Weekend reading links

1. John Burn-Murdoch points to two studies about the likely impact of AI on occupational groups. Here's about the first one (paper here)

In an ingenious study published this summer, US researchers showed that within a few months of the launch of ChatGPT, copywriters and graphic designers on major online freelancing platforms saw a significant drop in the number of jobs they got, and even steeper declines in earnings. This suggested not only that generative AI was taking their work, but also that it devalues the work they do still carry out. Most strikingly, the study found that freelancers who previously had the highest earnings and completed the most jobs were no less likely to see their employment and earnings decline than other workers. If anything, they had worse outcomes. In other words, being more skilled was no shield against loss of work or earnings.

And this about the second study (paper here) where the consultancy BCG randomly gave GPT-4 to its employees and monitored its impact,

BCG staff randomly assigned to use GPT-4 when carrying out a set of consulting tasks were far more productive than their colleagues who could not access the tool. Not only did AI-assisted consultants carry out tasks 25 per cent faster and complete 12 per cent more tasks overall, their work was assessed to be 40 per cent higher in quality than their unassisted peers. Employees right across the skills distribution benefited, but in a pattern now common in generative AI studies, the biggest performance gains came among the less highly skilled in their workforce. This makes intuitive sense: large language models are best understood as excellent regurgitators and summarisers of existing, public-domain human knowledge. The closer one’s own knowledge already is to that limit, the smaller the benefit from using them.

There was one catch: on a more nuanced task, which involved analysing quantitative evidence only after a careful reading of qualitative materials, AI-assisted consultants fared worse: GPT missed the subtleties. But two groups of participants bucked that trend. The first — termed “cyborgs” by the authors — intertwined with the AI, constantly moulding, checking and refining its responses, while the second — “centaurs” — divided labour, handing off more AI-suited subtasks while focusing on their own areas of expertise.

His conclusions

First, regulation will be key. Online freelancing is about as unregulated a labour market as you will find. Without protections, even knowledge workers are in trouble. Second, the more multi-faceted the role, the less risk of complete automation. The gig-worker model of performing one task for multiple clients — copywriting or logo design, for example — is especially exposed. And third, getting the most out of these tools, while avoiding their pitfalls, requires treating them as an extension of ourselves, checking their outputs as we would our own. They are not separate, infallible assistants to whom we can defer or hand over responsibility.

He has a tweet thread here.  

2. Interest rates on 10 year Treasury bonds touched 5% in the US for the first time since 2007. Investment grade corporate bonds now yield 6%, and junk bonds demand nearly 10%. Small businesses are paying almost 10% for short-term loans, up from 4.1% in mid-2020.

The rising rates has also stressed developing countries,

That has left the proportion of emerging and developing countries whose borrowing costs are more than 10 percentage points above those of the US at 23 per cent. That compares with less than 5 per cent in 2019, the World Bank calculates, in an indication of the stress those economies are now under. As a result, debt interest payments as a share of government revenues were at their highest level since at least 2010, according to the bank... Emerging market and middle-income countries’ average gross government debt burden is heading above 78 per cent of GDP by 2028, according to IMF forecasts, compared with just over 53 per cent a decade earlier...

The volume of foreign currency debt issued in emerging markets has slumped dramatically over the past two years as the cost of borrowing has soared. Emerging markets have issued about $360bn of foreign currency debt this year, according to Dealogic, following total issuance of $380bn in 2022. That follows issuance of between $700bn-$800bn in each of the previous three years. Issuance has been hit by a lack of demand, as investors favoured issuers with high credit ratings, and waning supply as many sovereigns with low credit ratings lost market access during the rapid increase in US rates of the past 18 months.

3. Extremely detailed map of NYC neighborhoods here. 

4. The Belt and Road Initiative (BRI) has transitioned from being the largest sovereign debt provider to being the largest sovereign debt collector. 

After lending $1.3 trillion to developing countries, mainly for big-ticket infrastructure projects, China has shifted its focus to bailing out many of those same countries from piles of debt... now the two main Chinese state banks that provided most of the infrastructure loans have reduced their new lending. Rescue loans climbed to 58 percent of China’s lending to low- and middle-income countries in 2021 from 5 percent in 2013, according to a new report from AidData, a research institute at William and Mary, a university in Williamsburg, Va., that compiles comprehensive information about Chinese development financing. “Beijing is navigating an unfamiliar and uncomfortable role — as the world’s largest official debt collector,” the institute wrote...

Much of the work for the Belt and Road Initiative has been done by Chinese construction and engineering companies, which sent thousands of engineers, heavy equipment operators and other specialists across Asia, Africa, Latin America, Eastern Europe and the Pacific... China provided the money almost entirely as loans, not grants, and the loans tended to be at adjustable interest rates. As global interest rates have soared for the past two years, poor countries have found themselves owing far higher payments to Beijing than they expected. Chinese lenders and contractors were able to build projects rapidly because the Chinese government seldom required extensive environmental studies, financial viability reviews or checks on the displacement of local populations forced to give up land. National governments of developing countries were required to guarantee repayment of loans made to their local and provincial governments. In the early years, 65 percent of the loans were made by China’s state-owned policy banks, notably the China Development Bank and the Export-Import Bank of China, AidData found.

5. Interesting trends on post-pandemic work commutes. Post-pandemic commutes have become shorter across cities

But public transport usage has shrunk faster than personal vehicle use, and the decline has been very steep.

And these trends carry further manifestations of widening inequality. Their nature of work means more educated workers can at least partially work from home, which in turn lowers their commute times. And this is reflected in the sharp reduction in commute times of the more educated workers. 

6. The much welcome trend of broadening of India's equity base which is attenuating the impact of foreign capital exits,

October witnessed the highest ever monthly SIP inflow of Rs 16,928 crore. While that takes the seven-month aggregate in the current fiscal to Rs 107,240 crore, it follows an inflow of Rs 155,972 crore in FY’23 and Rs 124,566 crore in FY’22... In October, for example, the FPIs pulled out a net of Rs 28,891 crore from Indian equities between October 1 and November 9. But its impact on the benchmark Sensex has been just 1.5 per cent. Contrastingly, an FPI outflow of Rs 10,836 crore in August 2011 led to the Sensex fall of over 8 per cent. Even in October 2018, an FPI outflow of Rs 28,921 crore led to a Sensex fall of nearly 5 per cent. Why this difference? While the domestic institutional flow led by mutual funds exceeded the FPI outflow by 21 per cent between October 1 and November 9 this year, the DII flow in August 2011 was lower than the FPI outflow by 23 per cent. In October 2018 too, the DII inflow was nearly 10 per cent lower than the FPI outflow. The DII strength has come on account of the SIP inflows. If the SIP inflow in October 2018 amounted to Rs 7,985 crore, it more than doubled to Rs 16,928 crore in October 2023. The big change has come not in large cities but in those that are ranked below 110. Their share in industry AUM (assets under management) in September 2023 — is 18.33 per cent. Ten years ago, the share of these cities in the MF industry AUM on a much smaller base was just 2.57 per cent and five years back, it was 9 per cent.

