30 June 2009

Water From Conventional Sources Is Better

Whilst we may be pleased with the progress we have made, and continue to make, with waste water reclamation and desalination, which enable us to reduce if not eliminate our dependence on adequate rainfall and imported water, we should not lose sight of the fact that obtaining potable water from waste water or sea water is more costly than that from conventional means because of the extensive use of membranes and the energy intensity of the purification processes.

However, we don't necessarily have to incur this higher cost, at least for part of our water consumption.

So long as the relevant reservoirs in Johor collect more than enough water to satisfy Johor's own needs and our entitlement under the existing water agreements, it probably makes more economic and environmental sense for both countries if we purchase such surplus water from Malaysia.  This will be particularly so when the 1961 water agreement expires in 2011, freeing up 86 million gallons per day which Malaysia is obligated to supply to us until then.

Of course, both parties must be willing and the price must be right.  The price needs to be lower than the lowest variable cost of producing our own water to a comparable level of purity by reclamation or desalination.  The price can be much lower if the quantity that is offered to us is not fixed over an extended period, but is allowed to vary from time to time, so that it is really water that is surplus to Johor's needs and will otherwise flow into the sea.

We benefit from a lower cost of water and Malaysia benefits from realising some monetary value for a commodity it cannot harvest at the moment.  It won't affect our overall trade balance, but it will improve Malaysia's.  It will reduce the impact on the environment.

This does not mean that we should revert to being dependent, even partially, on imported water.  We should, and must, continue to develop the infrastructure to reclaim and/or desalinate water, but we may want to use these facilities only to the extent that we can't get imported water at a meaningfully lower cost than the variable cost of doing so ourselves.

05 June 2009

Limiting Proprietary Foreign Exchange Trading

Apart from maintaining a book to facilitate foreign exchange transactions with their non-bank customers, should banks engage in proprietary foreign exchange trading i.e., speculating for their own account?

Many banks have systems which try to quantify the potential loss of their trading positions under certain stress scenarios.  Such systems usually work well, provided the mathematical models on which they are based correctly reflect historical experience and then, only to the extent that historical experience can accurately predict future exposure.  However, markets have fat tails (periodic, albeit infrequent, price movements that are much larger than predicted by most finance theory) which may not have been built, or not adequately built, into their models.

Even with capital adequacy ratios in the mid-teens, banks are more highly leveraged than many other companies.  A bank with a capital adequacy ratio of, say, 15 per cent, has 6.67 times as much risk-weighted assets as capital, and this is after taking the credit risk of not-so-risky assets at less than their full face value.

When banks falter, either depositors lose their money or governments rescue them with taxpayers' money.

Risks aside, a more fundamental question is this is speculating on currency movements a banking activity, or even a business activity?

Many people do not consider foreign exchange, or any other, speculation as a business activity of non-banks.

What differentiates banks from non-banks then?  Is it expertise or more sophisticated risk management systems?  Is it because banks have been doing it for years, perhaps profitably?  Or, is it some notion that it is a banking activity by reason that it involves currencies, economic analysis, etc.?

There's no difference, really.  If individuals wish to speculate, that is their prerogative.  But, companies banks as well as non-banks should not speculate.  Not as a business and not with money not theirs to risk.