A visionary ecosystem

Microfinance is not innovative. Many will be understandably aghast at such a statement. The origins of microfinance is of a hapless yet determined economist, Muhammad Yunus, attempting to sell the novel idea that the poor can be creditworthy, a notion that was shunned by virtually all the banks existent in the late 1970s. Banks could not imagine loaning to those without collateral. It was simply too big a risk. This is precisely what is not innovative about microfinance. It was just another example of a loan to a customer. It is not like a bond, which is also a loan, as bonds are transferable securities; nor is it like a derivative, whose value depends on another financial asset.

Instead, what makes microfinance unique, though not innovative, is its success depends on monitoring and mentoring. Without observation or the support required to set up small enterprises, the likelihood is that the poor, in general, would fail to pay back their loans. This is not an indictment on the poor, far from it. Rather it is to say that the presence of an overseer and an enabler can lead to ideal outcomes.Hardly a novel insight, it is not only a characteristic of microfinance; we see the importance of mentors in other industries, particularly venture capital and private equity industries.


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Greece, Please Let Me Introduce You to Mr.Tony Soprano

In the HBO drama, the Sopranos, there is a scene in which the anti-hero, Tony Soprano, mob-boss and sociopath, chases a middle aged gangster across the streets of New Jersey. The unfortunate pursuant crashes his car and injures himself, much to the glee of Mr. Soprano. He stops, gets out his car, walks to the injured man still sitting in the driver’s seat moaning in pain, and opens the door. Feigning care for a stunned public that gathers around, Mr.Soprano grabs the hapless man’s neck, proceeds to threaten the anguished driver and demands the money that is owed to him to be given within 24 hours. Mr. Soprano then casually leaves quietly and unperturbed.

If one could find a most appropriate metaphor for the current situation in Greece, perhaps this is it. Greece, shattered and devastated, has an unemployment rate of 25.4%, and is struggling to pay its public sector workers. Its manufacturing sector contracted for the 8th consecutive month according to the Purchasing Managing Index, and its GDP has been falling rapidly since 2009 when it was at $341.6 billion. Greek’s GDP is currently at $241.72 billion. With high unemployment, an anemic manufacturing sector and declining GDP, Greece is still expected to pay 6.74 billion Euros in June, 5.95 billion Euros in July, and 4.38 billion Euros in August. They owe the IMF 2 billion Euros and 6.7 billion Euros to the European Central Bank.

The ECB have pushed Greece to increase taxes and more importantly collect taxes the Greek government is owed. At the end of 2014, Greeks owed their government about €76 billion in unpaid taxes accrued over decades. The government says most of that has been lost to insolvency and only €9 billion can be recovered. Nevertheless, the incumbent Syriza government is attempting to negotiate better terms with creditors in order not to default on its impeding payments.

Unsympathetic creditors argue that Greece’s descent into economic chaos is a product of their own financial indiscipline and corruption. Up to 2009, Greece had accumulated high debts and prices were high making the country uncompetitive. There were even accusations of the unproductive Greek work force that chose to slack rather than to work hard. One could certainly argue that Greece is a victim of their own opulence, chasing loans without building a sufficiently strong growth stimulating sector. Indeed, in 2010 the Greek Ministry of Finance identified a bloated public sector and an inordinate focus in channeling investments into non-growth sectors (such as the military).

But Greece is also trapped by the rigidities of being part of the Euro. As economists such as Paul Krugman argue monetary policy instruments as a means of combating economic problems are more or less absent for countries that are under a common currency. Greece cannot increase interest rates in order to incentivize saving; neither can they print money in order to encourage banks to loan to productive industries. They have to rely on fiscal policies solely that require the participation of a public that is witnessing unemployment and salary cuts.

With high debts, high unemployment, lack of a monetary policy, shackled by the Euro, and condemned by a haughty international community, Greece’s condition is remisicent of Germany in the early 1930s. The Weimar Republic was beset with problems emanating from WW1. The Treaty of Versailles in 1919 had imposed a reparation bill that Germany continually complained was too high to pay. Throughout the 20s Germany had to borrow heavily, particularly from the US, in order to reconstruct. Once an industrial center, the Allies had sought to weaken Germany following the war, with France being particularly belligerent. She took over Germany’s industrial heartland, the Rhur, in 1921. This led to the famous hyperinflation bout in 1923.

