Tuesday, March 30, 2010

The Federal Reserve Bank of India?

The crisis of 2008 had revealed beyond doubt that regulators and policy makers contributed to it in no small measure. It is also a fact that regulatory and policy failures were not of the same nature everywhere.

In the US, the belief that failures were mostly regulatory in nature is now gaining ground. There is, of course, some criticism of monetary policy as well, but it is clear that de-regulation of financial entities bears a significant share of the responsibility. Also, proof of monetary policy successes in the US is available in plenty, especially after 1980. The belief that excessively loose monetary policy led to successive asset bubbles is rational as well, but an asset bubble needs regulatory support. Monetary policy, by itself, can create the required environment, but a bubble cannot be inflated if regulators remain vigilant.

India, on the other hand, experienced the crisis differently. An exceedingly pragmatic regulatory environment ensured that the Indian Financial system was completely insulated from contagion. But monetary policy ensured that India suffered around the same time and almost the same fate. For a detailed discussion, please read my earlier note - Inflation and the RBI. In summary, we can conclude that the RBI has been an excellent regulator, but has performed disastrously in the conduct of monetary policy.

Now, imagine an environment where the RBI's regulatory expertise and the Federal Reserve's monetary policy skills could co-exist. Monetary policies designed for a low inflation, high growth environment could be coupled with a regulator vigilant enough to prevent undue risks to the financial system.

The Indian Economy would grow at the pace needed to create enough jobs for our rapidly growing workforce. The Indian Rupee would be a strong and stable currency, one the world would trust. Inflation would remain low because of currency strength, and interest rates would remain low as well. Growth would be driven primarily by domestic consumption and prosperity of the local populace driven by job creation. The regulatory environment would include enhanced deposit insurance which would result in even more trust in the financial system. Strict regulation of banks and other financial entities would ensure that they did not take undue risks with depositor money, either as deposit taking institutions or as second level intermediaries, which would in turn protect entities insuring the deposits. In short, the present regulatory environment with skilled monetary policy conduct.

That's what dreams are made of.... And all it takes is for the RBI to open it's mind.

Monday, March 29, 2010

Crisis Insurance?

With healthcare now out of the way, the focus of the Obama administration is shifting to financial reform. Amongst the many issues that need to be resolved (I love this word. It implies that a solution had been found earlier but since that solution isn't working anymore, the issue needs to be solved again. And this, when one is faced with issues of the kind never experienced before... Amazing language, English) is that of how regulators and regulatees respond to crises to ensure there is no risk of contagion.

Of course, many suggestions have been made in this regard but according to N. Gregory Mankiw, a Professor of Economics at Harvard, it's now down to 3 proposals which he describes as follows,

"Much focus in Washington has been on expanding the government’s authority to step in when a financial institution is near bankruptcy, and to fix the problem before the institution creates a systemic risk.

That makes some sense, but creates risks of its own. If federal authorities are responsible for troubled institutions, creditors may view those institutions as safer than they really are. When problems arise, regulators may find it hard to avoid using taxpayer money. The entire financial system might well become, in essence, a group of government-sponsored enterprises.

Another idea is to require financial firms to write their own “living wills,” describing how they would wind down in the event of an adverse shock to their balance sheets. It is hard to say whether this would work. Like real wills, the next of kin may well contest the terms when the time comes. That would slow the process and defeat much of the purpose.

MY favorite proposal is to require banks, and perhaps a broad class of financial institutions, to sell contingent debt that can be converted to equity when a regulator deems that these institutions have insufficient capital. This debt would be a form of preplanned recapitalization in the event of a financial crisis, and the infusion of capital would be with private, rather than taxpayer, funds. Think of it as crisis insurance."

While I take exception to many things mentioned in this article by Professor Mankiw, I will, for the time being, restrict myself to the topic of this note.

As far as Professor Mnakiw's favorite proposal is concerned, I fail to understand who would invest in an instrument that behaves like debt in good times and equity in bad times, effectively the worst of both worlds? Wouldn't investors ideally want an instrument that is the exact opposite? And since no one is ready to issue their ideal instrument, they have to settle for instruments that behave in exactly the same manner in good times and bad so that reward is in sync with risk.

And which issuer wouldn't want to issue such an instrument? Isn't it an ideal instrument from an issuer's perspective?

