Riaz Haq writes this data-driven blog to provide information, express his opinions and make comments on many topics. Subjects include personal activities, education, South Asia, South Asian community, regional and international affairs and US politics to financial markets. For investors interested in South Asia, Riaz has another blog called South Asia Investor at http://www.southasiainvestor.com and a YouTube video channel https://www.youtube.com/channel/UCkrIDyFbC9N9evXYb9cA_gQ
It is becoming increasingly important for nations to build knowledge-based economies to effectively compete and win in a globalized world. Here is a presentation by Vivek Wadhwa, a Duke professor, discussing facts and myths in the globalization debate:
The world's GDP in 2009 will shrink for the first time since WWII, according to the World Bank. Poor developing nations will be particularly hard hit with a shortfall of $270 billion to $700 billion, which will set them back by many years. Many of these nations are looking for help from the traditional donors in the West. But the West itself is preoccupied by its economic woes, with tent cities popping up all over the United States as home foreclosures rise.
According to the latest estimates of the World Bank, almost 40 percent of 107 developing countries are highly exposed to the poverty effects of the current economic crisis, less than 10 percent face little risk and the remainder are moderately exposed. Bangladesh, India, Nepal and Pakistan are ranked among the 43 countries most exposed to poverty risks, raising the horrible specter of further political instability and dangerous social strife in a very important region of the world.
As one of the developing nations facing a serious economic crisis, Pakistan has received International Monetary Fund's commitment of $7.6 billion rescue package. But it needs more help. China refused cash aid to Pakistan during last month's China visit by President Asif Ali Zardari to seek financial assistance. At the time, many press reports inaccurately said that Zardari returned empty handed.
Instead of cash aid, the Chinese offered $450 million to Pakistan as suppliers’ credit for Neelum Jhelum Hydroelectric Project during Zardari's visit. China and Pakistan also signed specific agreements to help Pakistan on a number of other water and power development projects. Prior to these agreements, China has been helping Pakistan in many infrastructure projects such the Gwadar port and a number of nuclear power plants. Looking at how the Chinese are working with many developing nations in Asia and Africa, it appears to be an unwritten Chinese policy to offer trade and investment in projects rather than direct cash aid. Given the rampant government corruption in many developing nations, including Pakistan, the Chinese policy is a sound one. It attempts to benefit the people and the nation more than the corrupt politicians and government officials who they must deal with.
The Chinese government recognizes the crucial role it must play to lead the world out of the current economic crisis. Not only has it announced significant stimulus spending, it is also continuing to lend to the United States to help in America's recovery back to health. Together, the US and China have become the twin locomotives pulling the global economy. The combined behemoth of China and America has been labeled by Harvard business school professor Niall Ferguson as "Chimerica". Ferguson believes "we are living through a challenge to a phenomenon Moritz Schularick and I christened “Chimerica.” In this view, the most important thing to understand about the world economy over the past decade has been the relationship between China and America. If you think of it as one economy called Chimerica, that relationship accounts for around 13 percent of the world’s land surface, a quarter of its population, about a third of its gross domestic product, and somewhere over half of the global economic growth of the past six years."
Along with helping the US economy recover, China has a unique position and policy to help the developing world at the same time. Not only does the West have the white man's colonial baggage to contend with, the western view of Africa is one of wasted aid and growing poverty. This view holds that, if Africa generates any kind of growth, it is in suffering—and in the overseas aid sent to address that, now a $40-billion-a-year industry, according to Time Magazine. Naturally, with a new appeal every year and a new disaster every other, some people are feeling donor fatigue. They have begun to wonder if all that money is doing any good. They argue that aid creates dependence, fuels corruption, undermines democracy and stifles development in Africa and some of the poor underdeveloped nations in Asia and Latin America.
Learning from the western experience, the Chinese have sought to avoid fueling the culture of corruption and dependence by staying away from cash hand-outs. Instead, the trade between Africa and China has grown an average of 30% in the past decade, topping $106 billion last year. Chinese engineers are working across the continent, mining copper in Zambia and cobalt in the Democratic Republic of Congo and tapping oil in Angola, according to Time. Nor is this merely exploitative. China bought its access by agreeing to create a new infrastructure for Africa, building roads, railways, hospitals and schools across the continent. The current economic crisis is not expected to affect China's march in Africa: on the contrary, with the West's plans in Africa on hold at best, Beijing views it as an opportunity to extend China's lead. "We will continue to have a vigorous aid program here, and Chinese companies will continue to invest as much as possible," Chinese Foreign Minister Yang Jiechi said in South Africa in January. "It is a win-win solution." Dambisa Moyo, who wrote Dead Aid, says those who need convincing about Africa should ask themselves if they are convinced about China, "because if you back China, you're backing Africa." Ecobank CEO Ekpe says part of the explanation for China's zeal for Africa is a new way of looking at Africans. "[The Chinese] are not setting out to do good," he says. "They are setting out to do business. It's actually much less demeaning."