But perhaps the one key shackle for Germany was being part of the Gold Standard. The Standard which had worked reasonably well in the 19th century was causing distortions in the global economy at the time. The four great powers – US, France, UK and Germany – faced differing economic scenarios which impacted the other. US and France had most of the world’s gold bullion, whereas UK and Germany were hamstrung by a lack of it. The abundance of Gold allowed the US to divest capital into Germany, who were only too happy to accept the largesse as it sought to rebuild and pay off its debts and reparations. The problem was that in 1928 when America raised interest rates in fear of a overheating stock market, Germany were left with a decreasing flow of capital, and fell into recession. The tap had been closed, and with it Germany’s ability to suitably build its own industrial sector. It could not increase its deficit in order to invest, and with pressures from UK and France to repay, it had little room to manoeuvre.

The Great Depression changed the situation dramatically, as the world began to suffer, and countries experienced their own financial crisis. They were less concerned about Germany’s ability to repay, and by 1932, forgave Germany’s reparations bill. In the 13 years since the Treaty of Versailles, where the bill was set at $32 billion, Germany had only paid $4 billion. Thereafter, Hitler came into power, and the central bank, led by the enigmatic and ill-tempered Hjalmar Schacht, started to print money to invest in public works, mostly those industries that related to rearmament. Even though Germany remained on the Gold standard (unlike the other great powers) it had the breathing space to build its own economy. While by 1937 cracks began to appear as Germany were priced out of the world markets and austerity at home affected the living standards of its people, perhaps a key lesson from this situation, was less oversight and greater freedom allowed Germany to work out its own destiny.

Returning to Greece, there is an irony that Germany is acting with an iron fist, condemning Greece for its profligacy and imposing directives. Greece, like the Germany of old, has to turn to more creditors just to pay the bill, and being part of the Euro, it cannot devalue its overvalued currency thereby cheapening domestic prices. Certainly, Greece is a victim of its own detrimental actions – just as Germany of old were – but being hamstrung by the Euro and with a supercilious international community, it can hardly atone for its economic actions without being condemned. Like Mr. Tony Soprano the international community is acting like gangsters without sympathy. All Greece can then do is remain servile, looking for loans to pay its creditors, and hope its people do not descend further into impoverishment. But without a flourishing economy, it is hard to see how in the future Greece can improve. And like Germany of old it may have to eventually ignore the international community in order to settle its own affairs.

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The Musk of a Dynamic Business Model – Part 2

This is the second post and final post of this series. To read the first please go to this link.

One thing that connects both Tesla Motors and SolarCity is renewable energy. Lower oil prices, shale oil, and the huge reserves of oil and gas that have not been tapped into still offer energy sources that can sustain humanity for a few centuries. But the clamor for sustainable energy sources that has gained steam at the turn of the century has meant that our profit maximizing capitalist is looking towards renewable energy. Indeed, the UK even has a green investment bank. But being highly capital intensive as well as offering less energy than what can be produce from fossil fuels, renewable energy is not a particularly attractive option for the capitalist looking for a decent return.


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The Musk of a Dynamic Business Model – Part 1

Elon Musk does not think small. Neither does he think narrow. The South African born entrepreneur has managed to dip his fingers into a number of industrial sectors to varying degrees of success. With SpaceX (Industry Sector: Space Exploration), Tesla Motors (Industry Sector: Automotive) and SolarCity[1] (Industry Sector: Renewable Energy) remaining going concerns, Musk has etched his way into the global consciousness as someone who can achieve whatever he puts his energy into.


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Making banking a public good

Following the financial crisis, the banking model was criticized for being inherently unstable. There were two key reasons for this instability: first, the fractional reserve model in which banks keep a percentage of their deposits within the coffers and lend or invest the rest was thought to encourage irresponsible decision-making. With deposits being insured by the central bank up to a certain limit, moral hazard is a cause for concern. Secondly, the money creation process allows the central bank to create money through the act of lending, or more generally, the utilization of debt finance.  Since money is no longer tied to anything tangible, the central bank effectively has a carte blanche to print as much money as it chooses. What limits its’ discretion is inflation and the fact that the money goes to commercial banks. Banks in turn will have to lend out, but will have to ensure they lend to people who can pay it back. This means that it is incumbent on the borrower to make a sufficient amount of profit from the sales of goods and services. If there is inflation, the value of money will decrease, making goods more expensive. Central banks and commercial banks need to ensure a balance the amount of money in the system with the amount of goods and services.