The only reason why no issuer would want to issue such an instrument is that of expected returns. What kind of return will an investor demand from such an instrument? Ideally, to make sense for issuers, this return has to be higher than debt and less than equity. But would that be enough when investors know that the conversion to equity would happen only during a crisis, and would surely result in some loss of value? Or would investors demand a return equal to, or even higher than equity, knowing that this is an instrument one is sure to lose money on if one holds on to it long enough? In this case, wouldn't banks be better off raising more equity?

Pricing will be a crucial determinant in this instrument's success. Given the complexity of the instruments risk reward positioning, there is a distinct possibility that pricing will be determined through some complex algorithm which only a select few would pretend to understand, and everyone would accept in the belief that these select few know what they are doing. Suspiciously like mortgage assets that triggered the current crisis.

While Professor Mankiw does state that Banks don't particularly favor this proposal as it would increase the cost of doing business, there is no mention of what expected returns would be like or any suggestions for pricing. Nor is there any mention of other options that could have been proposed and discussed.

Being a firm believer in Occam's Razor, I think the easiest solution would be to impose asset specific capital adequacy requirements on Banks. If an asset class is new or not completely understood, the capital adequacy requirement may be kept at a very high level, even 100%. This would essentially mean that banks wouldn't be able to leverage for investments into new asset categories. As an asset category matures, it's capital adequacy requirement could decrase slowly till it reaches that of traditional banking over a period of say, 10 years. Banks could then choose to either remain in the traditional banking space (and instruments which are understood) and be subject to relatively low capital adequacy requirements or follow a more adventurous path and maintain additional capital.

Creating a complex instrument to resolve a situation arising from sub-optimal understanding of another complex instrument seems to be an exercise in futility. An exercise best avoided at this juncture.

Friday, March 26, 2010

Is it time for "De-globalisation"?

Has the great globalization experiment been terminated? Will it all be rolled back? And if yes, rolled back to what? Can we even imagine a de-globalized world vividly enough to understand it's implications? These questions and more, are haunting both supporters and opponents of US protectionism today.

Unbelievable as it is, protectionist voices in the US are gaining ground. What was once a cathedral to free markets is now turning away from it's beliefs. And the reason, or so they would have you believe, is alleged currency manipulation by China. The background to this has been discussed in detail in an earlier post, China's Currency Policy, The Financial Crisis and the Future of Financial Reform. In summary, US Dollar purchases by China, an attempt to prevent the Yuan from appreciating, has distorted the perfect markets required for "efficient globalization".

The solution, according to these protectionists, is de-globalization. They propose to levy a penalty of 25% on all goods imported from China. In their opinion, this could incentivize, or force, China to stay out of it's currency market, which it intervenes in consistently and on an unprecedented scale.

The implications of this discussion go beyond just US and China. If the US were to label China a Currency Manipulator, Europe won't be far behind. Lower demand for their goods could result in the Chinese economy contracting and force China to respond. But it's ability to respond economically is limited. It is the world's production unit and it's economic survival is dependent in exports so a reciprocal import penalty on US goods won't serve any purpose. It is the largest lender to the US and could sell it's holdings of US Treasuries, drive up interest rates in the US and then sell US Dollars to weaken it. But that would only mean a stronger Yuan which would be the opposite of what it needs to support exports. So how can it respond? Militarily? Opponents of protectionism Seem to believe this could be an option, but it isn't something that I can elaborate with expertise...

Moving on, if the US succeeds in it's attempt to force China into doing it's bidding, will it stop there? There are more countries that the US blames for it's economic woes. India's one of them and can very easily be designated a Currency Manipulator, because pretty much like China, it is one.

And Many countries in Europe believe that Germany exports far more than it should to the rest of them. Right now, as part of the EMU, they have no protection, but the EMU isn't cast in stone. If countries could opt in, they can opt out as well. Will protectionism result in a disintegration of Eurozone?

The point is, a protectionist step by the US would give legitimacy to protectionist forces everywhere. And unleash a slew of legislation aimed at protecting domestic economies from foreign competition. Once set in motion, this movement's path cannot be predicted, or even imagined, with any degree of accuracy.

As of now, more than 130 US Senators (Democrats as well as Republicans) have introduced a Bill in Senate seeking levy these penalties on Chinese imports. Most of them have also signed a letter to the US Treasury Secretary and the US President asking the administration to act against China. On April 15, 2010 the US Treasury Department will release it's semi-annual report on global currency management practices and it is widely expected that this report will label China a Currency Manipulator. If this were to happen, the China Currency Manipulation Bill will gain credibility and find the bipartisan support that it needs. Leaders of the group of 130 are expecting that this bill will become law by the end of May 2010. Which gives us just over 2 months to prepare for a strange unknown world.

