Saturday, July 21, 2012

Where Else Will the Money Go?

Episode 4 - Perverse Incentives

This 21-part series (excluding the prologue and the epilogue) examines the challenges facing India and the economic headwinds. The title of the series comes from the book Breakout Nations by Ruchir Sharma, from a nouveau riche kid in New Delhi quoted by him. The quote captures the confidence, almost arrogance, that India has built up during the last decade, which is not limited to rich brats and extends to business tycoons, policy makers and politicians alike. The series tries to separate the myth from the fact, and examines some hard choices the country will have to make over next few years. 

First things first, the 'perverse' in the title has nothing to do with anything outside economics. It is standard economic terminology applied to an examination of situations where actual outcomes differ vastly from outcomes that 'rational' people intend. In its core, it is achieving, with thumping success, what you set out to avoid in the first place.

The reason why I am digging up the concept is that it is probably the only explanation behind so many policy debacles we face today in the country. The reason behind diesel subsidy, for instance, is avoiding inflation. But the very subsidy, as it gets ballooned by 'players' along the chain taking their 'cut', comes back in the shape of fiscal deficit. It ultimately causes a far bigger impact through a generalized inflation, the impact becoming bigger with multiple perversities adding up on the way. Cheap diesel means it is economical to run older, highly inefficient vehicles and machinery. It also means people start buying diesel cars, which cause far more pollution, cost more to make and are difficult to maintain. It also means that industry can keep on getting cheap substitute power through DG sets (if power is correctly priced, at least there will be some incentive to use more efficient, and thus economical, ways to produce). And it also means that people living in swank houses and condos use up far more power than they need through 'DG backups' (which, incidentally, are used for at least 8-10 hours a day in almost all the cities in India). The end result is that far more diesel is used up than it would be had there been no subsidy. On top of that, no private company is willing to enter petro-distribution due to the screwed up policy. Hence, you have government monopoly that is adding its own inefficiency to the system. You end up paying for it all, through a much higher level of inflation than would have resulted had diesel been allowed to be priced at market levels.

This is a pervasive situation in India. No matter which policy area you look up, the outcome seems to be the opposite of intent. Power sector is comatose, though with the given energy deficit in India, it should be booming (and it was booming for a while). States are opposing GST, though they lose thousands of crores through evasion every year as the current structure makes it easy to steal. Fertilizer subsidy is primarily putting money in the pockets of fertilizers producers, instead of farmers who it is supposed to benefit.

Currency policy
The currency policy the country has followed over the past decade can be explained in this context. It is not that we started out intending to do this, but it eventually turned out to be a policy that has harmed the industry; like so many other well intended policies.

Beginning with 2004, India started attracting huge capital flows. Most of the flows were still of the 'hot money' nature, FII flows that could be pulled out of  the country any time. The RBI, at that time, had a strong policy of 'sterilization', i.e., insulating the economy from any monetary effects of the same. Thus, excess dollars were mopped up and the central bank issued sterilization bonds to mop up the excess rupee flows created by such conversion. In effect, the effect of inflows was completely neutralized.

But this policy was quietly dumped soon after 2004. The conservative policies of the NDA government were abandoned and UPA-I became eager to show a great score card. And currency as a tool came in handy, an appreciating currency itself starts to attract higher capital flows. Thus, from FIIs putting money into the stock markets to investors putting up power plants, the returns suddenly became attractive because whatever you make on your investments in rupee terms gets further boosted by currency appreciation. India used to be a country where you always worried about currency depreciation before investing. Instead, now you no longer had to worry about depreciation, and if there was any risk, it was more to the upside.

Why are these capital flows important to India? Because domestic capital formation has been inadequate to fuel the hectic pace of growth that became the norm during middle of the last decade (that is a separate debate altogether). Suddenly, you had everyone lining up to invest in India, and Indian firms also became big borrowers in the international market. The herd was on the move, investments started ticking up, the GDP growth gained momentum. The best part of it all? The government didn't have to do anything to make it happen, no painful deals with allies, no unpopular reforms. All they had to do was to tweak a thing or two like letting the rupee appreciate. And you were delivering 9% growth, something India had only dreamed of.

Building its own momentum
But these things tend to create their own momentum. By 2008, we had built huge risks into the system due to the overvalued currency. People who had borrowed dollars or had poured money into India in 2007 with rupee at 40 per dollar suddenly looked vulnerable in 2008 as first set of shock waves started to hit India. Suddenly, everyone who had anything to do with dollars started looking like on the verge of collapse. 

The impending collapse looked scary at the moment. Investors would lose huge amount of money on the currency, apart from losing their shirt in the stock market. Entire corporate sector would lose profitability for at least a couple of years, if they avoided bankruptcy in the first place. On top of that, exporters had earlier joined the bandwagon as selling dollars forward looked like an easy way to make money. If you sell a year ahead, you not only lock into the current dollar rates, but make a premium on top of that too. With dollar going only one way, down, the temptation was huge. Exporters not only sold forward for one year, but more ambitious folks went ahead to sell several years forward. And where RBI rules did not allow selling so far ahead, banks came up with 'innovative' structures like dollar call options, where the seller was paid a premium upfront to make the bets. The gravy train was set. And when the tide turned, these very people stood to lose everything as the realized losses would wipe out a big chunk of their net worth.

Given the environment in 2008, policy choices were limited. Risking collapse at such a large scale would have been imprudent, so the interventions (rightly so) were aimed at protecting the currency. But as we have learnt from the experience elsewhere, we created our own 'too big to fail' problem. People do not use such opportunities to let the poison out of the system. And we also did not. Instead, the imbalance has been allowed to carry on.

