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.

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