A De-Globalised World.

Thursday, March 25, 2010

The Sovereign Rating Scam

Sovereign Ratings are ratings assigned by internationally known rating agencies to countries. While the primary intention behind these ratings is to classify the risk associated with investments made in the Soveriegn Debt of the nation, they're increasingly taken as an indicator of the relative safety of investing in any asset in the country. This is because each country has it's own currency (well, most do) and this currency represents an obligation of the government to holders of the currency. Since most domestic assets in a country are denominated and traded in it's own currency, the safety and stability of the currency is the major determinant of the safety of these assets.

Soveriegn Ratings take many factors into account. Most important amongst these are the ratio of Government Debt to the GDP of the nation, ratio of foreign currency obligations to GDP and interest coverage ratio which is the ratio of all debt service payments to government revenues for a particular time frame.

The first two are stock indicators which are representative of the long term sustainability of government finances. Interest coverage is a flow indicator, a short term measure which indicates how comfortable a government is servicing it's debt.

With the definitions out of the way, it's time for a small story.

Once upon a time, there were two governments which spent more than they earned. One which planned it's income & expenditure on a yearly basis, didn't make many open-ended commitments and borrowed an amount equal to it's mismatch every year. Over a period of time, due to this policy, this country ended up with accumulated debt equal to 75% of it's GDP and long term commitments which equalled another 67% of it's GDP. Because a major part of its borrowing was conducted within its borders and denominated in it's own currency, its foreign currency obligations were small at about 5% of GDP. It's Interest cost was about 14% of revenues, but it in a scenario where it had accounted for most of it's obligations.

The other country took a different path. While it did have a yearly income & expenditure plan, a bulk of it's commitments spanned many decades into the future. Since, these commitments could not be quantified immediately, they weren't accounted for as liabilities in government books. At the same time it also overspent on an annual basis and it's debts amounted to about 85% of GDP. The borrowings were conducted globally, and as the world was ready to trust it's currency, it had no foreign currency obligations. But it's future commitments were so large that they dwarfed it's accounted debts. In fact, they grew to be much larger than GDP itself, 7 times larger. Since a bulk of this country's obligations were unaccounted, it's interest cost remained restricted to 11% of GDP.

International rating agencies rated both these countries, and in their own indecipherable manner, rated the first country BBB-, the lowest investment grade rating and rated the second country AAA, the highest possible rating.

Besides this, they kept on warning the first country that any slippage in it's fiscal imbalance would lead to a lowering of it's rating, an event which would spook foreign investors.

The first country in this story is India. The second is the United States of America.

While the story itself is a simplified narration, the numbers are all from either government sources or independent studies. Independent of the rating agencies, that is. India's unaccounted obligations are primarily pension obligations towards Central and State Government employees, both past and present. The unaccounted obligations of the US are on account of Medicare and Social Security.

Yes, there are areas in which India can improve. Government tax revenues are just about 10% of GDP as compared to 30%+ for the US. And interest costs are high due to high interest rates as well. If tax collections were to improve, and they are improving, with the current year's target at 11.5% of GDP, and interest rates were to reduce for an extended period of time, interest coverage would improve as well. Probably to a level below that of the US. The point is that India is in a position to improve it's indicators of indebtedness significantly as it's problem lies in the flow and not the stock. The US, on the other hand has a problem with it's stock of debt, a problem which can be extremely difficult to solve.

But as far as the international rating agencies are concerned, the US is still AAA and India's a poor BBB-....

Did I mention the word "scam" earlier? Well then, there's nothing more to say.

Wednesday, March 24, 2010

Credit where it won't be due...

For those of you who read Paul Krugman's blog, it'll be obvious that I've borrowed the title from him. But it's as relevant here as there. Let me elaborate...

When the RBI hiked interest rates recently, it supposedly acted in response to a buildup of inflationary pressures in the economy. Whether higher interest rates provide a solution to current inflation or not is a matter for separate discussion, detailed in an earlier post, Inflation and the RBI.

What is more striking is the timing of the hike. No matter what projections one uses to forecast inflation, it is obvious that inflation has peaked. This is because of a phenomenon called base effect.