This is the essence of today's conundrum. The moment currency depreciates a little bit, there are howls of protest as the pain is excruciating among all, including people who should logically benefit from a weaker currency. We have created our own vicious currency cycle.

Is the 'worst' over?
Over past month or so, we have seen the currency stabilize around 55 level. Many have assumed that the worst is over and rupee will start appreciating again. But this is not a given.

Reality is that years of imbalance have created fundamental issues with the economy. Our current account deficit, for instance, has hit an unsustainable level of 4.5% of GDP. This is enough to create doubt in the minds of some people. The challenge today is that even a small doubt is enough to stop the stream of money from coming in, and that flow has become essential to plug the gap in the current account.

And this situation is not likely to ease any time soon. The exchange rate study that I cited in an earlier episode also found another piece of vital evidence. In early 2000s, currency changes were feeding through in the export-import system with a lag, which is logical. It takes time for people to adjust their cost structures, pricing, etc., and set up new contracts to factor in new exchange rates. The lag I calculated for 1994-2004 period was around 18 months. This time around, lag is likely to be longer, particularly on the export side. 

Enduring pain
The only sustainable solution to an unstable currency is a pickup in exports and correction of the huge trade imbalance. This is not likely to happen any time soon.

Till 2004, while exporters did sell dollars forward, they were naturally wary of creating too much risk and sell too far ahead. The currency was prone to sudden bouts of depreciation, which meant whatever gains they made from forward dollar premia could be wiped out many times over if they took too big a risk. Still, they were taking about 18 months to register higher sales in case there was a serious currency devaluation.

At this moment, however, the same assumption is not true. The risks extend well beyond a year, though they have become far shorter than those seen in heady days of early 2008. Exporters are still locked in poor or toxic hedges that will keep their cost structures in bad shape for at least another year. This means pass through of more competitive exchange rates is likely to take longer than 18 months seen in early 2000s.

The external environment does not help. Given the global 'doom and gloom' scenario, export demand continues to be weak. This means currency pressures will continue for some more time. And the moment the tide turns again on investment money, the pain will start all over again.

Where do we go from here?
I have usually avoided predicting a definitive version of the future. It simply does not work, except for large financial houses. This time around, the predictions are on familiar lines. You keep hearing that the 'fair value' of rupee is somewhere between... (plug in your favorite range, based on your choice of bankers). The hilarious part is that the range usually happens to be within 2-3% of where the currency currently is.

Predicting in the current environment is especially risky. The truth is, no one knows. We don't know how long the global demand slow down will last. We don't know if portfolio flows will continue. We don't if investors will keep on tolerating the policy logjam we have created. And we don't know if players in the system have systematically removed risks (e.g., by hedging short term loans) or have allowed them to be there hoping for another 'too big to fail' based largesse. 

What can be said, however, is that the current situation is finely balanced. And downside risks in such situations can be perilous. One bit of bad news, a gentle nudge, can start a chain reaction. And the effects can last for a long time.

Wednesday, July 11, 2012

Where Else Will the Money Go?

Episode 3 - Of Currency and Value

This 21-part series (excluding the prologue and the epilogue) examines the challenges facing India and the economic headwinds. The title of the series comes from the book Breakout Nations by Ruchir Sharma, from a nouveau riche kid in New Delhi quoted by him. The quote captures the confidence, almost arrogance, that India has built up during the last decade, which is not limited to rich brats and extends to business tycoons, policy makers and politicians alike. The series tries to separate the myth from the fact, and examines some hard choices the country will have to make over next few years.

Historically, Indian rupee has been a weak currency. The currency was subject to a peg till early '70s, till the breakdown of the gold standard, but was frequently devalued. Post the gold standard, the currency stayed under various forms of control, again subject to multiple devaluations. 

Current account convertibility came to the rupee in the '90s. For a fairly long period of time (till 2003), the only direction the currency saw was downwards, with RBI's role limited to breaking the fall in order to avoid panic. 2003 turned out to be turning point for the rupee. For the first time in recorded history, the currency started gaining, notching up gains of more than 20% eventually over a five-year period. 

This has led to a peculiar problem. We seem to have acquired a taste for an expensive and overpriced currency. Even a minor swing (2-3%) downwards gets howls of protest, while massive upwards moves (up to 20%) do not even register. For a country that runs higher than world inflation, and is looking to build a strong manufacturing sector to create jobs, it is not a healthy situation. Not only is it confounding all sorts of logic, but it has the potential to damage long term competitiveness of the economy too.

Countries ranging from Japan to China, Germany to Argentina, have tried to manage their currencies in order to stay competitive. A weak currency was a 'weapon of choice' for the BOJ during the '90s to keep the industry afloat. China, likewise, has faced persistent pressure from the US to allow its currency to appreciate and relented only by middle of the last decade. Why would these countries push so hard for keeping their currencies cheap even though their economic fundamentals were pushing otherwise? Is it just a desire to push a bit extra on exports? 

The problem with the exchange rates is that impact does not stop with minor things like how much your widget will cost in the international market. Instead, exchange rates tend to have long term impact on the economy of a country, which extends far beyond whether tourists find it cheap to visit a country. It is worthwhile to examine some cases where a country neglected this aspect, which came back to haunt them later.

Perils of Too Much Wealth or a Spanish Problem
Columbus not only discovered America, but he also suddenly put Spain on to a seemingly endless path to wealth and power. The conquistadors found new land, and also stumbled upon probably the greatest horde of gold the old world had seen till then. All of that wealth funneled back to Spain, making the country fabulously wealthy for a while.

Over the following two centuries, the gold was used to build up Spanish military power and at one time, Spanish armies were marching across much of Europe. Spanish monarchy used the immense wealth and the power it projected to spread its version of orthodox Christianity, culminating in institutions like the Spanish Inquisition. 

