What should Obama do?

Unconventional problems require unconventional measures to solve them. This is

what every government on the earth is doing right now. Several of them have
already announced stimulus packages while some of them are in the process of
announcing yet another tranch of such packages. There are others that are
contemplating such steps to bolster the economy and restore the confidence of
consumers, business and the public at large. The current financial crisis emerged
in the US of A which is the one of major victims of its own misdeeds. So, naturally
all eyes are on the charismatic leader and President elect Barack Obama for his
actions once he takes the charge after entering in the Oval Office. Experts and
economist across the globe are discussing what should be his immediate priorities
and are speculating what steps he should take to produce the desired results. In
this report, we will discuss what challenges Mr. Obama is going to face and what
he should do to tackle them?

The US Fed has cut its interest rate almost to zero (0.25%). Soon the BoJ too cut
its rate to 0.1%. The question is whether the zero rate regime can arrest the
economic de-growth? Is it really a useful tool the central banks can use to derive
the desired result? The Fed has already begun an aggressive plan of Quantitative
Easing (QE) that has doubled the size of its balance sheet in just two months of
time span. As of now, banks are still hoarding on the cash and credit flow is yet to
resume supporting the demand.

Seriously speaking, this is a perilous and precarious situation. After exhausting all
the conventional measures to stimulate the economic growth being failed, the Fed
is left with fewer options now. Japan which has been living with almost zero rate
regimes for almost a decade recently cut its rate to 0.1%. So, what else the
governments or central banks can do to bring the economy on the track? In this
report, we will try to discuss what are the unconventional measures that can be
taken to shore up the economy growth and whether they are effective at all?

Deepak Tiwari
Research Analyst

deepakt@arthamoney.com

T: + 91 22 4063 3007

Dec 23, 2008 For Private Circulation only 1

 Mr. Obama and the world
One of the challenges Mr. Obama is going to face is handling current financial
convulsion and terrorism. Both of them have global impact and consequences.
True, this is something Mr. Obama himself cannot do on his own, as it requires a
coordinated and concerted endeavor from every corner of the world. However, he
will play a pivotal role and lead from the front. The success of this will depend
much on how he manages the show. Some of the priorities that he will take up as
soon as he takes the rein from his predecessor Mr. George W. Bush are
mentioned underneath:

 Designing the new fiscal stimulus program which may amount to US $ 700
billion to over 1 trillion.
 Restoring and rebuilding confidence of consumers, investors and
business.
 Chalking out quite extensive and tougher regulations for banks (limiting
their risk taking abilities and overall banking operations), consumer lending
and investments.
 Creating more jobs. It will be a major challenge for him because already in
2008, over 1.7 million jobs have been lost and it’s expected that it will
touch 4 million in the coming year pegging the unemployment rate to over
9%.
 Announcing new economic legislations where the primary focus should be
on doing whatever is necessary to get the economy going again.
 Ensuring balance sheet cleaning up of banks and consistently increasing
funding for them.
 Addressing the energy issue.

The “Change” Mr. Obama will bring in will definitely change the mind-sets of
regulators and great American lifestyle. It’s expected that the new regime will do
whatever is necessary to stabilize the financial sector and get credit flowing once
again. The previous $700 billion bailout was very badly handled. Now it’s yet to see
how the Mr. Obama and his retinue would handle the next stimulus package. We
expect that the primary focus would be on spending on investments that offer long-
term benefits in addition to the short-term benefit of stabilizing the economy. The
media reports suggest that Mr. Obama has made his first priority to sign an
economic recovery package with significant focus on infrastructure projects to help
boost jobs aiming at 3 million job creations over a couple of years.

No doubt, few things will change for forever. Americans wont like to bank just upon
credit lines and will start saving for the future. It is pertinent to mention that in US,
the savings rate is in negative for several years. And the banks too will be more
prudent and cautious in their lending policies.

Dec 23, 2008 For Private Circulation only 2

 Unconventional monetary measures
After exhausting all the conventional measures to spur the demand and stimulate
the economic growth being failed, the Fed is left with fewer options now. It is
expected that the Fed will take some exceptional measures like Quantitative
Easing (QE) which is a tool of monetary policy also known as printing money
mechanism. This is used usually to fight domestic deflation. Deflation is a
persistent decrease in the general price level of goods and services only when
annual inflation is below zero percent resulting in an increase in the real value of
money - a negative inflation rate. All developed economies are in recession and
are expected to see deflation by the second half of the next year. Inflation in the
US has pegged at 1.1%, in Japan 1.7% and in the Europe area at 2.1%. The
classic example is Japan which has experienced unprecedented recession and
deflation for more than a decade. The Bank of Japan has been maintaining short-
term interest rates at close to their minimum attainable zero values since 1999.
However, it’s still debatable how these measures are effective to such deflationary
situations.