7. GMR has lined up a Rs 4000 Cr loan with a 14 year tenor at an interest cost of around 10% with a consortium of banks led by IIFCL for the construction of its 2200 Acre Bhogapuram greenfield airport at Visakhapatnam. The consortium also includes REC and PFC.

This fund raising highlights the importance of bank loans in infrastructure financing. Contrary to the conventional wisdom that bond markets should form the major share of infrastructure financing, experience from across the world show that except for US and China, bank loans are the biggest source of infrastructure financing. 

8. Top Four banking sector dominance in the US,

The four biggest US lenders grabbed almost half of all banking profits in the third quarter, highlighting their growing advantage in the new era of higher-for-longer interest rates. Earnings at JPMorgan Chase, Bank of America, Wells Fargo and Citigroup were up 23 per cent according to BankRegData, which collates quarterly reports from lenders to the Federal Deposit Insurance Corporation. Of the nation’s almost 4,400 banks, the big four made 45 per cent of the industry’s overall profits in the third quarter. That was up from 35 per cent a year ago, and well above the 10-year average of 39 per cent. By contrast profits at all other institutions dropped by an average 19 per cent in the quarter, their largest fall since the early months of the coronavirus pandemic.

And there's an implicit too big to fail subsidy enjoyed merely by being big.

But the biggest reason for the divide is the fact that the big banks, perhaps because of technological advantages or perceived safety due to their size, have not had to pay up as much to keep depositors. The big four were paying less than 2 per cent a year on accounts that paid interest in the third quarter. That compares to nearly 3 per cent average for regional banks. What is more, more than 40 per cent of the deposit accounts at the nation’s four largest banks pay no interest at all. That compares to 30 per cent for the industry overall.

9. A stunning expose of Ray Dalio and Bridgewater Associates, the world's largest hedge fund, by Rob Copeland in the NYT. Far from being a meritocracy where investment decisions were made by a team after rigorous research and vigorous debate, Bridgewater appears to be like an institution where the founder, Dalio here, took all the decisions. 

Mr. Dalio was Bridgewater and Mr. Dalio decided Bridgewater’s investments. True, there was the so-called Circle of Trust. But though more than one person may have weighed in, functionally only one investment opinion mattered at the firm’s flagship fund, employees said. There was no grand system, no artificial intelligence of any substance, no holy grail. There was just Mr. Dalio, in person, over the phone, from his yacht, or for a few weeks many summers from his villa in Spain, calling the shots...

Mr. Dalio largely oversaw Pure Alpha, the main fund, with a series of if-then rules. If one thing happened, then another would follow. For Pure Alpha, one such if-then rule was that if interest rates declined in a country, then the currency of that country would depreciate, so Pure Alpha would bet against the currencies of countries with falling interest rates. Many of the rules dealt simply with trends. They suggested that short-term moves were likely to be indicative of long-term ones and dictated following the momentum in various markets. Bridgewater’s rules gave it an unquestionable edge in the wildly successful early days, in the late 1980s and 1990s, when most people on Wall Street, from junior traders to billionaires, still believed in the value of their intuition. 

As the years passed, however, Mr. Dalio’s advantage softened, then seemingly ceased by the 2010s and into this decade. The rise of powerful computers made it easy for any trader to program rules and to trade by them. Rivals quickly matched Mr. Dalio’s discoveries, then blew past them into areas such as high-frequency trading. Mr. Dalio stuck to his historic rules... And if Bridgewater’s main hedge fund had for years fallen behind the pace of global markets, it still mostly avoided negative results, and so could fairly say it was making clients money on an absolute basis. Its growth was a testament to the firm’s marketing prowess, which had cultivated a mystique around Pure Alpha’s hands-off, rules-based approach... A newcomer to the investment team as recently as 2018 was gobsmacked to learn that the world’s biggest hedge fund’s trading was still reliant on Microsoft Excel, a decades-old software... Mr. Dalio’s grand automated system — his investment engine — wasn’t nearly as automated or mechanized as was promoted. If he wanted Bridgewater to short the U.S. dollar (as he did, unsuccessfully, for roughly a decade after the 2008 financial crisis), the trade went in. There was not a rule more important than what Mr. Dalio wanted, Mr. Dalio got...

With the hope of turning around the firm’s investment performance, members of the Circle of Trust put together a study of Mr. Dalio’s trades. They trawled deep into the Bridgewater archives for a history of Mr. Dalio’s individual investment ideas. The team ran the numbers once, then again, and again. The data had to be perfect. Then they sat down with Mr. Dalio, according to current and former employees who were present... One young employee, hands shaking, handed over the results: The study showed that Mr. Dalio had been wrong as much as he had been right. Trading on his ideas lately was often akin to a coin flip.

The group sat quietly, nervously waiting for the Bridgewater founder’s response.

Mr. Dalio picked up the piece of paper, crumpled it into a ball and tossed it.

This about how Dalio courted the Kazakh government is typical of the way Wall Street snares gullible sovereigns

In 2013, Kazakhstan began developing what was then the most expensive oil project — a giant field in the Caspian Sea — helping it grow a $77 billion sovereign wealth fund. That money would have to be invested somewhere, and Bridgewater’s client services squad put a meeting on Mr. Dalio’s calendar with Berik Otemurat, the fund’s chief, a bureaucrat who had begun his career barely 10 years earlier.

Mr. Dalio showed interest in the delegation. “What are they doing beforehand?” he asked Bridgewater’s marketing team.

His underlings answered that Mr. Otemurat would be in New York a few hours before he was due in Westport. 

“How are they getting here?” Mr. Dalio then asked.

Bridgewater had arranged for a chauffeur in a Mercedes.

“Get ’em a helicopter.”

The dramatic entrance preceded an unconventional presentation, at least compared with what Mr. Otemurat had experienced in New York. There, titans of industry, such as KKR’s co-founder Henry Kravis and Blackstone’s Stephen Schwarzman, wooed him over sea bass, caviar and an orange hazelnut Napoleon dessert loosely based on the Kazakh flag.

Mr. Dalio drew an indecipherable chart on a dry-erase board and rambled on about the nature of markets. He barely mentioned the specifics of Bridgewater’s approach, according to a person present. There was an undeniable charm — and confidence — to it all. Bridgewater’s marketing team had seen this move before. The end goal would be something other than money. So when Mr. Otemurat raised the prospect of investing $15 million in Bridgewater’s main hedge fund, the fund’s representatives shooed away the suggestion. “We don’t want a relationship with you right now,” one marketing executive said. “We’re in it for the long game.”