There was a downside to all this wealth too. As a result of all the gold backing up the currency (or gold being the currency), Spain ended up with a relatively expensive currency. In terms of relative prices, a unit of gold in Spain would buy far less than it would buy in England (which had relatively puny gold reserves, depressing local prices). In effect, Spain ran probably the longest experiment with an overpriced currency in the global economy.

The results were not pretty. The industrial revolution that transformed Europe effectively passed Spain by in its first wave. The country that benefited the most, no surprises for guessing this, was England, whose puny gold reserves at the start kept its currency undervalued over a fairly long period of time. For Spain, effects were devastating. As the free flow of gold from the Americas ceased, the impoverished nature of the economy came forth and lasted for a long period of time.

The reasons are not hard to understand. Short term mispricing of currency can pass without any serious damage to the economy. But long term mispricing can play havoc. Not only 'export oriented' industries suffer, but local industry has to face a good amount of unfair competition from cheap imports. Staying out of the market for extended periods, not being able to build up a wealth of capital and productive capacity, not being able to develop necessary skills and human capital for a long time; all these factors contribute to an effective destruction of local industry. There is a good reason why governments provide subsidies to build up their local industries. Such subsidies are designed (or supposed) to build up infrastructure, bring the industry to scale, build a wealth of knowledge and experience, and create sustainable advantages that last in the long run. The subsidy is supposed to go in a short period, but the effects are supposed to last for a long time. An underpriced currency also achieves the same thing, a de facto subside. By this logic, an overpriced one does exactly the opposite, subsidizes imports at the cost of local industry. And its effects too are likely to last for a long time.

Good as Gold
Gold has served as a dependable currency over a long period of time in the history of civilization, sometimes directly and sometimes indirectly (such as through the gold standard). Countries did abandon the gold standard at times, when the governments simply did not have the necessary resources to support the standard. But results were usually problematic (though not due to delinking gold from the value of currency). The standard dictated that there was a limit to printing money. Without the standard, governments printed money with abandon, often to disastrous results. The hyper-inflation that ensued in Germany during the Weimar Republic, for instance, saw a trillion-mark note being printed at one time.

But the gold standard has not been very productive either. Consider the Great Depression. An empirical analysis suggests that the restrictive monetary policy forced by the gold standard did contribute to the event and its duration. Countries eventually did abandon the gold standard during the depression, though different countries did it at different times. The interesting part is that there is a direct correlation between when a country abandoned the gold standard and when it came out of depression.

Currency purists would point out that currency devaluations are ultimately a zero sum game. If everyone devalues by the same amount, you end up in the same spot; with a lot of inflation (due to printing of extra money) and its bitter aftertaste. This is not what I am arguing for. My contention is different, all else being equal, if you continue to have a currency that is not moving in line with the economic fundamentals, results can be both bad and long term in nature. Nothing more, nothing less.

Coveting a Strong Currency
Notwithstanding this, many countries have coveted a strong currency, particularly if they don't have to worry too much about competitiveness. Also, countries with high level of 'pass through' (i.e., imports and exports being large percentages of GDP, with low local value add) tend to benefit from strong currencies. An example is Singapore, where low taxes and good infrastructure acts an allure for a lot of 'entrepot' or pass through trade. Since the local value add is relatively low, the strong currency does not act as a deterrent. Rather, the low inflation and stability brought in by a strong currency acts in favor of the country through strong capital flows and investments.

The US has followed a 'strong dollar policy' for a fairly long period of time. The reasons are not hard to guess. Moving mainly to a services economy, running a negative savings rate and needing a lot of foreign capital to plug its deficit, the US did need a strong dollar. It also got the benefit of being the world's reserve currency and needed to preserve the status (which a weak currency would have underminded). But the impact on the real economy was still pretty much the same. Manufacturing moved out of the US, first to Japan, then to Korea and Taiwan, finally moving towards China.

The interesting part is that the Bush years saw a quiet burial of the policy (though it was never officially announced). Large deficits, twin wars forced a lot of new money supply into the system. It had its unintended consequences through excesses committed (that led to the financial crisis). But another unintended consequence has been that now US manufacturing has started looking competitive again. Apparently, there was enough productive capacity in the economy to absorb all the extra money supply, hence the low inflation. 

Other than strategic reasons, some countries do want strong currencies, 'national pride' being one of the reasons. But it has its price. For decades, Soviet Union managed an overvalued currency and kept the ruble slightly ahead of the US dollar. The real value of the currency was probably 1/10th of that level. Though it did not cause the complete collapse of the Soviet economy, but the fact that it had to supply huge amount of resources to its allies around the world at prices far below the cost of production would not have exactly enriched the economy.

India's Situation
Viewed in this light, the slide of the rupee does not look so bad. India has historically run high inflation, far in excess of global levels. Hence, to keep the local value-add cost competitive, the currency needs to depreciate by an equal amount. If that does not happen, the local industry and services effectively price themselves out of the market. Wages and other costs rise with inflation and then some more (real wages tend to increase with economic growth). While the 'real' part of wage increases needs to be managed through productivity gains, the inflation part must be adjusted through the exchange rates.

Is India Overpriced?
Looking at just the inflation differential parameter, here are some numbers. Between 1994 (effectively the time when the current account convertibility took hold) and 2004; the rupee gained about 20% against its trade weighted basket after accounting for the inflation differential with the world economy. China, which devalued its currency in 1994 (hence, the currency already started with a low base), fell further by 21% over the 10-year period. Effectively, there was roughly a 40% gap over this period between the two currencies.

The more interesting part is that the rupee gained in value from then on and appreciated by a good 20% by 2007. The Yuan/Renminbi also appreciated, but by then China had been hugely undervalued and local inflation was practically in line with global inflation. The rise of the Yuan meant that China allowed some of the undervaluation to be corrected.

