a financial product only that you understand. Read the terms and conditions carefully before you buy any financial product.
6. Understand what your insurance policy covers. Pay attention to exclusions and other terms and conditions of your policy contract
7. Be careful about buying any financial product on impulse. Determine your need and buy what is suitable for you
8. Do not give into persistent sales tactics and learn to say ‘No’
9. Plan early for your retirement. The government pension scheme normally covers only the basic retirement needs
10. Invest wisely by spreading the money over different types of investments. A financial product that has a higher return usually comes with higher risks as well

Source: Singapore ‘Money Sense’ program, 2004

Three days left to vote!!

If you have not voted yet, here's your last chance to take part in this survey. The survey will end in three days!

IMF Executive Board Concludes Article IV Consultation with Maldives

http://www.imf.org/external/np/sec/pn/2009/pn09142.htm

Determine the happiness level of Maldivians., the survey continues..

Please take part in this survey, and tell me whether you're happy with your life.

Are you happy with your life? Take part in the survey

Please take part in this survey, an effort to obtain an idea about the happinness level of Maldivians. There are several factors that determine the average happiness level of a population / community. Some of the factors include, their income levels, how often you get access to paid holidays, the level of health sector development, the food and nutrition standards, and family values or family ties.

The survey will be open till January 15th 2010.

Thank you

Sea level Raees

Our president has done a great job obtaining the attention of both international and local media through his campaign on environmental issues. The underwater cabinet meeting was telecast on many well known international tv channels, and reported on many newspapers. His speeches, and media interviews also cover the impact of environmental change to the Maldives. Particularly, that sea level rise will result in Maldives being submerged in water, and that all Maldivians are gonna ‘die’.

Having the attention of the international media is one thing. A president repeatedly advertising the death of its country, while at the same time participating in seminars/forums attracting foreign investments and aid, is yet something of great concern.
I’m sure the president shows admirable character; through his articulate skills, entertains and convinces huge groups of people on different issues. My guess is that as he used to be a journalist, it seems that he’s a firm believer in ‘letting the truth out’, no matter what. So, Indian tv channel got the story about Maldivian terrorists fighting in Pakistan.
Many of my friends who are in regular contact with foreign investors have told stories of some huge investors being a bit uneasy about the president’s remarks regarding the fate of Maldives. I’ve also seen some of the e-mails sent by such investors on the subject.
I guess there are serious issues that need to be brought to the attention of the government, and the president.

For a start, president Nasheed needs to rethink his real objectives, and give priority to the welfare and future of the nation instead of promoting his personal fame in the international forefront. His recent remarks and speeches in the international media has had un-measurable damages to the Maldivian economy. Foreign investors are scared and reluctant to make new investments in Maldives, as the president appears on TV and other media interviews to announce that the country’s going under water pretty soon, and also, that the country has a stock of terrorists who are being trained from Pakistan.

Existing investors are also in a state of confusion, and may in the near future leave the country after selling off their investments.

I’m not suggesting that we stay in denial, by just ignoring the harmful effects of climate change and sea level rise. We need to work out plans and put in place adaptive measures to tackle environmental disasters. We need to reduce our carbon emissions, and call other countries to do the same. At the same time, we need to keep living instead of giving up on everything, saying that we all gonna die soon. We need to attract foreign investors to come and set up their businesses here. Especially, when the government’s main policy on economic reform is to privatize existing state owned enterprises, and where possible rely on public private partnerships for provision most of the public goods and services.

Random thoughts on 2010 government budget

I’m still not very much convinced that we’ve formed all these independent institutions with their fat salaries, at the right time. I know, we need political reforms, we need to protect human rights, we need to maintain police integrity, all this and that. But first of all, we should be able to afford all this. Looking at the 2010 budget, we are spending about Rf 12 million on human rights commission, Rf 14 million on anti-corruption commission, and a combined Rf 10 million on police integrity commission and the employment tribunal. A grand total of Rf 463 million for the budget of all the independent institutions. On the other hand, a mere Rf 14 million for teacher training faculty, Rf10 million for training nurses, Rf 5 million for faculty of tourism.

From an economic point of view, the latter expenses will definitely directly contribute to the productivity of the labor force, and GDP of the country. What we spend on teacher training, nurse training, and even training for tourism personnel are future investments with high economic returns. But, Rf 12 million for human rights commission?? I’d like someone to explain to me, or justify why we should spend that much money on that institution. And Rf 14 million on anti-corruption? I’d definitely would like to conduct a study to find out how corruption is decreasing in our country, and how much corruption money is ‘saved’ as a result of the efforts of this commission. Then it’d be easier for us to justify spending that money.

I think we need an effective system that can measure, or determine the productivity or the effectiveness of all these independent institutions. At the moment, it seems that most of these institutions are just a means of providing employment, with ‘fat’ salaries and allowances. The end result is that we end up with a wage bill of almost Rf 4 billion for 2010.

Recurrent Expenditure

Even the 2010 budget has an extremely high percentage of recurrent expenditure (70 percent), just like the past years. Tragedy is, out of the Rf 11.9 billion budget proposed for 2010, Rf 4.6 billion would be the deficit, that has to be financed mostly through loans. Which means, our children will pay for our salaries, as these debts will be repaid in the days to come. I say, if we are taking loans, or incurring debt now, such funds should be spend on capital investments that will be beneficial even for our children, especially if we are asking them to pay part of it. Our recurrent expenditures should be financed through the revenue that we earn now.

Dhiraagu shares

The shares we own in dhiraagu, I’m sure it’s a capital investment, as we earn dividends every year. And the company pays well. Last year, the company paid the government over Rf392 million as dividends, this year we expect it to be over Rf 447 million. However, according the proposed budget numbers, in 2010 we are expecting only Rf 166 million. Meaning, Rf 280 million less than this year. I’m sure that this is partly because the government has sold part of its shares recently for a sum of $40 million. By selling these shares, we’ve reduced our share of future dividends. If so, I’d like to find out, HOW DID THEY SPEND THAT $40 MILLION?? If this $40 million is also spent on recurrent expenditure, then it’s a pretty stupid thing hu? But, if we invest that $40m on something productive, its completely a different story.

Revenue estimates

It’s a good move by the government to go towards business profit taxation and having an ad valorem tax on the tourism sector. That’s the ultimate and the most sustainable form of government revenue. But the Rf 300 million revenue from business profit tax in 2010,, I don’t know how realistic it is, as there are many legal and administrative pre-requisites for it to become a reality.

The Rf 1.3 billion to be raised from privatization; I would want to know the details of how they plan to obtain it.

Final thoughts

Government needs to figure out ways to reduce its recurrent expenditure, including those of the independent institutions. And these recurrent expenditures have to be covered only through the revenue that is earned. Definitely not through selling shares of revenue earning corporations.

So many mistakes have been made in the past; like collecting advance lease payments from resorts, and they have been spent on recurrent expenditure. In order to avoid reliance on ‘once-off’ extra ordinary revenues, a good tax system needs to be put in place. Working towards introducing business profit tax, and having a GST on tourism is also a good thing.