Inside Bridgewater, a relationship meant access. The country’s new oil field had taken more than a decade to develop, with near-constant delays. Anyone who knew how the project was proceeding could adjust bets on oil accordingly. Bridgewater’s representatives told the delegation that their firm would be happy to offer free investing advice, and Bridgewater’s team would likewise appreciate the opportunity to ask questions about industries of local expertise. Mr. Otemurat and others in his delegation seemed eager to chat. Soon enough, Bridgewater got it both ways. A few months after Mr. Otemurat’s Westport visit, the Kazakh fund asked again if it could invest in Bridgewater’s funds. This time, it dangled a sum far larger than $15 million, and Bridgewater assented, former employees said.  

Dalio comes across as a super-sized version of the local broker/fixer who has his ears on the ground and an excellent network which he uses to drive his business. 

10. Noah Smith has a simple explainer of Singapore's fabled housing policy,

The government of Singapore owns most of the land, and has a government agency called the Housing Development Board (HDB) that builds a ton of housing. It then sells this housing, mostly to first-time homebuyers (i.e. young people), at a cheap price. who are then free to resell it. The combination of the discount for first-time buyers and the government’s ability to make prices appreciate slowly and steadily over time means that HDB apartments function not just as a cheap place to live, but also as a sort of wealth-building pension system. In other words, in Singapore there’s no contradiction between using your home as a place to live in, and using it to build wealth... The government doesn’t actually sell HDB apartments to people; it sells them 99-year leases.

11. In a big boost to the bankruptcy resolution process, the Supreme Court has ruled in favour of the constitutionality of the IBC provisions on personal guarantees issued by promoters of companies. 

As of September, 2,289 insolvency applications have been filed against personal guarantors involving corporate debt of more than ₹1.64 trillion. Some of these cases involve high-profile names. Guarantors had been seeking legal protection against the automatic application of insolvency proceedings against them, claiming that it amounted to a violation of natural justice, and that resolution professionals could not play an adjudicatory role... So far, as many as 150 of the applications filed against personal guarantors have reportedly been rejected, while 282 were admitted. After the top court’s order, this ratio will likely see a far sharper skew in favour of case admissions.

Meanwhile the performance of IBC has so far fallen short of expectations, though its incentive shaping impacts may be much bigger than these numbers convey

In the first five years of its operation, the value of capital realized from all cases admitted under IBC was only 20%, implying a rather dismal haircut rate of 80% for creditors. And nearly 30% of all cases were landing up in liquidation, which was not the main aim of the law... In its latest quarterly report, the Insolvency and Bankruptcy Board of India (IBBI) reports that more than 65% of the cases under resolution have exceeded 270 days... The IBBI also noted that till June 2023, creditors have realized ₹2.92 trillion of value under various resolution plans of the initial total claims of ₹9.23 trillion. Thus, the realization ratio had improved marginally since 2021, from 20% to 32%.

12. Long read in Mint on the K-shaped economic growth.

13. iPhones are programmed to disallow an increasing share of parts being replaced or repaired.

For a decade, it was easy to get help repairing an iPhone. Cracked screens could be replaced in minutes, and broken cameras could be exchanged without a hitch. But since 2017, iPhone repairs have been a minefield. New batteries can trigger warning messages, replacement screens can disable a phone’s brightness settings, and substitute selfie cameras can malfunction. The breakdowns are an outgrowth of Apple’s practice of writing software that gives it control over iPhones even after someone has bought one. Unlike cars, which can be repaired with generic parts by auto shops and do-it-yourself mechanics, new iPhones are coded to recognize the serial numbers for original components and may malfunction if the parts are changed.

This year, seven iPhone parts can trigger issues during repairs, up from three in 2017, when the company introduced a facial recognition system to unlock the device, according to iFixit, a company that analyzes iPhone components and sells parts for do-it-yourself repairs. The rate at which parts can cause breakdowns has been rising about 20 percent a year since 2016, when only one repair caused a problem.

iFixit has analysed iPhone parts and have this excellent graphic on iPhone parts repairing issues,

This trend is part of the Apple business model, which not only leaves nothing on the table for others but also maximises its own revenues from post-sale possibilities.

The software phenomenon, which is known as parts pairing, has encouraged Apple customers to turn to its stores or authorized repair centers, which charge higher prices for parts and labor. In recent years, only approved parts and sanctioned repairs have avoided the problems. Replacing a shattered screen typically costs nearly $300, about $100 more than work done by an independent shop using a third-party screen.

To put it another way: The cost of replacing a cracked screen on a year-old iPhone 14 is nearly equivalent to the phone’s value, which Apple appraises at $430 in trade-in credit. Apple’s grip on the repairs creates an incentive for customers to spend up to $200 on device insurance, known as AppleCare, which provides free battery replacements and screen repairs. Apple collects an estimated $9 billion annually for the service.

And this practice of controlling parts repair has now become a feature in the industry, with Apple showing the way.

Using software to control repairs has become commonplace across electronics, appliances and heavy machinery as faster chips and cheaper memory turn everyday products into miniature computers. HP has used a similar practice to encourage people to buy its ink cartridges over lower-priced alternatives. Tesla has incorporated it into many cars. And John Deere has put it in farm equipment, disabling machines that aren’t fixed by company repair workers.

14. Times reports about the problem of fake reviews in the internet commerce sites. The problem is likely to get acute in the times ahead as the advances in the likes of generative AI make fake reviews easier to write and more difficult to detect. 

Fake reviews are a good example of the negative externalities created by e-commerce, which is not even anywhere near sufficiently internalised by the private e-commerce firm. There's a market failure. 

For the individuals shopping on an e-commerce site, reviews are often the most important (even the only) signal of credibility and genuineness. Purchase decisions that compare across multiple choices on the same good/service are usually made purely on the ratings score. But the platform operator's incentive is limited to deploy just enough resources to ensure that fake reviews don't swamp the platform. And this incentive too is inversely related to the size of the platform. 

This is a very good example of one more regulatory arbitrage enjoyed by internet companies - they are allowed to socialise costs while appropriating all profits.  

15. Even after all that has happened on the US-China relationship front, interest among corporate bigwigs in the US in courting China does not appear to have dimmed. FT reports that Xi Jinping was given a standing ovation at a meeting at San Francisco. 

Xi himself appeared in a conciliatory tone, reminiscent of the better days of the US-China relationship, as he courted US investments in China. He spoke of an enduring friendship between the two countries that could not be impacted by the recent turmoil. This change of tone is perhaps an indicator of the desperation in China as the economy gets squeezed by the restrictions imposed by the US. 