Is India priced competitively with China today? I do not think so. Though there are 'economists' who keep pointing out that "Indian rupee has devalued by X% against the RMB since 2007". Well, first of all, you don't take artificially low bases for making such comparisons. Two, if you look at the long term currency values, the rupee has depreciated barely by 15% of its 2002-2004 trough against the dollar (48.50). At the same time, the country has experienced double digit inflation in CPI terms for most of the years since then. Even if our inflation differential was 3-4% against the global economy; the depreciation still does not offset the inflation impact even at current levels. In reality, we have run a hugely overvalued currency, particularly against our key manufacturing competitor, right up to 2011.

Manufacturing Prowess
Impact on India's manufacturing sector has been mixed. We have lost many battles to China in the process. The entire chemical manufacturing base of Indian pharmaceutical industry has shifted to China, with only some downstream operations and pill punching being done in India. Cheap Chinese toys, firecrackers and what not have killed Indian industries. Textiles, a huge employment generator, is virtually comatose, while countries like Bangladesh are emerging as the next big exporters after China's local wage rises have made them expensive. Even areas where high levels of expertise are required have seen a shift towards China. Thus, power equipment heavy weights like BHEL have lost to their Chinese competitors for building up the Indian power sector.

These are not 'export oriented' industries we are talking about. We are talking about hard core manufacturing for building up the country. If we cannot support this, whatever industrial base we have built up so far may wither. 

Why are We Doing This?
The question then is, what have we gained from this all? National pride? Some ad jingles that pompously predict "one rupee equal to 45 dollars"? What truly confounds is the fact that no one has bothered to argue against this policy till date, even those for whom it has proven disastrous. More surprising still, even the exporters who directly gain from a lower rupee heave a sigh of relief when a weakening trend reverses and brings the currency back up. There is an army of 'analysts' and 'economists', which starts howling the moment there is any significant weakening of the currency. The picture painted is that of disaster and the country going to the dogs.

It is wrong to pin the blame on collective ignorance, mania or even national pride. There are underlying forces at work that have brought this to pass. The key questions are short term gains vs long term health of the economy, gain for the few vs gains for the many and finally, how the incentives in the system are aligned. We will try and untangle this knot in the next episode.

Saturday, June 23, 2012

Where Else Will the Money Go?

Episode 2 - Of Paralyses and Deadlocks
This 21-part series (excluding the prologue and the epilogue) examines the challenges facing India and the economic headwinds. The title of the series comes from the book Breakout Nations by Ruchir Sharma, from a nouveau riche kid in New Delhi quoted by him. The quote captures the confidence, almost arrogance, that India has built up during the last decade, which is not limited to rich brats and extends to business tycoons, policy makers and politicians alike. The series tries to separate the myth from the fact, and examines some hard choices the country will have to make over next few years.

The world is justifiably angry with the European leadership for dithering on the crisis facing the Eurozone and taking only piecemeal measures. A couple of weeks back, some wires even termed it 'policy paralysis' in news items, a phrase we are familiar with.

Europe may have a policy paralysis, but it is of a different kind. At the heart of the issue is the question, should a diligent and prosperous neighbor bear the burden of profligacy of the guy next door? It may look necessary to the outsiders, and the one who needs the bailout may scream like a sacrificial lamb, but is it so easy to bear the burden?

The Germans view the problems of South in this light. They believe they are working harder than the Southerners (which is a myth), are more diligent in managing their finances (which is true) and should not be forced to bear the burden of others' inefficiency. The reality is a bit more complex.

Why the Germans Love the Euro
Germany's competitiveness comes from many sources, some of which are not really the result of diligence. Eastern part of the country is still not at par with the West, the process of economic integration is still not complete. Unemployment is high, cost of living is still low and Germany has an 'Eastern Europe' in its own backyard. Germany has also gained from a depressed Euro and did get the benefit of a cheap currency (unlike the Deutsche Mark) to boost exports, with none of the fiscal evils that would ensue had they tried to artificially cheapen their currency. 'Weaker states' kept the overall currency competitive, and the Germans did not have to live with the costly currency their levels of productivity would have demanded. The 'weaker states', on the other hand, lived with a currency that was costlier than their productivity levels would have permitted. The German export machine has prospered, while the rest has been laden with the need to make real adjustments in their economies. As an integrated market boosted trade in the Eurozone and made market access easy, German industry gained from both within and outside the Eurozone.

Today, you find the Germans preaching from the pulpit that Germany has created its competitiveness through the long and painful process of productivity improvement. This is, of course, true. Germany has real strength in overall productivity, technology and industrial processes. But they have also been aided by the Euro significantly, the costs of which have been diffused to all the member countries. Had their philosophy and economic policy been such a great success, they would not have had a significantly poorer east in their own backyard after 20 years of 'integration'. 

Hence, the dilemma for the Germans, they have gained a lot out of the Euro and keeping the mechanism afloat is in their interest. They may have borne 'disproportionate' burden over the years for the sake of keeping the currency intact, but it was certainly not of philanthropic interest. The only problem is that demands like Euro bonds extend too far. And from their own point of view, making ECB the lender of last resort is also too much to bear.

A Political Issue
The problems of Eurozone, therefore, are much more political than economic. The North wants to continue with an arrangement that has kept it competitive and thriving, the South wants a monetary regime that is more suited to a weaker public finance situation and lower productivity. Pundits point out that a monetary union without a fiscal union cannot work. But if that is the answer, you cannot stop at fiscal union alone. You have to allow free mobility of labor and other factors also. It cannot be just imposing strict budgetary controls that suit German tastes, a more potent version of the deficit targets and austerity agreements that is already being pushed. This is a problem that cannot be solved rationally, someone has to drop their agenda of artificially tight budgets (which would punish the weaker economies and push them towards economic gloom for at least a decade) or others have to suck up to being forced into those very consequences just because the consequences of dropping out of the single currency are just too horrific. So far, the latter outcome is winning, as the Greeks have blinked and the Spanish have capitulated. The test will be when Italy (and later, possibly France) also gets pushed towards the same situation. Till then, I expect the deadlock to continue.