How it works is extremely simple. Inflation is measured every week for a 52 week period. This means that every week the 52 week period moves one week forward with the latest week being added and the oldest week removed. For example, when measuring inflation for the period ending March 19, 2010, the 52 week period starts March 21, 2009. After one week when measuring inflation for the period ended March 26, 2010, the 52 week period will start from March 28, 2009. Now suppose that inflation in the week of March 21-28, 2009 was higher than inflation in the week of March 19-26, 2010. Since, the former, which is a higher number will be left out of the calculation and the latter, which is a lower number will be included, Inflation will reduce.

What this also shows is that inflation coming down does not mean prices coming down. All it means is, the pace at which prices were rising has been reduced, but prices are still rising. It is only when inflation is negative that prices have can be said to have actually come down. And a negative inflation number in the Indian context is a rarity.

So what does all of this mean for inflation in coming days? Well, since prices were rising very rapidly in the period March to November last year, and the pace of increase has slowed this year, inflation in the period March - November 2010 is expected to be significantly lower than inflation in the period March - November 2009. This means that when inflation is calculated in December 2010, it will be much lower than that in December 2009. Using even the most pessimistic projections, it is forecast that inflation will be well below 6.00% by December 2010. In fact, if more realistic projections are used, inflation should be well below 5.00% by then.

So inflation will come down because of statistical reasons. It would have reduced even if no monetary policy action had been taken by the RBI. But guess what's going to happen in December 2010.

The RBI, the Prime Minister, the Finance Minister & the Chairman of the Planning Commission will all be claiming credit for reducing inflation through "proactive monetary policy and fiscal measures" which in reality have no role to play. They will pat each other, and themselves, on the back. I would also bet that a self serving statement on inflation will be a part of next year's budget speech.

Amazing, the lies our politicians and bureaucrats will tell us. But who's to stop them?

Tuesday, March 23, 2010

Do Policy Rates really matter right now?

Interest rates are typically of two types. Ones which are decided by Regulators such as the RBI are called Policy Rates. In India at the moment, the RBI uses the Repo and Reverse Repo at Policy Rates. These are the rates at which the RBI lends and borrows from eligible market participants respectively. Other than Policy Rates, almost all rates are decided by market participants through methods of price discovery and are called market rates.

Policy Rates are an important monetary policy tool and are often used by policy makers to influence the direction and pace of the economy. Interest rates are raised to cool an economy and lowered to provide a fillip in bad times. These changes are usually gradual and are looked upon as economic fine tuning by the Central Bank (RBI, in India's case). Then there are times when dramatic movements are needed. These are typically times when imbalances are created, hurting the economy, needing an immediate resolution.

Market rates are influenced by Policy Rates and should ideally move in lockstep. When this happens, transmission of monetary policy is said to be near perfect, and there is a distinct possibility that monetary policy aims will be achieved. However, market rates are also influenced by other factors such as Liquidity, Demand & Supply and Reserves that Banks needs to hold with the Central Bank. And as a result, monetary policy transmission is diluted as also the possibility of it's aims being achieved. Normally, a Central Bank would anticipate this and try to compensate by calibrating it's moves accordingly.

Transmission of monetary policy is also affected by the belief market participants have in the stability and predictability of the Policy Rate. For this reason, most Central Banks strive to maintain a high level of transparency in their Policy Rate deliberations and prefer to have one Policy Rate. In India, we have two Policy Rates, the Reverse Repo Rate at which the RBI borrows from market participants and the Repo Rate at which the RBI lends to market participants. Also, the amount of money that the RBI lends to market participants is restricted to the excess Government Debt owned by these participants. Right now, and for some time now, the difference between these two policy rates is 1.50%. After the recent hike, the Reverse Repo rate is 3.50% and the Repo rate is 5.00%. This difference between the Repo and Reverse Repo Rates of 1.50% is called the corridor for overnight rates which, depending on the level of liquidity in the market can settle anywhere between 3.50 - 5.00%. And if market participants need to borrow more than their excess holding of Government Debt, there is no limit to which the overnight rate can rise. This was experienced in October 2008, when extreme measures instituted by the RBI resulted in the overnight rate varying between 0 - 100% in the space of 15 days. From a prespective of stability and predictability, this is probably the worst arrangement for Policy Rates.

This uncertainty is reflected in the spread that market participants charge on long term investments. If the overnight rate is predictable, the spread will be low and if there is a high level of uncertainty, the spread will be high.