16. Finally, as the World Cup Final beckons, a striking feature of the Australian and English media coverage of the event has been its gracelessness, hypocrisy, dishonesty, and small-mindedness. This article in Daily Telegraph stoops as low as it can get. There are several other pieces in Daily Mail, Sydney Morning Herald etc, which reek of yellow journalism. Mark Ramprakash puts the issue in perspective, describing such attitudes as arising from jealousy and unconscious bias. 

For the large part, this is a combination of racism, colonial hangover, and inability to stomach the sudden and complete reversal of history (both in terms of controlling global cricket administration and dominating in the field). For a few years now, both off the field, and on the field and across formats, India have become dominant. In this World Cup they have raced so far ahead that there's daylight between them and the rest. 

On India's dominance in this World Cup, I think it can be traced almost completely to the rare and fortuitous confluence of all players getting into their peak form at the same time. Every one of its batsmen and bowlers have hit their respective peak form. I cannot recollect any instance in test or ODI or T20 when an Indian team have had its entire team being in form at the same time. Even having the majority of players in the peak form is rare. As an example, even as India has been a dominant test nation over the last 4-5 years, it has struggled with the form of all its batsmen and have had to rely on Rishabh Pant with the support of an ever  changing cast of one or two among the rest and lower order batsmen. 

And when a team consisting of as talented individuals as India have all their members in peak form, there's little that even the strongest opponents can do to beat them. They can only hope that they play at their best and some among the Indians have an off-day. 

Weekend reading links

1. WSJ looks at the solar energy transformation in India. This graphic says it all from the supply side.

This, from the comments section, is important,

One must view these renewable cost comparisons with some perspective. If they are quoted as costs per kW (or mega- or giga-watt), they refer to construction costs for generating capacity, not actual generation (kW-hrs). Engineers use a term called "capacity factor," i.e. the % of time that a resource can actually generate it's rated capacity. Solar and wind have an average capacity factor of ~30% (because they can only generate when the sun is shining or wind blowing) versus ~90% that is typically achieved by fossil and nuclear plants. So theoretically, you would need to construct 3x the renewable capacity to be equivalent. But that's not the whole story, because if all 3x are generating at the same time (i.e. when the sun is shining), they would overproduce then, but not fill the demand at other times. And if you factor in the costs of battery storage (or fossil generation) to supplement during these other times, it would greatly distort the cost comparisons.

2. Nice visual calculator of the costs of traffic congestion in Mumbai from the IDFC Institute. The associated report is here.

3. Very good article on the tax arbitrage strategies of pharma and technology companies by Brad Setser. This is very apt,

I wish that Apple’s global tax strategy was as widely understood as the global nature of its supply chain.

Pharmaceutical imports from countries like Ireland, Singapore and Switzerland (where manufacturing facilities are set up to limit tax) now is the single largest line of US trade deficit with the import topping almost $200 billion. This has nothing to do with low wage labour competition. Instead of reversing this, the Trump tax cuts actually ends up not only lowering their effective tax rates but also encouraging more such tax arbitrage in case of pharmaceuticals.

This testimony in the US Senate by an official about shifting of profits abroad by US MNCs is a great read.

4. Nice article on the debate on the duel between two schools of thinking on how early grade reading instruction is to be administered,

The “science of reading” stands in contrast to the “balanced literacy” theory that many teachers are exposed to in schools of education. That theory holds that students can learn to read through exposure to a wide range of books that appeal to them, without too much emphasis on technically complex texts or sounding out words. Eye-tracking studies and brain scans now show that the opposite is true, according to many scientists. Learning to read, they say, is the work of deliberately practicing how to quickly connect the letters on the page to the sounds we hear each day... Phonics has gone in and out of style for decades, and the current conflict over how to teach reading is only the latest in a tug-of-war that dates to the 19th century. A major push for phonics instruction under President George W. Bush, through a federal program called Reading First, did not produce widespread achievement gains, raising questions about whether the current efforts can succeed... States have passed laws requiring that schools use phonics-centric curriculums... The guardians of balanced literacy acknowledge that phonics has a place. But they trust their own classroom experience over brain scans or laboratory experiments, and say they have seen many children overcome reading problems without sound-it-out drills. They value children picking books that interest them and worry that pushing students into harder texts could turn them off reading entirely.

5. The march of low yields continues unabated. Sample this

The cost of insuring against the default of some of the world’s biggest corporate borrowers has dropped to its lowest levels since 2007, as investors bet that continued strong support from central banks will keep credit markets ticking over.

The price of CDS to provide protection against US corporate defaults is lower than 2007.

6. Reinforcing the point above, Europe's richest man, Bernard Arnault of LVMH, raised over $10 bn at ultra-cheap rates,

The luxury giant raised 7.5 billion euros ($8.3 billion) and 1.55 billion pounds ($2 billion), over a range of maturities from two to 11 years, to help finance its $16 billion purchase of Tiffany & Co. Two of the five euro tranches were placed at negative yields, meaning investors are paying single A-rated LVMH to borrow money. Arnault’s expectations back in November for yields from the sale of “between 0% and 1%” have been surpassed. Even the 11-year tranche has a coupon of just 0.45%. M&A has never been cheaper.

And ECB is perhaps most likely itself directly buying the LVMH bonds. This graphic is perhaps the story of our times from the financial markets,

It is not as if, as ECB meant it, this cheap debt is being used to finance new investment. Instead they are being used to swap existing higher cost debt, and boost the bottom-lines of these large companies.

7. Sweden's Riksbank, which was the first to introduce negative interest rates in 2015 has rolled back its negative interest rate policy arguing that while it has been successful so far, but if continued for longer will have a detrimental effect. However, the decision comes even as the Swedish economy is slowing and inflation has been falling. 

It has been estimated that European banks have paid the ECB 25 billion euros for deposits since June 2014 when the ECB cut rates to negative zone. This has been one more blow to banks already struggling under the weight of ultra-low interest rates. This is an apt summary,

Bank lending in the eurozone was, however, shrinking when the ECB first cut rates below zero in 2014 and has since rebounded. Household lending is up more than 12 per cent since negative rates started, while corporate lending has grown 3 per cent. The ECB has also taken action to soften the blow for the banking sector, including a “two-tier” deposit system that exempts some of the money it holds for banks from negative rates, while also offering them loans at sub-zero levels to stimulate lending.  Among the big losers have been savers. With more than $13tn of bonds trading at negative yields, a growing number of pension funds, insurance companies, and banks are struggling to generate sufficient returns, raising doubts over some business models.