The implications for the global economy are serious. The Euro has been jeered at, it has been called impractical and all sorts of things. But the currency has found its place in the global financial system. Over the years, it has steadily emerged as a viable alternative to the US Dollar as the reserve currency of the world, something that gives Europe tremendous clout in the political and economic world. The fact that an economy with $15 trillion plus GDP, a tight monetary policy and strong currency vying for the reserve currency status can turn out to be a bad bet for investors is not something easy to digest.

The Indian Parallels
On more familiar grounds, policy paralysis is a term that is quoted almost daily. People have found different ways to express their frustration about it. Thus, terms like governance deficit, leaderless country and so on have found their place in the public discussion. But, is India's policy paralysis and political deadlock comparable to Europe? Is Merkel's refusal to consider Eurobonds similar to Mamata's refusal to allow FDI in retail? Can Hollande's populism be compared to antics of team Anna? 

The problem with the scene in India is that almost all the rhetoric is based on random whims and poor policy. Merkel's opposition to Eurobonds is grounded in sound economic policy (from Germany's point of view) and national interest. Can we say the same thing about Mamata's opposition to retail FDI? Is it grounded in sound economic policy for Bengal or the state's (or national) interest? Hollande at least had some grain of truth in his policy pronouncements, that Euro zone will have to return focus on growth if the common currency  has to survive in the long run. Dose any of Hazare's policy prescriptions come even close to solving the problems we have today? Appointing another layer of bureaucracy on top of existing one is hardly likely to cut corruption. While Mamata's work brought policy making at the top to a complete halt, Mr. Hazare's has managed to bring the same level of paralysis down to the bottom, with no one in the bureaucratic chain willing to take a decision.

Who is the Gainer?
The best part about the situation in India is that it is not in any one's interest. In the European impasse, something substantial is at stake for everyone. What is at stake for the regional satraps in India when they indulge in their fancies? And what is at stake for a ragtag group of people, who have no policy experience whatsoever, when they shoot their mouths off on everything related to public policy?

As of today, the industry is not happy, investors are not happy, and above all, people are not happy. It is really hard to understand how a situation that makes everyone really unhappy is impossible to resolve. A frozen leadership is a contributor to this, but it has gotten ample support from other quarters.

Are We Better Off than Europe?
If yes, how? We continue to believe that the flow of money will reverse miraculously as we are the dream economy. No matter how many times we shoot ourselves in the foot, global economic tide will turn, lifting our boat again. But we need to seriously ask ourselves, if Europe is being pummeled by investors for being high on paralysis, where is ours going to take us?

Thursday, June 21, 2012

Where Else Will the Money Go?

Episode 1 - A Tale of Two BBBs...
This 21-part series (excluding the prologue and the epilogue) examines the challenges facing India and the economic headwinds. The title of the series comes from the book Breakout Nations by Ruchir Sharma, from a nouveau riche kid in New Delhi quoted by him. The quote captures the confidence, almost arrogance, that India has built up during the last decade, which is not limited to rich brats and extends to business tycoons, policy makers and politicians alike. The series tries to separate the myth from the fact, and examines some hard choices the country will have to make over next few years.

For several years, we have been denying that we have a problem. We can look at the specific instances later, but what hurts us today has been known for a while (including the issue of corruption in infrastructure projects during the first term of Dr. Manmohan Singh). We have, instead, chosen to blame external forces for our problems and woes. Europe, and its travails, have been the favorite topic for everyone to discuss. It comes in handy for policy makers to avoid blame for inaction. It also provides some perverse satisfaction to people who think India shines by contrast (we do not). But there are critical lessons being doled out for developing countries, which we are choosing not to learn.

It is useful to examine what is happening in probably the most concerning country situation in Europe today, Spain. Though Greece has been hogging the headlines for quite some time, I do not believe Greece is of a great consequence to Europe (other than for political reasons). The economy is tiny (Greece accounts for just 2% of Eurozone GDP). The debt level may look massive in comparison to the GDP of Greece, if the push comes to the shove, taking a hit of some 300 billion Euros is not a major problem for the Eurozone. The country mattered till it sparked fears of contagion, but beyond that, it does not have much relevance.

Spain, on the other hand, is of special interest to us. There are several striking parallels between what Spain is facing today and where India is. Both the countries are rated at a somewhat similar level by S&P, Spain has a BBB rating while India has a BBB- rating. The public debt to GDP ratio is also similar, Spain has 68% while India's estimates vary from 67% to 71% (depending on who you listen to). And above all, both the countries have the same level of GDP, $1.4 trillion.

Spain is getting a hammering from the markets that defies logic, at least in comparable terms. Spain today pays close to 7% (it went beyond that too for a brief period) on its 10-year bonds. India, in comparison pays around 8.25% (give or take 25 basis points for market fluctuations). But Eurozone inflation is a comfortable 2.5 - 3%, while India has been boiling over with 7%+ in WPI terms and 10%+ in CPI terms. Even if take WPI as the benchmark, as per the latest numbers, India is paying less than 1% in real terms on its bonds, while Spain is paying more than 4%.

The explanations behind this seem logical. There are concerns about Spain's ability to service its debts and the yields have shot up. Market estimates that Spain will have to pump in more money into its banking system and the debt levels will peak out at around 90% of the GDP. That is too high, according to the market wisdom. Or is it?