At this point in time, when there is a small liquidity surplus in the market, the overnight rate is close to 3.50%, the Reverse Repo Rate. Despite this, the yield on 10 year Government Debt is over 8.00%, a spread of 5.50% which is more than twice the long term average. This is a reflection of fear in market participants that even a small change in market liquidity could send the overnight rate to 5.00%, the Repo Rate. The fact that the overnight rate can increase by 1.50% without any policy action of the RBI is reflective of the fragility of the overnight market and contributes to high market yields despite an apparently accomodative monetary policy.

Then is the matter of demand & supply. If the Government needs to borrow more than the market's ability to lend, spreads will rise and if Government borrowing is restricted to reasonably low levels, spread will fall. The market's ability to lend is a function of participants in the market and liquidity available with these participants. In the Indian context, the major participants in the market are Banks, Insurance Companies, Mutual Funds and Primary Dealers. The first two are long term investors as the nature of their funds allows them to invest in that manner. Investments made by Mutual Funds have an element of uncertainty in them, as the funds available with them are a function of market liquidity. Primary Dealers are special entities set up under the aegis of the RBI with the intention of easing the borrowing process for the Government. They are essentially traders, buying Government debt directly from the RBI with the sole intention of selling it to other participants.

The Union Budget for 2010 - 11 placed the Government's gross borrowing at Rs. 457,000 crs and Net Borrowing at Rs. 345,000 crs. If one were to take interest payments by the government into account, the net liquidity drain the market would experience as a result of these borrowings will be in the region of Rs. 235,000 crs. This amount is exceptionally large given the country's bank deposit base and it's expected growth. Market partiipant's perceive the liquidity impact of this borrowing to be significant enough to demand a premium on the normal yields that would be available if this wasn't the case.

For the reasons mentioned above, yields or interest rates for the safest investment option in India remain at elevated levels. It is only natural that interest rates charged by Banks to commercial enterprise will also be high. In fact, despite the fiscal stimulus announced by the government and as mentioned earlier, an apparently accomodative monetary policy, interest rates charges by Banks to Small and Medium Enterprises have remained between 13 - 14%. This gap in the transmission of monetary policy is as much a failure of the RBI as faulty monetary policy itself.

The solution to this lies in tackling the core issues themselves.

Forthe first part, the stability and predictability of policy rates, the RBI needs to act immediately and reduce the size of the corridor for overnight rates. It can be done immediately without hurting the market or causing unnecessary euphoria by reducing the Repo rate by 0.50% and increasing the Reverse Repo rate by 0.50% simultaneously. This would reduce the size of the corridor to a more acceptable 0.50% without giving a clear interest rate signal to the market when none is intended.

With regard to market liquidity, the RBI has three options which can be undertaken individually or together. The first would be to increase the amount of liquidity available with the current set of market participants. This can be achieved by conducting Open Market Operations to buy Government Debt from market participants. The second way would be to reduce the amount of government debt sold to the current set of market participants by buying a part of the government's fresh borrowings directly from the government. This is called Private Placement. Both these options are frowned upon by economists as they amount to a monetization of the government's deficit.

The third option, which is the most viable at this point in time, would be to expand the set of participants. For many years now, Foreign Institutional Investors have exhibited a high degree of interest in investing in Indian Government Debt. This interest has not been capitalized upon by the RBI due to a vague fear that allowing FII participants in the government debt market could be the tantamount to issuing debt to foreigners or borrowing overseas. The operative difference in these situations is the currency in which the debt is denominated. If FIIs are allowed to invest in the Indian debt market, all the debt they buy will be denominated in Indian Rupees. In case of foreign issuances, this debt would be denominated in a foreign currency, which results in increased foreign exchange liabilities for the nation. But since this isn't the case with FIIs investments in the existing debt market, this conern can be discounted. Another fear could be the influence these FIIs would exert on the domestic debt market if they were allowed unfettered access. This can very easily be remedied by not allowing unfettered access.

Even currenty, FII investments in the debt market are regulated by limits set by SEBI in consultation with the RBI. This limit is divided into a sub limit for investments in government debt and another for investments in corporate debt. These are currently at USD 5 bln and USD 15 bkn respectively. To put this in context, total outstanding government debt is approx. Rs. 1,785,000 crs or USD 391 bln. The current limit for FII investments in government debt is just over 1.25% of the market's size. An increase in this limit to a more realistic 15-20% would allow FII participation without dominance. Also, like some other countries, a minimum residual tenure can be specified for these investments which restricts FII investments to securities which have more than say, 7 years to maturity at the time of purchase. This would prevent FIIs from playing on the short term interest differentials and / or the currency market.