While it is difficult to construct counterfactuals and make credible assessments of the impact of ECB's policy, the longer term effects of negative rates can be unpredictable and not so benign,

Research published last year by Princeton University economists Markus Brunnermeier and Yann Koby found that many of the benefits of negative rates are front-loaded — such as gains in asset prices on bank balance sheets — while the corrosive side-effects last longer.

The long-term impact of negative rates on consumers and savers will be an interesting thing to watch for in the years ahead. 

8. Interesting take on Indonesia's deepening of state-led industrialisation since Jokowi took over in 2014. 

When Jokowi became president in 2014 he inherited an impossibly cumbersome bureaucracy with redundant and often incomprehensible regulatory architecture. It could take years to get the proper permits and licenses to a start a business, and in the absence of an eminent domain law land acquisition could drag on indefinitely. Moreover, in the new decentralized governing structure, it was unclear who had the authority to break through these bottlenecks. Jokowi’s solution was to re-concentrate administrative and legal authority with the central state government in Jakarta. Through a series of Ministerial and Presidential Decrees he equipped the central state with broad powers to issue financial guarantee for high-priority projects, circumvent regulatory requirements and acquire land in the public interest. He also found himself in an economic environment that was not very conducive to private investment, so he leaned hard into SOEs to do the heavy lifting of building roads, bridges, power plants, hospitals and airports. The size of the state-owned sector, which was already large, has accelerated dramatically throughout Jokowi’s first term... As exports have fallen as a share of GDP, fixed capital formation (including investment in major infrastructure projects) has increased to pick up the slack... Given the narrow policy goal of building infrastructure quickly and given unreliable regulatory architecture and weak rule of law, the strategy of tapping SOEs to carry out major project development has largely achieved its aim.

The flip-side of this argument is that perhaps private companies would have fared better, and the dominance of SOEs is crowding out more competitive and sustainable private investment. Unfortunately, we cannot test this empirically as time moves in only one direction. But we can look at some sectors that were opened exclusively to private developers, such as renewable energy. Since 2013, Indonesia has been experimenting with various incentives to induce private investment in the renewable energy sector – yet, as I have written here and here, growth has been anaemic. Even with lucrative rates of returns, private developers just weren’t interested. This is a complicated issue with many potential explanations, but the bottom line is that when private capital is left to fend for itself given the way Indonesia’s economy is currently structured, it often flounders. By contrast the state is uniquely positioned, for reasons of history as well as institutional design, to cut through the bottlenecks that can side-line private investment.

I am sympathetic to this line of reasoning. I am inclined to see similar limitations with India's private sector that are likely to surface in the absence of state's role. 

But the problem is that, unlike you are China, there are clear limitations to this type of growth. It should be used build the foundations for sustainable market-led capital formation and growth.

9. Livemint has a couple of graphics about India's fiscal revenues. The first shows that India has among the least progressive tax distribution

Further, the quality of government spending as a percentage of GDP is poor, with a greater proportion towards interest payments. is very high.

10. A Livemint summary of the continuation of India's disappointing economic performance.

Arbitrage and efficiency - externalising costs and capturing gains

This post is triggered by Neil Irwin's fantastic article that I blogged here.  

Consider these. Robots replacing human workers to reduce defects and increase output. Companies focusing on their core-competencies by outsourcing non-core activities. Companies that either outsource or off-shore their production facilities to lower costs. Executives and companies that cut costs by aggressive reduction of their workforce and hiring contract labour, all in the name of competitiveness. Internet-based companies that reduce market frictions by bringing together buyers and sellers of goods and services. Constructing complex ownership structures that enable cross-border shifting of profits so as to minimise tax obligations. Supercomputers that connect to the exchanges through dedicated optic fibre cables over the shortest distance to promote high frequency trading that claim to increase market liquidity and thickness. 

The common thread in all these stories is the search for efficiency and value for money, both in turn aimed at maximising profits, even if, and often because so, at the cost of jobs or the quality of jobs. These trends are considered essential and desirable attributes in today's capitalism, in fact even the ultimate objective of the business enterprise. But this has not always been the case.

The traditional idea of a good business firm was of one which created jobs, productive jobs. Apart from being socially responsible, this was also sound economics. After all jobs provided the demand that sustained businesses, the economy itself. In other words, the firm's actions contributes to the creation and sustenance of the market itself. It is capitalism which generates a win-win equilibrium of private and social gains. It also involves both the firm and the workers accepting trade-offs to create a mutually beneficial system.  

Fast forward to today and the conception of a good business firm has changed dramatically. Ironically, today's good business firm is one which maximises shareholder value, even if by inflicting unacceptable social costs. This in most cases, translates to cutting costs, by among other things, reducing the expenses on labour. The embrace of labour-displacing robots is only the most direct and extreme manifestation of this trend. In other words, today's business firm is an entirely private entity, with limited social responsibility and aimed at maximising private gains. Sustenance of the soil on which the enterprise itself grows, the market, is the least of considerations.

Whereas annual reports of companies earlier took pride at highlighting the number of jobs created that year, today it is all about the bottom-line, even proudly mentioning the savings from lay-offs and tax avoidance. 

In the pursuit of individual business models that rely on realising returns through arbitrage and externalising the associated costs while appropriating all the benefits, capitalist enterprises are collectively chipping away at the sustainability of the market, and thereby capitalism, itself.  

In the cases mentioned at the beginning, it is debatable as to how many of them would be sustainable if all the social costs are internalised. In many of them, far from directly improving the net productivity (across markets) by way of inventing a new technology or a new business model, the efficiency gains arise from arbitraging across markets. These arbitrage opportunities arise from differences in input costs (outsourcing, offshoring, contracting) arising significantly from failures to internalise costs, regulatory standards (digital commerce, tax avoidance), information access (HFT), and so on. The gains from these arbitrages are privately captured, whereas their costs are borne by the society at large. In simple terms, where possible, today's business enterprise seeks to privatise gains and socialise costs.

This is not to decry all arbitrage opportunities. In fact, all economic transactions involve some form of arbitrage, including the mother of all arbitrages, comparative advantage in the natural order of things. Accordingly, labour wages in developing countries are lower than in developed ones, or farm produce is cheaper in villages than in the cities, and so on. Outsourcing and off-shoring can be legitimate productivity enhancing business models. Where these and others become less benign is, as aforementioned, when the private party appropriates all the gains in the arbitrage transaction and externalises all costs. 

It is disturbing when arguably some of the most exciting business opportunities of our times - e-commerce and sharing economy firms - is in making money pursuing activities whose competitiveness lies in regulatory arbitrage that allows externalisation of the negative social and other costs inflicted by them. It is equally disturbing sign when the most admired business leader and company of our times, Steve Jobs and Apple, have made their staggering fortunes not by fulfilling market "needs" but almost exclusively by creating market "wants". Finally, it is disturbing that both these cases are considered today's touchstones of a shift towards a higher trajectory of economic progress.