You might want to ask what Japan's debt to GDP ratio is, since the country has experienced practically no growth or very low growth for about 20 years now, and yet pays less than 1% on its 10-year bonds. Does it explain Spain's situation? No, it does not. People cite lack of control over monetary policy as the reason behind Spain's problems. Yet, there have been numerous countries that have pegged their currencies to stronger currencies time and again (usually dollar). Do their dollar borrowing rates climb to such levels, even though they lose control of their monetary policy as a result? There are issues that Spain is facing today, but the more you examine them in depth and ask the question 'why', the more intriguing it gets.

Now, coming to India, how is India getting away with paying a much lower effective yield (or even a negative one, if you base the computation on the CPI) when its finances are not in a better shape than Spain? The belief that India is better in terms of public finances is not backed by evidence (compare the budget deficit of both the countries). To believe Spain has a bigger debt problems is also not supported (both the countries have similar debt levels). Even Spain's banking system may not have bigger issues than India. Spain's bad loan percentage is about 8.7% according to latest numbers. India is well below 3% today, but you have to consider the liberal rounds of CDR the banks have been doing to avoid classifying loans as NPAs. With the entire infrastructure sector under water, it is hard to believe that banks would be able to recover money lent to power companies, BOT companies, real estate companies or construction companies any time soon. Spain has a consumer level debt problem, where home buyers cannot service the debt. In India, problems reside in a trickier place, the sellers have borrowed too much and they cannot service their debt.

This is not to argue that both the countries are absolutely similar and India will necessarily have the same problems. Though the economies of both the countries are of the same size, their per capita income is not. At $32,000+, Spain has a per capita income more than 20 times that of India. India obviously has a lot of pent up demand that can drive growth with relatively little effort. There are other important differences too that would have a bearing on the outcome.

The comparison raises disturbing possibilities for India, that is why it is important. We have been assuming that India has a much higher growth trajectory and we will be able to service our debt. So long as that condition continues to be true, we might be safe. But is that condition necessarily true? And why is Spain being hammered in the markets like this to begin with? These questions might help us understand what the Indian growth scenario will look like over next two years or so.

Sunday, June 17, 2012

Where Else Will the Money Go?

This 21-part series (excluding the prologue and the epilogue) examines the challenges facing India and the economic headwinds. The title of the series comes from the book Breakout Nations by Ruchir Sharma, from a nouveau riche kid in New Delhi quoted by him. The quote captures the confidence, almost arrogance, that India has built up during the last decade, which is not limited to rich brats and extends to business tycoons, policy makers and politicians alike. The series tries to separate the myth from the fact, and examines some hard choices the country will have to make over next few years.

Through the better part of the last decade, India seemingly came into its own. The country developed a certain sense of pride. Unlike the stark days of the 80's and 90's, people did not fear ridicule if they said they loved the country. Foreigners flocked here, ever smiling and doling out flattering views on the country to people who were seeking and absorbing a vast amount of reassurance. In general, we tried to develop a sense of confidence in what we are and what we wanted to be.

The new found confidence, unfortunately, spelt a death knell for reforms. The global liquidity tide lifted India well above its earlier growth trend line, and it meant a complete end to the will to do anything meaningful to address the massive problems besetting India. Instead, those who could get away with it, found a new license to loot the country in innovative ways. From telecom licenses to hosting games, the ugly structural underbelly got exposed a tad bit late.

Today, the mood is a bit somber. Some are a bit incredulous that India is slipping back. Some are in denial. We are finding it hard to accept that the new assumptions about India that took hold in the last decade are fading. 

Denial won't do. Nor will random policy prescriptions. "Cut rates", "don't cut rates". "Give more stimulus", "don't give stimulus". "Inflation is a problem", "inflation is not a problem". "Debt is too high", "debt is not too high". "India shines by comparison", "India has grave problems". The cacophony of voices goes on and on. Underlying these voices is a mix of several contrasting undercurrents; the sudden alarm you feel when a horrifying bit of vulnerability comes to your notice, the promise India holds and the betrayal of that promise, the hope that somehow it will all work out, and the despair of having a divided polity, a comatose government and no clear sense of where we are heading.

"Where else will the money go?" will try and look at some stark facts below the surface and examine many of the assumptions we have come to regard as sacrosanct and as the given truth. "We are one of the few choices investors have globally, India will always grow at 7% or more, India's troubles are caused by Europe, the rest of the world is in far deeper trouble than India"; these are some of the assumptions that are quoted by those who want to put a positive spin on things. Equally problematic are the assumptions we continue to hold about role of growth in uplifting people out of poverty, the redistributive agenda that rules our thinking and the how horribly we underestimate the forces that have kept India in the shadows of the world over past two and a half centuries. Once you sort through the mess, you would probably come to recognize not all is rosy, but also conclude there is a silver lining to the clouds, a light at the end of the tunnel. 

Hope you enjoy reading it.

Wednesday, May 2, 2012

Long Grind Ahead

The sentiment post the budget has turned out to be a lot more negative than was anticipated at the time of the previous post. ‘Policy paralysis’ has become talk of the town. GAAR has everyone fuming (notwithstanding the fact that it was always part of the plan, as part of the long awaited DTC, which, ironically, is part of the reform agenda). These are not surprising things. When the economy is roaring and everyone sees money being made everywhere, even dumb policy things seem quite palatable (remember the fringe benefit tax?). And when things are not looking as nice, even reasonable questions look like nit-picking.
Take GAAR for example. Which government in the world is not going after ‘tax havens’? Be it the US or the UK, tax laws are tightening to prevent leakages. And what is so wrong if the ‘Mauritius route’ to money gets closed? For FIIs, the impact is going to be zero if they hold shares for one year and sell through a stock exchange. Even if they sell before a year, the 15% they pay is nowhere near exorbitant.