From the timing perspective, it is absolutely imperative that these measures are put in place immediately before the new borrowing season starts on April 1. Apart from easing the strain on market liquidity, these measures would improve the effectiveness of RBI's monetary policy actions by improving transmission. They would also provide participants with market conditions favorable to increased volumes, greater efficiency and improved price discovery.

Without these measures, the RBI's runs the risk of being completely ineffective in it's policy actions, resulting in chaotic domestic debt market conditions. There can be nothing more disastrous for the Indian Economy right now.

Saturday, March 20, 2010

Inflation and the RBI

Once again, interest rates have been hiked at a time when The Indian Economy was just about stabilizing. The one striking fact that I have noticed through the time I spent in the Debt Markets was the RBI's haste in hiking rates and the lethargy in reducing them. Well, that's two striking facts, but you know what I mean...

The RBI has always had a fear of heights when it came to economic growth. In 2007, when the economy looked set to achieve a few successive years of 9% growth, Dr. Y.V. Reddy was fretting about the economy overheating. Overheating?! With more than 30% unemployment? With close to 30% of the population below the so called poverty line?

Money flowed into the country and the RBI kept on buying USD to stop the INR from appreciating. Close to Rs. 100,000 crs worth of USD was purchased within the space of 6 months which resulted in a liquidity surge of unprecedented magnitude (10% of GDP). If this wasn't inflationary enough, international commodity prices were going through the roof and since the INR wasn't allowed to appreciate, domestic commodity prices followed. Using rising inflation, caused purely by the RBI's FX intervention, the RBI unleashed draconian monetary policy measures that resulted in a liquidity crunch so severe that it almost lead to recession. Of course, the international financial crisis provided a ready peg to hang responsibility for the slowdown and the RBI escaped this incident without blame. But facts prove otherwise. Facts state that the RBI, through hare-brained monetary policy measures, was solely and completely responsible for the slowdown. And even if we believe, for a moment, that the international crisis was responsible for the slowdown, why was the RBI increasing interest rates till August 2008 and tightening liquidity till October 2008? The impact of the crisis was already being felt and central banks across the globe had initiated quantitative easing and lower interest rates as early as January 2008. Even in this case, the RBI cannot be blameless.

Through this time, the RBI was doing a victory lap saying that it had protected Indian banks from contagion. I agree with that completely. The RBI has always been a fantastic banking regulator. It's conservatism has protected India from many crises in the past and is responsible for the stability of the Indian banking system. But in the conduct of monetary policy, the RBI has been a disaster. There have been some periods of excellence like Dr. Bimal Jalan's tenure, but that accounts for a brief period in the history of Independent India. From the monetary policy perspective, the RBI has caused more harm than benefit to India. Double digit inflation, double digit interst rates, one of the worst performing currencies in the world since 1947, one of the slowest growing economies of the world since 1947... Proof of RBI's monetary policy failures is available on every page of India's economic history.

And this time is no different. The main contributors to Inflation today are fuel and food prices. Fuel prices were recently hiked by the Government in the Budget(Seriously, does a fuel price hike deserve to be a budget announcement? I mean, which century do we live in?). Food prices have been the subject on intense discussion and many reasons have been assigned to their rise. None of these reasons however, have a monetary policy remedy whether it's supply side issues, speculation or hoarding.

Looking at it in detail, what does the RBI expect higher interest rates to achieve? A drop in the international price of oil caused by lower demand in India? A change in the government's fuel price policy? Or probably a change in it's own weak currency policy... Because other than these, chances of a interest rate induced drop in fuel prices do not exist. As for food prices, the RBI probably expects food demand to drop as a result of high interest rates. People are bound to eat less when interest rates rise, right?

In fact, increasing interest rates at this point is like trying to make the one heatlhy part of one's body sick to match the rest. The only thing keeping the economy together at the moment is consumption of discretionary items. Unlike food and fuel, these are items which are consumed out of choice. When food & fuel prices increase in a stable income environment, discretionary budgets in household are squeezed by the higher cost of essentials. As a result, discretionary demand in the economy falls. In this environment, higher interest rates can only compound this reduction in demand and hurt the only stable contributor to real GDP growth.