Financial markets arbitrage fact of the day

From Sendhil Mullainathan's article in Upshot lamenting the human resource mis-allocation into finance in pursuit of careers that involve rent-seeking, transferring wealth from others to themselves, instead of wealth creation,

Arbitrage is valuable only to a point. It has a gold rush element with prospectors racing to get to the gold first. While finding gold has value, finding gold before someone else does is mainly rent-seeking. The economists Eric Budish at the Booth School of Business and Peter Cramton at the University of Maryland, and John J. Shim, a Ph.D. candidate at Booth, have shown in a study how extreme this financial gold rush has become in at least one corner of the financial world. From 2005 to 2011, they found that the duration of arbitrage opportunities in the Chicago Mercantile Exchange and the New York Stock Exchange declined from a median of 97 milliseconds to seven milliseconds. No doubt that’s an achievement, but correcting mispricing at this speed is unlikely to have any real social benefit: What serious investment is being guided by prices at the millisecond level? Short-term arbitrage, while lucrative, seems to be mainly rent-seeking.

The "drugs test" for financial products

Steve Levitt points to this paper by Glen Weyl and Eric Posner who aadvocate that all financial instruments should be rigorusly screened for their social utility before they can be traded. They claim that enhanced discolusre and the use of exchanges and clearinghouses, which form the centerpiece of most financial regulation proposals, will not achieve the objective of stabilizing financial markets. They write,

"We argue that disclosure rules do not address the real problem, which is that financial firms invest enormous resources to develop financial products that facilitate gambling and regulatory arbitrage, both of which are socially wasteful activities. We propose that when investors invent new financial products, they be forbidden to market them until they receive approval from a government agency designed along the lines of the FDA, which screens pharmaceutical innovations. The agency would approve financial products if and only if they satisfy a test for social utility. The test centers around a simple market analysis: is the product likely to be used more often for hedging or speculation? Other factors may be addressed if the answer is ambiguous."

The challenge with this proposal would be the definition of social utility. There is a thin line between gambling and hedging, especially with complex derivative instruments. I am not sure whether it is possible to draw any clear distinction between the two. In the circumstances, there is likely to be litigation and lobbying, which will generate incentive distortions that will benefit lawyers, lobbyists, and unscrupulous regulators.

However, a test to verify the exploitation of regulatory arbitrage stands a good chance of success and may also be socially and systemically desirable. After all, any regulation is put in place to address market failures. If market players are allowed to skirt around those regulations, it does not bode well for the stability and health of that market.

Another touchstone could be an examination of the possible conflicts of interest. This should determine who can buy and sell these products. As the events of the past few years show, regulators failed to control even basic, first-level conflicts of interests. Financial institutions like Goldman were peddling derivative products to unsuspecting clients, even as they themselves were shorting the underlying assets. Is it possible to have a code of conduct underlying the transactions for each product?

The Economics of Migration

Removal of cross-country barriers to labour mobility has often been described as the largest single policy intervention to address global poverty and the last remaining prominent distortion in the global economy.

Micheal Clemens, one of the leading researchers on labor migration and who has described it as the "world's greatest arbitrage opportunity", has an excellent summary of the literature on migration in the current issue of JEP. His conclusion about the benefits of labor migration is unambiguous,

"The available evidence suggests that the gains to lowering barriers to emigration appear much larger than gains from further reductions in barriers to goods trade or capital flows — and may be much larger than those available through any other shift in a single class of global economic policy... For the elimination of trade policy barriers and capital flow barriers, the estimated gains amount to less than a few percent of world GDP. For labor mobility barriers, the estimated gains are often in the range of 50–150 percent of world GDP. In fact, existing estimates suggest that even small reductions in the barriers to labor mobility bring enormous gains."

He finds "trillion dollar bills on the sidewalk" from liberalizing restrictions on emigration. The paper has a nice summary of the estimated benefits from emigration.



He argues that research on migration has hitherto focussed on remittances and "brain drain", and paid limited attention to the considerable direct and indirect human capital externalities that arise when people migrate from poorer countries to richer in search of livelihood opportunities. More fundamentally, migration research has focussed on the effects of immigration but little on emigration. He therefore sets out the agenda for work on this field,

"It should be a priority of economic research to seek a better characterization of the gains to global labor mobility and to investigate policy instruments to realize a portion of those gains. The four questions in this paper suggest one structure for that agenda. We clearly need a better theoretical and empirical understanding of human capital externalities; the dynamics of labor demand under large-scale migration flows; the magnitude and mechanisms of the effect of workers’ location on their productivity, relative to the effect of workers’ inherent traits on their productivity; and the policy instruments that might make greater labor mobility possible."

As Prof Clemens writes, the reason why "migration packs such an economic punch" is that a worker's productivity depends much more on location than any other factor, including skill. An earlier study (see also here), profiled the wage gaps of Peruvian workers with different profiles working in Peru and as immigrants in the US, and found massive differentials. The same would apply to workers from any other developing country migrating to developed economies and doing the same occupation. Differences in work environments, regulatory environments, legal systems, technology spill-overs, proximity to other high-productivity workers, etc explain this difference. The graphic below captures the differential for Peruvian domestic workers and immigrants.



The biggest challenge in achieving success with reduction of barriers to emigration will be political. In particular, it immediately raises the regular bogeys - loss of jobs for the destination country labour, downward pressure on wages there, impact on national security, and so on. Surmounting these very formidable and entrenched fears will be a big challenge before the issue of barriers to emigration can be addressed to some level of satisfaction.

The current weakness in developed economies is a dampener to immigration. The political opposition to immigration can be blunted only when the economy is flourishing and when the domestic workers in these developed economies are themselves not constrained by unemployment. At a time when protectionism is slowly creeping into international trade, policies that favor relaxation of restrictions on labour mobility may generate intense opposition in these economies.

However, the silver-lining could be the demographic trends in many developed economies. As the demographic profiles of these economies shift upwards, they will experience labour shortages across many areas. Once this starts affecting their economies, like what is already happening in Japan and parts of Western Europe, policies that favor immigration will find greater acceptance. This shortage is more likely to manifest itself in less knowledge-based and lower skilled professions, especially in services, which the older-aged workers will not be able to perform. Fortunately, these are also precisely the same labour categories where the marginal gains from immigration are the largest.