The critical point is, the country is becoming unattractive to the investors as a whole due to a slew of issues. Policy paralysis is being talked about today, but policy was always paralyzed under the UPA regime. I don’t think anyone can name even one big reform under the stewardship of Dr. Manmohan Singh as Prime Minister. So long as things were humming along nicely, everyone was happy with the paralyzed the government.

This is not to say the government is not to blame. Over past two years, the clock has indeed been turned back on the economy, and by a long measure too. We now have the redistributive agenda on top with MNREGA as the policy poster child of the government, fertilizer/fuel subsidies as the favorite way to spend money and corruption/cronyism as a preferred way to run the administration. This is quite a setback for a country that had learnt to take pride in itself only recently, over barely a dozen years.

The fact that it has coincided with global sentiment not being so sanguine only makes it worse. It means getting back from this spot is going to be difficult, with no global safety nets, no windfalls from a roaring capital flows gravy train, no respite from commodity prices that buoyed the 1st term of the current regime. The negative economic trends that have been unleashed in India will take some time to play out and even more time to reverse. Take inflation for example, the current bout which is hardly over is typical ‘demand led’ phase, which was fueled by copious liquidity. Soon, we will move to a ‘cost push’ as high input prices start getting passed on to buyers everywhere and then some more as expectations of future inflation would reset to a new level. Then follows the ‘wage-push inflation’, as high cost of living forces the workforce across the board to demand some compensation. Those who believe inflation is going to be tamed soon need not wait for too long to see what is in store. We just need to wait for MSPs for agri-products for this year to see when ‘cost push’ starts kicking in.

Coming back to the sentiment, issues like GAAR are the added "bad taste in the mouth" when you suddenly realize that you pumped in too much money in a mediocre growth scenario and it may take a while for you to get out. Just the act of trying to take it out is likely to lead to major losses for investors. 

When the government is bent upon taking the country back to ‘same old’ and there is no hope of your fundamental growth assumptions to be realized, anything and everything looks irritating. That, in short, characterizes the mood you are seeing in the market.

So why are people not talking about this souring of ‘India growth story’? Partly, they have begun to. Those who don’t have too much at stake will probably start getting more vocal about it. Those who have a lot to lose will probably not want to profess their views openly and create a rotten mood all around.

But make no mistake, there is a long road ahead if you are looking towards 9% growth...

Thursday, February 23, 2012

Precipice Ahoy!

The fundamentals of the economy paint a nice picture of where we are headed in the immediate future. Though the 7.1% growth estimate (by PMEAC) for FY12 takes us above our comfort threshold and many would have heaved a sigh of relief, projection for the next year comes with a list of contingencies attached to it. This is not surprising at all.

A quick look at a few statistics reveals where we are headed. Despite boasting a high rate of growth over past several years, India is one of the few economies globally that still posts a 10%+ rate of unemployment, which means there is a meaningful section of the economy that is not getting any benefit from the growth. Farm sector still accounts for 50% jobs in India. This sector has not benefitted from either growth or from global commodity price boom (due to policies that don’t allow farmers to move produce from one state to the other, let alone export it). With extent of poverty not declining and inflation eating away at the purchasing power of a significant section of the population, the Indian consumption story is seriously at risk.
The rest of the story is equally depressing. We have ongoing stalemate in many sectors which are critical to growth. This includes power, where the government coal monopoly cannot get its supply act together. Growth being a power intensive business, it is bound to have repercussions. Infrastructure continues to be in doldrums, despite fancy numbers like $1 trillion being thrown around. Telecom, aviation, textiles, capital goods, consumer durables…, the story is not very encouraging.

If we start adding the center and state’s fiscal woes to it, we get a fairly bleak picture of it all. The point is, how did we manage to dig ourselves into such a hole despite almost a decade of growth, and despite a global economy that has been essentially benign (though the financial crisis did look like dampening growth, the liquidity flood that ensued more than offset the disadvantage). Even today, if you ask yourself the question, what is it in the external environment that creates a big threat to Indian growth, I am sure you will struggle for a cogent answer. The best we can do is probably ‘high oil prices’. Unlike the rest of Asia, we are not export dependent to keep the growth engine humming. If we had our house in order, there is nothing in the environment to derail the economy.

The truth of the matter is, most of our problems are of our own making. Fiscal mismanagement means we have allowed inflation to get out of control (though the global flood of money has played its role) and it is seriously hurting. Large fiscal deficits always hold monetary policy hostage. Either the government prints money for filling the gap (which would be inflationary), or the central bank has to keep the system flooded with money to allow the government to borrow at reasonable rates. The same goes for the oil mess. The government never bothered to decontrol prices when oil prices were low (the government was making a good surplus out of it, of course). Now it is politically unacceptable to raise petroleum product prices. The same applies to other areas where subsidies are hurting. If you start adding policy paralysis, corruption scandals, fractious politics, etc., to the mix, it is wonderful recipe for concentrating the mind.

The outcome is a situation where everyone is hurting and everyone is looking to the government to sort out this mess. There are high hopes from the budget. Almost every sector is hoping for a duty cut, and almost everyone is looking for a dollop. It is anyone’s guess where these hopefuls are likely to end up.

The current stock market boom is probably a combination of copious amounts of money and some wishful thinking.  This may continue till the budget comes out. Chances are the budget will try to make everyone happy and end up pleasing none. Going by the track record of past 8 years, it is not likely that someone will stand up and say, ‘we need to make some hard choices, and we will throw everything behind these three (or four or whatever number you prefer) top priorities’.