The only way to combat current inflation is to allow the currency to appreciate. An appreciating currency will reduce domestic prices of fuel immediately and allow the government, or private enterprise, to import foodgrains at a lower cost. This will end up actually reducing prices rather than just slow their rise, which is the best case outcome when using interest rates.

Dr. Jalan wisely used a similar strategy during his tenure. Dr. Reddy reversed most of what Dr. Jalan has sought to achieve. One can only hope that Dr. Subbarao finds his wisdom in time.

Friday, March 19, 2010

China's Currency Policy, The Financial Crisis and the Future of Financial Reform

China's currency policy is once again under attack. But this time, it finds support within the US from prominent economists close to the Bush Administration.

The current administration is on the verge of labeling China a currency manipulator. They believe China weakens it's own currency artificially to support exports; hurting American producers.

On the other side are 'Bush' economists who refuse to acknowledge this as a threat. As these economists were a part of the Bush Administration, their response is as close to the erstwhile regime's thought process as we can get. They believe consumers benefit from lower costs and if China wants to subsidize American consumers through a weak currency policy, there is no cause for alarm.

Not surprisingly, there is strong logic on both sides. After all, both have an almost equal share of the brightest minds working for them.

However, the Bush Administration's argument has a serious flaw. Consumer benefit is restricted to the price difference between goods made in US and China. Loss to the US economy is the total value addition in producing these goods which now belongs to China. Logic dictates that the latter is substantially larger than the former. In addition, more Chinese goods would result in imports rising without a corresponding rise in exports and trade deficits would increase substantially.

The Bush Administration chose to live with this outcome because they discovered the power of consumer lending. The disinflationary impact of Chinese imports allowed the Bush Administration to follow inflationary fiscal and monetary policies without resultant inflation. Interest rates were cut and money created at an unprecedented pace. Cheap and abundant money gave consumers the impression that they could borrow as much as they wanted, when they wanted, and that this had nothing to do with their income.

The resultant wellbeing and cheer made the Bush Administration confident that they had found the Holy Grail of monetary economics. Ben Bernanke (A Bush Appointee) even went to the extent of suggesting that if things went wrong, he could always carpet bomb whole cities with money from a helicopter.

What they did not foresee, or chose to ignore, was the impact of this policy on asset prices. Consumer prices were clearly under control because China could always produce goods cheaper. But neither China, nor any country in the world, could produce investment assets at the required pace. This inability was more pronounced when it came to real assets like Land where mass production stopped roughly around the beginning of time. With more money chasing existing assets, prices rose, causing asset price bubbles.

The resulting trade deficits would lead to a currency demand-supply mismatch for most countries. But not the US. The status of the US Dollar as the world's Reserve Currency makes them special. It gives the US the ability of borrow from foreigners in their own currency, the US Dollar, making them immune to foreign exchange risk.

The belief that they could create large quantities of money without the associated pitfalls lead to the belief that they will always have enough money to repay any borrowing, regardless of their income. This, in turn, allowed them to run fiscal deficts of an abnormal magnitude and finance them through borrowings.

So we got substantial trade deficits, fiscal deficits, asset bubbles and overleveraged consumers. All the required ingredients for a full blown financial crisis.

But is Chinese currency policy responsible for the financial crisis, or did it merely provide American policy makers the required environment to perpetuate one? The Obama Administration seems to believe that the answer is somewhere in between. And they want it to change.

But change will take more than twisting Chinese arms on currency management. It will need real financial sector reforms, which Chris Todd's proposed legislation is not. It is based on the belief that regulators were completely faultless and the financial crisis was caused by some rogue regulatees. It is designed to give more powers to the existing set of regulators and the odd new one in the hope that they will be able to identify financial risks earlier and contain them better than they have ever before.

At the moment. the solution to the worst financial crisis ever is based on some coercion and lots of hope. It's not nearly enough.

Thursday, March 18, 2010

Home Economics 101-Make your Wife feel Beautiful

A while back, I committed one of the many unforgivable mistakes in marriage. I told my wife that she was fat. Well, not in so many words apparently, since I'm here writing about it. Like a good Punjabi, I told her she was 'healthy'.