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In Defence of the Bum

There is typically a strong disgust for people who live off the largesse of the state but do not work for such benefits. Social security for the unemployed is in theory meant to be a means for sustaining individuals as they look for a job. For those whose lassitude prevents them from strenuously searching, and who take from the state through job seekers allowance, or if they have children, child benefits, or other forms of social security, these individuals are considered as societal leeches, the dregs of society, taking while not giving. Indeed if society is to function and endure it has to be assumed that its members are contributing in some form though occupation, and the production of something. That thing can be tangible objects such as buildings and clothes, or intangible things such as entertainment.


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The Weakening of Bargaining Power

Venezuela is worried. Scarcity of basic items have caused consumers to queue in front of convenience stores overnight to buy milk. Hugo Chavez’s socialist ideals seem to have floundered as the social hierarchy unravels with the poorer waiting and the richer satiated. Many blame the corrupt government for siphoning money away from social services; others blame the drastic reduction of the oil price. The anchor of the Venezuelan economy has been oil, and diversifying away was never strongly encouraged, leaving the South American nation a dependent state.

It would be mistaken to think that there is one reason for the crisis in Venezuela. Corruption and decreasing oil prices have all contributed to the problem. One cannot say that Venezuela would still be suffering if the oil prices had stayed over $100 and corruption remained; none of these issues are mutually exclusive. Indeed, the economic success and sustenance of any nation is multifaceted and dependent on both internal forces (politics, commercialism, cultural philosophy, etc) as well as external (remittances, sanctions, oil prices, etc). A ruler has to be concerned with both.

Even so, the complexity of modern day markets, the intertwinement of systems, the ripple-effect ramifications of the actions of foreign nations means that nations can no longer look inside for sustenance and growth (unless you are North Korea, but as the recent Hollywood debacle has shown, they are far from being out in the cold). OPEC has shown that with reducing prices to increase supply, countries can be affected in different ways. While the US and Saudi Arabia may be lighting up a cigar with a smile on their blackened faces, Venezuela and Iran are wiping their brow.  We do not seem to live in a United Nations world.

In theory when countries trade with each other, they are making themselves better off (both countries are getting what they want).  It is the case of the market forces acting in favor of both parties. Yet this is not always the case. The bargaining power of one nation or one company can be far greater than the other, placing them in the position to dictate prices. The more powerful, in the end, have a greater say in how a transaction should effectively take place.

Thus the markets are not so benign as the theory of perfectly competitive markets would aspire for, and neither does the invisible hand exercise the best outcome where we reach market equilibrium. It is assumed that demand will meet supply where both parties are happy with the quantity sold and the price for each unit. This notion is weakened the greater disparity in bargaining power.  We see this both in the goods and the labour market and more often than not these markets intertwine.

As an example, a major brand in West wish to sell shirts. The brand shops around and finds a Bangladesh garment factory that is offering to sell shirts for the lowest cost. Higher management of the brand go to Bangladesh, accept the quality to be reasonable, and offer the contract to the garment factory. The brand can now buy at a cheaper cost but sell at a higher price. That latter price might be at a correct market price as the brand has to rely on the consumers to buy and the higher the price, the less the demand. In Bangladesh, however, the garment factory owner is thinking he wants a lot of money too. He has the luxury to push down wages to such a point as the workers are happy although not comfortable. Now one could argue that this is a market wage, yet cut the share of the profits going to the garment factory owner and transfer it to the workers wage, market wages go up.

Thus the bargaining power of the brand is higher with the garment factory, and the bargaining power of the owner is higher than his worker. Those with stronger bargaining powers can dictate terms manipulating the needs of their transactional partner. Recently in the UK, the Think Tank Civitatis was found to charge their unpaid interns 300 pounds for a reference. A graduate looking to climb the career ladder and finding options in today’s economy to be limited would begrudgingly pay (if he had the money). Civitatis would argue we are offering them a benefit, and they should pay. All that is happening is a manipulation of bargaining power.