In absence of any real measures taken to put the economy on the growth path, stock market is likely to see the reality quickly enough. The current levels may be sustained till the budget day, but reality is likely to sink in fairly quickly post budget (if it does not happen before then). A surprise may be in waiting for those banking on wishful thinking to continue the good run.

Tuesday, February 21, 2012

Riding on Fizz...

Indian stock market has outperformed practically every other market in the world in 2012. This is not very surprising. India was among the worst performing markets in 2011 and relief rally has seen many beaten sectors/stocks recover some of the lost ground.

The surprising part is the speed of the rally, failure of most of the big players to spot it well in time and the relative paucity of good explanations on why India is suddenly booming. Most of the people I speak to are just dumbfounded. Barely 8 weeks ago, the India story had gone bust, the infrastructure sector had caved in, power plants did not have fuel, policy didn’t have direction and government didn’t have the tenacity needed to stand up and deliver. The question is, what has changed in a month or two?

The sad part is, nothing. Fundamentally, we are exactly where we used to be. To the extent that behind the veneer of a booming stock market and a massive inflow of portfolio dollars, even the liquidity situation is as tight as November, prompting hints from the RBI on another CRR cut. Falling car sales, slowing tractor and durable goods sales in the rural sector, ballooning real estate inventory; all the elements are the same as before.

This leaves few explanations for the ongoing rally. One of the plausible few is the fresh glut of liquidity in the wake of the Greece crisis. Equities worldwide have gone up as a result and India has received a good chunk of the money. The precipitous fall of the rupee last year provided an added incentive. Strong defense of the currency by RBI and past experience would have convinced many that rupee weakness was unlikely to last for a long time. Stocks looking doubly cheap on a dollar basis would have added to the temptation. Indeed, if you invested in dollar terms in December, you would have already made a 16% on the stocks and another 16 on the currency, quite an unbeatable package.

But where do we go from here?  The answer is not very clear. Once again, my bet is on commodities. Stock markets across the world may be rising, but their ability to absorb the excess liquidity is going to be limited due to poor fundamentals. Bond yields are also likely to continue to stay low globally (and high in India, more on that later). It is very likely that a good chunk of liquidity will flood commodities, causing an upward spiral all over again.

This does not augur well for the Indian market. High commodity prices, particularly oil, will further worsen the fundamentals. Coupled with Government’s inability to implement policy reforms (we have not even been able to sort out whether luxury cars should get a fat diesel subsidy or should finally bear the cost of fiscal and environmental damage they do), this will only worsen the pressures the economy is facing. The market is currently riding on fizz and it is hard to tell how long the fizz will last.

Monday, February 20, 2012

Government Debt and the Role of RBI… Back to the Future?

Governor D Subbarao’s musings about government debt and need for a cap on borrowing hark back to an era that we have almost forgotten in India. Not so long ago (say, till late 1990s), the primary role RBI played in balancing monetary policy was managing the government’s borrowing needs against the monetary needs of the economy.

Government borrowing in India has historically crowded out the private sector, there is nothing new about it. Till late 1990s, the traditional monetary policy tools were more or less ineffective due to this. For the banking sector, the primary tool RBI deployed was 90 and 180 day T-bills. Banks were more or less relying on their T-bill purchases to meet their reserve requirements on every reporting Friday. The catch? RBI used to measure their reserve adequacy only on reporting Fridays and the bills could be discounted freely by the banks. The highlight of this policy setting was that more than 99% of the T-bills bought by banks were discounted the following Monday. In essence, banks were keeping their funds in T-bills for only a few hours over the entire fortnight for which the reserves supposed to be maintained.

Bank rate, similarly, continued to be totally ineffective tool for a long period of time. Banks could technically borrow from RBI at the bank rate, but only to the extent of a small fraction of their incremental deposits, in effect making the bank rate practically useless for managing monetary policy or interest rates in the economy.

This situation prevailed primarily because the RBI was tasked with managing government’s debt requirements. Thus, whatever deposits the banks raised, a large chunk of that went into government bonds as the SLR component. In a cash starved economy, it meant that there was little liquidity left in the system for the private sector and banks. The result, a farcical situation in which banks needed to game the system to meet the liquidity needs and RBI did not have choice but to turn a blind eye to it.

The situation changed dramatically in the 2000’s. Falling fiscal deficit, rising growth rates and flood of global money meant that India was suddenly had a deluge of liquidity. Private sector could access capital internationally at far more competitive rates. Liquidity started chasing yields, which meant government bonds became attractive and banks started keeping more money in gilts than SLR required. With this flexibility, RBI, perhaps for the first time, gained true control of monetary policy and its tools gained a true bite.

All this can change dramatically again, if the government allows the current fiscal mess to continue and its borrowing needs start crowding out the private sector. And many signs are pointing in that direction. International money is no longer flooding India the way it was in the middle of the decade, borrowing internationally is becoming more difficult and costly, and RBI is forced to tighten domestic liquidity due to inflation concerns. Though the situation has eased somewhat with January inflow of portfolio dollars, it is the only source of liquidity at the moment and its drying up could suddenly lead to a drought of money.

In this situation, RBI could find itself in the same dilemma again. In a tight liquidity situation, government borrowing will start crowding out the private sector. Interest rates, in that case, would be driven more by the ‘going rate’, rather than tightly controlled by the RBI. Hence, the comment by the governor assumes significance.  

What does it mean for the markets? One key factor to keep in mind is that if liquidity starts drying up again, the assumption that interest rates will fall no longer holds true. RBI will be hard pressed to inject liquidity into the system but will be constrained by inflation rearing its head again. Token rates may fall, but with no money available at those rates, private sector will be forced to borrow at whatever rates money is available. Not a great situation when most of the sectors are reeling under less than stellar outlook and growth has started hurting. The only hope lies in the government being able to manage its finances better and letting the economy be.
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