Under Quantitative Easing (QE), the central banks inject commercial banks with
excess liquidity to promote private lending, leaving them with large stocks of
excess reserves, and therefore little risk of a liquidity shortage. It also involves
reducing the reserve requirements and buying treasury bonds for cash to offset
the reduction of money supply in the private sectors due to the collapse of credit
through "open" market operations. Moreover they buy asset-backed securities,
equities, and extend the terms of its commercial paper purchasing operation.

How the QE is effective in buoying the economy?

The Bank of Japan’s QE policy was introduced in March 2001 and terminated in
March 2005. The policy was introduced with the intention to open-up a new
possibility for further monetary easing when the interest rate was already as low as
zero. The policy was unprecedented and was an ambitious experiment by itself.
The effectiveness of it has been a point of great controversy since its introduction.

Several empirical studies have confirmed positive macroeconomic effect of the QE

and have found out that the increase in the excess money led to the increase in
aggregate demand and helped the economic recovery since 2002. However, no
effect has been established on expectations and portfolio rebalancing by
investigating the increase in Current Account Balance (CAB) targets and increase
in government bonds purchases by the central bank. It’s very cumbersome
exercise to quantify the exact effect of such measures but the consensus is that
they have positive effect on the economy.

Dec 23, 2008 For Private Circulation only 3

 Japan: A case study

To understand the effectiveness of the QE we need to examine whether the

change (increase) in the Current Account Balance (CAB) is really possible.
Demand for the CAB depends on the nominal interest rate, which is the opportunity
cost of maintaining the CAB. Therefore, to increase the CAB, generally we need to
decrease the interest rate. As the interest rate is already almost zero, increasing
the balance seems difficult. In reality, the CAB has increased greatly. Two reasons
are possible:

1. Telecommunication expenses and various costs associated with funds

transactions may not be paid as the market interest rate is very low. So,
private institutions cannot invest funds held at the BOJ's current account
into money market instruments.

2. Financial institutions feared that obtaining capital from the short-term

market would become difficult because of the unstable financial markets.

How does the increase in the CAB affect interest rates and other asset prices
viz. equity, government and corporate bonds? The short-term interest rates are
theoretically expected to decrease in response to an increase of the CAB.
Similarly, stock prices would rise and the yen would depreciate. However, the
influence on interest rates and stock prices largely has not been realized. The main
reason is that there was no room for short-term interest rate to decline. For the
exchange rate, the Japanese yen actually depreciated from 116.44 yen/$ to 133.89
yen/$ (between February 2001 and February 2002), but this is mainly because of
the economic recovery of the US and the instability of the Japanese financial
system. Furthermore, it is noted that the depreciation of yen would end deflation
but it is costly to Japan.

How does the policy affect the depository institutions? Theoretically, the
portfolio rebalance effect exists. In general, financial institutions consider the
changes of interest rates and construct their optimal portfolios by increasing or
decreasing loans, bonds, stocks, and other assets. When the short-term interest
rate drops, banks expect to increase their lending activities. However, the interest
rate seemed not to have a strong influence on banks' behaviors. The reason is that
the interest rate in Japan was near zero, and Japanese financial institutions could
not increase their risk-taking because they had large (non- performing loans)
NPAs. Thus, the portfolio rebalance effect was not realized.

The quantitative easing effects on the economy

It is important to consider the movement of the monetary base, money supply, and
GDP. These three indices exhibited similar trends around 1995. Since then, the
increase of the monetary base has been remarkable; on the other hand, the
increase of the money supply was not so large, and the GDP leveled off. Raising
the reserve target may have been perceived as a signal indicating the BOJ's
accommodative policy stance. Most economists also argue that the QE policy has
contributed to financial stability. However, the above-mentioned brief evidence may
suggest that the QE has not been very effective. In addition, many Japanese
economists have stated that the recent economic recovery is not due to the QE
policy. However, there is some possibility that the "time duration effect" is effective.
References:

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

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

Dec 23, 2008 For Private Circulation only 4