There are possibly two other reasons why this differential will be predominant among lower skilled than high-skilled knowledge workers. In case of the later, as part of globalization and demand in advanced economies, restrictions on labour mobility have been eased considerably over the past two decades. This has also had the effect of lowering arbitrage opportunities in their wages. Further, many of these activities are not location based and could be easily off-shored. In contrast, many semi- and lower-skilled professions in the services sector cannot be off-shored, and their persistent high wage differentials coupled with the impending labour shortage (in developed economies) will offer attractive opportunities for migrants.

Update 1 (9.11.2014)

Tyler Cowen makes the case of liberalization of immigration controls for developed economies facing adverse demographic headwinds.

Eric Posner and Glen Weyl makes the case that the Arab countries, despite their extremely high inequality (between locals and migrants), and through their liberal immigration policies, have been the biggest contributors to the reduction of global inequality. The graphic below shows that the developed economies, despite their low internal inequality, contribute little to reduction of global inequality, whereas Arab contribute, especially those like Qatar, contribute massively to the reduction of global inequality.

Google and the art of "tax arbitrage"!

In the aftermath of the sub-prime mortgage crisis, with its numerous examples of executive excesses and corporate greed, corporate governance issues among businesses have assumed critical importance. It is universally agreed that for all the regulatory oversight, markets cannot be made to run efficiently and fairly without appropriately addressing important corporate governance issues.

One of the most controversial of such concerns revolves around the complex accounting strategies that businesses adopt to avoid taxes. Corporates point to the fact that they are not doing anything illegal but only exploiting a legally available provision to maximize their bottom-lines and thereby shareholder value. Critics argue that such actions, while technically legal, blurs the boundaries between the legal and dishonest, and engenders a culture of opacity and much else.

In this context, it cannot be denied that even as tax authorities across the world focus their energies on curbing domestic tax evasion, there have been very little attention paid on evasion through shifting of incomes and expenditures across national boundaries. Global economic liberalization and closer integration of national economies, coupled with the dramatic expansion of global financial markets, have empowered businesses to indulge in "tax arbitrage".

Businessweek has an excellent account of how Google, which tells employees "don’t be evil" in its code of conduct, employs a strategy to avoid US corporate taxes, that while being legal appears suspicious at best and plain immoral at worst. It is clear that Google is not only a leader in technology but also in its ability to evade taxes!

Google, which has cut $3.1 bn from its tax bill since 2007, pays an effective corporate tax of 2.4% on its overseas profits, the lowest corporate tax rate on overseas profits among the top five US technology companies by market capitalization. It utilizes provisions in US and Irish tax laws to allocate income to tax havens and attribute expenses to higher-tax countries ("transfer pricing"). See this superb interactive guide.

1. US law allows companies to license to a subsidiary the offshore rights to its intellectual property for undisclosed fees. If this fee is kept low (despite the requirement that subsidiaries pay "arms length" prices for technology rights), their taxable income at home becomes less. In Google's case, its deal is with a subsidiary called Google Ireland Holdings.

2. This Dublin-based subsidiary , in turn takes advantage of an Irish law ("Double Irish") that exempts taxes for companies which claim to have their management based elsewhere. Google Ireland Ltd - which employs about 2000 people, gets credit for about 88% of the company's overseas sales (total of $12.5 billion in non-US sales in 2009) - reported a pre-tax profit of less than 1% of sales in 2008 since it paid out $5.4 bn in royalties to its management vested in a Bermuda-based company.

3. The royalty payments from Google Ireland Ltd. in Dublin then takes a quick detour to the Netherlands ("Dutch Sandwich") to avoid triggering an Irish withholding tax. Irish tax law exempts certain royalties to companies in other EU-member nations. In Amsterdam, Google Netherlands Holdings BV, which does not have a single employee, paid out 99.8% of the $5.4 billion it received from Dublin to the unit managed in Bermuda.

4. Bermuda, being an off-shore tax-haven, does not impose any corporate tax. More perversely, the Google's subsidiary (management center) in Bermuda changed legal form in 2006 to become a so-called unlimited liability company, so as to take advantage of another Irish law that permits such firms to not disclose such financial information as income statements or balance sheets. This meant that it became impossible to track its balance sheet.

It is estimated that the US alone loses $60 bn annually due to such "transfer pricing" of taxes. Such international income-shifting helped cut Google’s overall effective tax rate to 22.2% last year, against the US corporate tax rate of 35%. It is also estimated based on a rough analysis that if the company paid taxes at the 35%rate on all its earnings, its share price might be reduced by about $100 from its current $600 plus.

Google's success has encouraged other technology firms to adopt the same model and license the foreign rights to their intellectual capital to subsidiaries in countries with low tax rates, while retaining the expenditures on their balance sheets. Microsoft employs a "Double irish" strategy to avoid tax payments on part of its external income.

This example illustrates the negative externalities generated by Ireland's policy of keeping tax rates low to attract investments. Coupled with its leaky taxation laws, this strategy not only does not benefit Ireland, but also ends up transmitting very costly incentive distortions across the global economy. In other words, Ireland's liberal taxation rules are classic examples of beggar-thy-neighbour policies, which, as the country's recent fiscal crisis shows, does not benefit even Ireland.

This example highlights the need for harmonization of tax policies across economies. Its importance will increase in the coming years with greater global economic integration and as companies start exploiting such tax arbitrage opportunities to minimize their tax payments. In the absence of reasonably uniform standards, such beggar-thy-neighbour policies could end up triggering "tax wars" among the major economies.

Update 1 (20/12/2011)

The Times reports that GE, America's largest corporation, reported worldwide profits of $14.2 billion in 2010, and said $5.1 billion of the total came from its operations in the United States. But it paid no American taxes and even claimed a tax benefit of $3.2 billion. Times writes,

Its extraordinary success is based on an aggressive strategy that mixes fierce lobbying for tax breaks and innovative accounting that enables it to concentrate its profits offshore. G.E.’s giant tax department, led by a bow-tied former Treasury official named John Samuels, is often referred to as the world’s best tax law firm. Indeed, the company’s slogan "Imagination at Work" fits this department well. The team includes former officials not just from the Treasury, but also from the I.R.S. and virtually all the tax-writing committees in Congress.

Though corporate tax rate is 35%, effective tax rates are much lower and corporate share of the nation’s tax receipts have fallen from 30 percent of all federal revenue in the mid-1950s to 6.6 percent in 2009.

Update 2 (29/4/2012)

Times has this story of how Apple uses the same strategy to avoid payment of taxes. For the record, Apple paid cash taxes of $3.3 billion around the world on its reported profits of $34.2 billion last year, a tax rate of 9.8 percent.

This graphic captures the Double Irish tax arbitrage strategy nicely. Apples treats its domestic profits as royalties payable to an Irish subsidiary on patents it owns, so as to avoid paying the 35% corporate tax on its profits. And in Ireland, if the Irish subsidiary is controlled by managers elsewhere, like the Caribbean, then, after paying Irish tax rate of 12.5%, the profits can skip across the world to the tax-free haven in the Caribbean.