Would we call these examples as milder forms of oppression? Many would disagree arguing that the weaker party is getting a benefit he otherwise would not have. Furthermore, by working he has the opportunity to rise out the mire of his own poverty and be able to strengthen his own bargaining power. This is a curious argument, yet one that development economists hear when explaining growth in nations. The developed world was once a drudgery with inequality far greater than today. The UK and US lived with stark class tensions with the working classes toiling while the upper classes reaped the rewards. Yet wealth trickled down changing society in remarkable ways.

One could argue this was due to the market. However, this is too simple and general an assumption. Certainly the market led to better distribution, but more importantly, it was the values of market participants that led beneficial changes. Here we are not talking about just the buyer and seller; we are talking about society in general with members invested in the distribution of social benefits. The notion of a social welfare state rests upon a polity that is looking out for their own.

The market, therefore, cannot be considered in isolation. Every market agent is member of society, and if society is to be utilitarian then the market has to be too, that is happiness for the greatest amount of people.  However, the more parochial and selfish the market participant then the likelihood is society will suffer its consequent ignominies. This is worrying if one simply considers the domestic market; it becomes are far greater concern if we increase the number of players as happens with the international market thus meaning an agent with greater bargaining power in one country can dictate the terms for his transactional party in another country who then dictates his terms to a weaker party in his own country.

In Venezuela, the above principle is manifest, as OPEC reduces its prices. Venezuela accepts the terms of lower oil prices. Corruption means the profits available go to a select few, who perhaps pay for more luxury items meaning money does not get into the domestic economy sufficiently. There is more to this story, but when we strip to the layers of complexity the basic lesson is that the greater disparity in bargaining power and the more self interested, the less likely the invisible hand will be successful as our free market proponents believe.  The values of market participants are central to understanding the markets irrespective of the laws that seek to restrain vices. But this is a story for another day.

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Economics: The Brilliant Dismal Science

Economics 101 typically begins with the theory of the firm and, more specifically, a perfectly competitive market. This market is characterised by demand equaling supply, the cost of producing one extra unit of a good equaling the revenue added from selling the good. There is no one dominant company and prices are at a level where people can afford them. It looks like a utopia, and as such, there are no real examples of a perfectly competitive market.


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Gold and Wishful Thinking

There is much criticism of the current Islamic financial paradigm. One criticism is that an authentic Islamic finance industry is not possible with the proliferation of fiat currency. Since the Prophet’s time, the currency utilised was the dinar or dirham, the gold or silver coin. This bimetallism ensured that the opportunity to keep producing money was limited and therefore the possibility of inflation was reduced, as excessive inflation is when there is too much money chasing too few goods. Moreover, by limiting the amount of money in the economy, inefficient use of money on profligate investment can be reduced.


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Essence of Islamic Finance Part I


Having completed his Masters in economics, Rizwan Rahman worked at the World Bank in Bangladesh, acting as a researcher for the Senior Economist. After returning to the UK, Rizwan pursued his legal studies while concurrently working at leading law firms. In 2008, he was introduced to Islamic finance through undertaking an internship at European Finance House (now Qatar Islamic Bank). Rizwan has since worked at the Islamic Finance Council and BMB Islamic. At Edbiz Consulting, he is jointly responsible for product development, drafting of legal documentation to ensure legal and Shari’a / Shariah compliance and conducting market research and analysis. He is also senior editor for Edbiz Consulting Publications.

There are two main criticisms of the current Islamic banking and finance (IBF) industry: the first one is that given the proliferation of fiat currency, and not commodity currency, one cannot have an IBF industry in the first place. Perhaps a revolutionary idea, there is no shortage of supporters, and there have even been attempts to create a gold dirham and silver dinar as legal dinar. Mints in Dubai and Malaysia issue currency according to weight of gold and silver. The Malaysian State of Kelantan have even issued dinars and dirhams as legal tender although this is not recognized by the central government, and has limited usage.

