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.

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