When the same product is sold overseas, profits go to a second Irish subsidiary. And because of Irish treaties that make some inter-European transfers tax-free, the company can avoid taxes by routing the profits through the Netherlands. The profits then flow back to the first Irish subsidiary, which sends the profits to the overseas tax haven.

 

More on the need for labor market flexibility

Much of the discussion about economic reforms remain confined to financial markets, infrastructure and agriculture. Labor market reforms tend to get overlooked, both because they are politically sensitive and there is a lack of understanding of its potential impact.

This is especially important given the widely acknowledged positive role that flexibility with labor migration across geographies and industries can play in promoting economic development. I have blogged about the need for labor market reforms in India here, here and here.

Our labor market suffers from numerous distortions both due to absence of appropriate incentives and presence of disincentives - lack of incentives for migration in search of better opportunities and disincentives against hiring and movement across jobs. In fact, these restrictive labor market regulations play no small role in the development of the massive black economy in the country. The challenge for policy makers will be to structure reforms that unshackles the market while providing some form of cushion to the workers against the uncertainty created and vulnerabilities introduced by these reforms.

Consider this example. Wages, for both unskilled and skilled labor, in Kerala are amongst the highest in the country. In fact, the unskilled labor wages are 3-4 times higher and skilled ones 2-3 times more than in neighboring Tamil Nadu. This is an absolutely staggering situation and highlights attention on the huge inefficiencies and rigidities that bedevil the labor market across the country.

Even though there are no legal restrictions on migration within India, internal labor movements remain sub-optimal within the country. Apart from the cultural and social issues that inhibit migration there are several institutional factors that come in the way of internal migration.

Fundamentally, migrants cannot access any of the welfare and other government benefits that the local residents enjoy. This is true not only of commonplace subsidies like rations, pensions, weaker section housing etc, but also of more critical benefits like access to local government employment openings, educational scholarships for children, health insurance, and self-employment scheme benefits. (In fact, another advantage of the UID/Aadhar is that it would provide portability of benefits and thereby help overcome many of these institutional obstacles to increased migration).

It is a reflection of the institutional bias against such internal migration that many state governments have policies in place specifically intended at discouraging migration. Further, the well-intentioned actions of state governments on various issues like housing end up with unintended adverse consequences. I have already blogged about the unintended incentive distortions caused by provision of housing units (linked to bank loans) in anchoring potential migrants to their villages thereby generating inefficient labor market outcome.

In this context, it would be interesting to study the role of NREGS in "crowding-out" beneficial rural to urban migration. It is possible that the NREGS will have disincentivized migration by a number of potential semi-skilled rural-to-urban migrants whose migration would have generated more efficient long-term labor market and economic outcomes. For example, rural-to-urban migrants would have a much greater chance of deploying their skills and even upgrading them, besides being a source of skilled labor supply for industries, than those who choose to remain in their villages.

In many respects, states like Kerala should learn from the bitter experiences of PIIGS economies in Europe who too face the formidable challenge of higher wages lowering their economic competitiveness in relation to their EU partners. Kerala's labor market is surely a major handicap for the state in its efforts to attract industrial investments, in the face of competition from other states, due to its uncompetitive labor rates.

Lack of adequate labor market integration across Europe means that the PIIGS economies have to take regulatory measures to address the issue of high labor wages. This naturally comes up against considerable political opposition and stands less chance of success. A more practical and efficient method to address this issue is to design policies that promote internal migration that arbitrages away such labor market distortions.

More regulatory arbitrage by Goldman Sachs

That Goldman Sachs is a master of regulatory arbitrage is well documented. However, hitherto such arbitrage was thought to be confined to itself and its private clients. Now here comes news that Goldman helped Greece hide the true extent of its indebtedness and beat the rigid EU Stability and Growth Pact conditionalities to raise money using clever cross-currency swaps.

Der Spiegel, via Felix Salmon and Marginal Revolution (also Mostly Economics), reveals that in 2002 Goldman helped structure cross-currency swaps for Greek government debt issued in dollars and yen and swapped it for euro debt for a certain period

"Such transactions are part of normal government refinancing. Europe’s governments obtain funds from investors around the world by issuing bonds in yen, dollar or Swiss francs. But they need euros to pay their daily bills. Years later the bonds are repaid in the original foreign denominations.

But in the Greek case the US bankers devised a special kind of swap with fictional exchange rates. That enabled Greece to receive a far higher sum than the actual euro market value of 10 billion dollars or yen. In that way Goldman Sachs secretly arranged additional credit of up to $1 billion for the Greeks. This credit disguised as a swap didn’t show up in the Greek debt statistics."

In other words, the extra debt was hidden in the currency swap. Incidentally, Goldman shed its risk on this deal after selling the swap to a Greek bank in 2005.

Felix Salmon also draws attention to a similar product structured in 2004 by Goldman for Germany, called Aries Vermoegensverwaltungs, by which Germany essentially borrowed money at much higher than market rates just so that the borrowing wouldn’t show up in the official statistics.

Update 1 (5/3/2010)
It now emerges that Goldman and other banks who helped hide Greece's debt and other hedge funds were using credit default swaps to bet on the likelihood of a Greek default and using derivatives to wager on a drop in the euro. These banks had helped Greece borrow billions to mask its poor finances by creating derivatives that essentially transformed loans into currency trades that Greece did not have to disclose under European rules. See also this account of how Wall Street helped Greece mask its debt.

Update 2 (11/3/2010)
Simon Johnson and Peter Boone argue that Europe's politicians and IMF must step in to provide financial assistance to help Greece restructure its debt if it is to remain within Euroland. The IMF estimates that by the end of 2011 Greece’s debt will be around 150% of its GDP, with about 80% of this debt being foreign-owned, a large part of this held by residents of France and Germany.

Johnson and Boone estimates that every 1 percentage point rise in Greek interest rates (necessary to attract investors to buy Greek bonds required to re-finance debts) means Greece needs to send an additional 1.2 percent of GDP abroad to those bondholders. At a 10% interest rate, Greece would need to send at total of 12% of GDP abroad per year, once it rolls over the existing stock of debt to these new rates (nearly half of Greek debt will roll over within three years). This is clearly unsustainable, and the only option is for Europeans to step in and inject cash to bailout Greece.

Update 3 (8/2/2012)

NYT has this account of a lawsuit that claims that Goldman Sachs' conflicts of interest (by having a role on both sides) resulted in El Paso being sold too cheaply in a $21.1 billion buyout of the giant pipeline and energy company by Kinder Morgan.