Clearly, the Chinese objectives are not entirely altruistic. Their strategy is driven by enlightened self-interest in the developing world, which they see as source of commodities that their industries need as well as growing export market for their products and services. But the Chinese want to do good and do well at the same time by helping to lift people out of poverty in the developing world. By doing so, they want to be seen as friends and partners by the people in Asia, Africa and Latin America. The strategy enhances China's status as the new superpower that takes its global leadership role seriously.
Not unlike Albert Einstein whose equation E=MC2 made possible the creation of physical weapons of mass destruction, Chinese mathematician David X. Li could go down in history as the man who enabled the development of financial weapons of mass destruction on Wall Street. Li's Gaussian copula models for the pricing of collateralized debt obligations (CDOs)are being blamed for the catastrophic losses leading to the global financial collapse.
In addition to underlying bonds, bond investors also invest in pools of hundreds or even thousands of mortgages. The sums involved are mind boggling: Americans now owe more than $11 trillion on their homes, according to Wired Magazine. But mortgage pools are not as simple as most bonds. There's no guaranteed interest rate, since the amount of money homeowners collectively pay back every month is a function of how many have refinanced and how many have defaulted. There's certainly no fixed maturity date: Money shows up in irregular chunks as people pay down their mortgages at unpredictable times—for instance, when they decide to sell their house. And most problematic, there's no easy way to assign a single probability to the chance of default. Al of this makes it much more difficult to calculate risk on mortgage pools and CDOs than on conventional bonds or old-fashioned home loans.
Wall Street "solved" many of these problems through a process called tranching, which divides a pool and allows for the creation of safe bonds with a risk-free triple-A credit rating. Investors in the first tranche, or slice, are first in line to be paid off. Those next in line might get only a double-A credit rating on their tranche of bonds but will be able to charge a higher interest rate for bearing the slightly higher chance of default. And so on.
David Li simplified the risk models further by using market data of credit default swaps on underlying debt, including pools of disparate mortgages, as convenient proxy for the probability of default on various tranches the CDOs. Almost all of CDS market data, however, was accumulated during a period of rising real estate values and fairly robust job markets, when defaults were rare.
What are credit default swaps? Credit-default swaps are an indicator of the cost of bond "insurance" that varies with the risk of bond default. Credit default swaps are privately traded derivative contracts traditionally bought by bond holders from CDS issuers like AIG, Ambac, FGIC, and MBIA and other entities. Like other derivatives, CDSs are not regulated by government agencies. Any investor can sell CDSs. The CDS sellers are expected (not guaranteed or back-stopped by governments) to reimburse bondholders or buyers in case the bond issuing companies or governments default.
As an investor, you have a choice: You can either lend directly to borrowers or sell investors credit default swaps, insurance against those same borrowers defaulting. In either case, you get a regular income stream—interest payments or insurance premiums —and either way, if the borrower defaults, you lose a lot of money. The returns on both strategies are nearly identical, but because an unlimited number of credit default swaps can be sold against each borrower, the supply of swaps isn't limited the way the supply of bonds is, so the CDS market managed to grow very raidly. Though credit default swaps were relatively new when Li proposed his idea, they soon became a bigger and more liquid market than the underlying bonds on which they were based.
The growth of the CDO market was exponential. Using Li's formula, Wall Street's quants saw a new range of possibilities. And the first thing they did was start creating a huge number of brand-new triple-A securities. Using Li's copula approach meant that ratings agencies like Moody's—or anybody wanting to model the risk of a tranche—no longer needed to puzzle over the quality of mortgages of various kinds that also proliferated. All they needed was that correlation number based on CDS data, and out would come a rating telling them how safe or risky the tranche was.
The CDS and CDO markets grew along similar trajectories, drawing strength from each other. At the end of 2001, there was $920 billion in credit default swaps outstanding. By the end of 2007, that number had skyrocketed to more than $62 trillion. The CDO market, which stood at $275 billion in 2000, grew to $4.7 trillion by 2006.
It all worked well until the housing market and job markets began to weaken, causing a wave of defaults, beginning with the less creditworthy borrowers. The CDS markets started to behave erratically out of fear. And the CDS data accumulated during the good times no longer served as a useful proxy for the actual risk of various trances of mortgage pools. Even the AAA rated tranches were hit by defaults, because some them contained subprime mortgages.
There were several people, including experts such as Darrell Duffie, Paul Wilmott and Janet Tavakoli, who warned about the dangers of blindly using Li's copula function as a basis for assessing risk of default for CDOs. But the greedy Wall Street executives and money managers, who were making enormous profits from such derivatives, ignored such warnings. And the politicians didn't care because they were receiving their share of the profits as Wall Street contributed large amounts of money to their campaign coffers.
The CDOs, based on Li's Copula function and created and traded on Wall street, now account for most of the toxic assets that have turned shares of major banks like Citicorp into penny stocks. The insolvent troubled banks are now receiving hundreds of billions of dollars from taxpayer funded bailouts orchestrated by the US treasury. The ongoing credit crunch and the wave of home foreclosures show no signs of abating. The negative effects of the US woes are being felt around the world. With globalization of the financial markets and trade, the rest of of the world is not immune from America's economic crisis.
Here's a video titled "The Formula That Wrecked the Economy":