The far more pervasive and ongoing criticism of IBF is that the products on offer resemble those offered by the conventional financial sector. Most of the products have some linkage to interest rates, and the economic substance of some products appears to replicate the economic substance of an interest based product. This discourages some people from entering the industry, regarding it a sham. For adherents, the attraction lies in the fact that Shariah scholars have rubber stamped these products, so in their minds there is some indelible connection between the Prophet’s juristic sense and the decisions passed in today’s IBF industry.

The criticism is not without merit. Exploring this further, it soon becomes clear that IBF is based upon two pillars: adherence to Islamic law as interpreted by the scholars, and the values of the conventional financial system. To explain further, an investigation into IBF’s history – and by extension global financial history – will help in our understanding of the essence of this nascent industry.

Proponents commonly say that IBF originated from the time of the Prophet. In the passing of legal opinion on contemporary IBF products, recourse to classical legal rulings is par for the course. But the link between today and yesterday is tendentious at best. The Prophet lived in far more primitive times with the economy simple and based on mercantile relationships. For that matter, the global economy at the time was archaic. This was the state of affairs until the 14th century, when we begin to see the development of a number of financial innovations including the formations of the bank.

Perhaps the most significant innovation was the Catholic Church’s acceptance of interest. Once considered a sin (although surreptitiously practiced) the Protestant theologian John Calvin declared in the 16th century that small interest charged for the disbursement of loans was acceptable. This completely revolutionized trade and the financial markets. Soon after, Goldsmiths (who used to offer security to gold deposits) in England realized that the gold they were protecting could be lent out, or rather the receipts identifying deposits of gold could be lent, and at an interest. Here we had the start of fractional reserve banking.

During this time interaction between Islamic East and Christian West was increasing. The Crusades and the conquest of Islamic Spain had created tensions between the two blocs, but trade and political relationships between Christian lands Islamic empires, particularly the Ottomans ensured relationships between the two flourished. In trade, came the exchange of ideas. Arguably, between the 7th and 13th century Islamic East was the source from which the West learned. Contemporary scholars have argued that a few substantive and procedural legal concepts were borrowed from Islamic law. We know that the Italian trade contract, the commenda, was taken from the Islamic mudaraba. However, as the West grew, Islamic East power began to wane.

By the 19th century, when the Ottoman Pasha Muhammed Ali looked favourably to the French systems, Muslim intellectual dominance had fallen dramatically. Colonialism was altering power structures and with that Muslims became observers and followers rather than producers. The East Indian Company showed the power of a multinational company, an idea completely foreign to Islamic legal thinking. This was not a state, the traditional loci of widespread power, but a coterie of people linked together to form a legal personality. The idea of a company having legal personality posed serious questions to Islamic commercial law. In Islamic law, there was no such thing and there was certainly no idea of limited liability. Islamic law considered that those investing should be responsible for covering any losses that the business incurs. For that matter, businesses in Islamic lands were small scale, one off relationships. This is not to say that capitalistic thought, free trade and profit maximization were absent from the merchants in Islamic lands, but the concepts underpinning a commercial relationship were far more simple, based on a large part on trust, and certainly not anthropomorphic.

Limited liability, legal personality and the perpetuity of the company allowed people to invest their money, comfortable in the knowledge that any investment made, would be the loss amount. With the formation of joint stock companies and the maturity of the stock markets, arms length individuals could invest creating a greater pool of income for the funding of the company. However, the entry of stock markets in the Islamic world, the first being in Istanbul in, was met with suspicion from the Shariah scholars. Such a concept was not present in Islamic legal thinking.

The final days of the Ottoman Empire was marked by reforms characterized by the desire to incorporate Western laws, and financial systems without divesting Islamic ideas. Unfortunately, the dominance of Western ideas was too great. For one thing, through colonialism, through increased GDP, through increased affluence, the West was evolving into prosperity. The Islamic East was suffering. Hence, it was natural for many secular people to look to the West as the fount for success, and regard Islamic laws as hampering development and progress. In what followed was the creation of two groupings: the Muslims looking at the secular West as the wellspring for ideas and innovations, and those Muslims who feared that their religion was being diluted by encroachment of Western (liberal) ideas. The antagonism played itself out in social space, the political space and the financial space. It became far more controversial in the 20th century.

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