Apart from the emotional mayhem, it's impact on the economics of my home was disastrous. It became apparent just this morning when I studied the contents of our bathroom shelf. Arranged, or rather spread out, on those shelves was an assortment of 6 facial cleansers, 4 shampoos, 3 conditioners, 2 body washes and a soap. Also, there were 2 facial moisturisers, a couple of sunscreens, a few full body moisturisers and a jar of some vague body toning cream. In comparison, I had a rich collection of 1 soap(glycerine) and a shampoo(anti-dandruff).

Her collection, built up slowly since my verbal accident befitted a small pharmacy and, undoubtedly, cost as much. Joining the dots, I realised that my foolhardy comment made her feel ugly, which she remedied by collecting toiletries which promised her beauty and a change in her husband's behaviour.

So much for honesty in marriage... It's easier, from every conceivable angle, to lie about your wife's appearance, unless the lie is worse than the truth. Apart from the obvious marital benefits, these lies can also result in increased savings.

So go ahead and flatter her. Who knows, you could probably save enough to buy that car you've been dreaming of!

Wednesday, March 17, 2010

The purpose of Exports - Part IV

Suppose that India exports USD 1 bln of goods and imports USD 1.1 bln. If the exchange rate is, say Rs. 40/USD, then the trade gap of USD 100 mln translates to Rs. 400 crs. But if the exchange rate is Rs. 50/USD, then the same trade gap of USD 100 mln costs us Rs. 500 crs.
This doesn't take into account the loss of purchasing power, of the economy as a whole and of its citizens in particular. The domestic price of almost all commodities in India are linked to their international prices with some lag, or adjustment. Since this linkage requires a currency conversion, the INR exchange rate becomes an important input for the domestic price. So if International price of Crude Oil is USD 100/ barrel and INR exchange rate is Rs. 40/USD, a barrel of oil would cost Rs. 4,000. Even if the price of oil remains stable, but the INR depreciates to Rs. 50/USD, the same barrel of oil would cost Rs. 5,000 in India. So while US citizens continue to enjoy stable oil prices, the Indian consumer has to pay 25% higher for the same goods.
This is the reason why the cost of Petrol in India has risen inexorably through the years. Some facts that make it apparent are given below.
In 1972, Petrol cost Rs. 1.73/litre in India and the international price of crude oil was USD 10/ barrel. Now, Petrol costs close to Rs. 50/ litre in India and the international price of crude oil is USD 60/ barrel. So while consumers in the US pay 6 times the 1972 price, consumers in India pay 29 times the 1972 price.
The same would hold true for most raw materials which are quoted internationally. And consequently, for the finished goods that all of us consume. And this is precisely why we cannot afford to buy the best quality domestic produce as well. The international consumer, where currencies have remained strong and stable, is able to pay a much higher price for this produce than the Indian consumer can afford.
In conclusion, a weak currency hurts the purpose of exports while benefiting exports themselves. A weak currency also impoverishes the citizens, making them pay more for the same produce, reducing their standard of living. Whether a country like india, where poverty is still rife, can afford this additional impoverishment is a question for each of us to answer for ourselves.


Inflation and the Prime Minister

So inflation has risen once again and we see all sorts of policy statements in response. Today's news is the PM's statement that interest rate hikes are being considered to combat rising inflation. It's incredibly funny that even an eminent economist such as Dr. Manmohan Singh has fallen prey to the simplistic belief that this will help.

The current spurt in inflation is not entirely unexpected. When fuel prices were increased in the Budget, it was only natural that the WPI would rise. So why the noise? And why ridiculuous statements which imply that somehow, fuel and food prices would miraculously come down if interest rates rise?

Fact remains that government policies are squarely to blame for rising inflation. Primary responsibility for this is borne by our weak currency policy. India's currency market is distorted by RBI intervention. Almost constant buying of USD, which is reflected in everincreasing FX Reserves, leads to an artificially weak currency which is completely at odds with economic reality. Granted that we have a trade deficit, but remittances and other invisibles ensure that we maintain balance in our current account. And in the odd periods that we do have a current account deficit, portfolio flows keep our overall balance strongly in surpus territory. Which is what the RBI buys to prevent the currency from appreciating. And does not allow the nation to benefit from the disinflationary impact of a strong currency.

But why do we need a weak currency? Supposedly, it helps exporters and is therefore, considered beneficial to the economy. This belief has absolutely no fundamental foundation. Please read my multipart post on The purpose of Exports for a detailed analysis.

The prices of Food, Fuel and all other commodities would reduce if the currency were to appreciate, but that of course isn't reason enough to allow it. Not even at a time when, according to Montek Singh Ahluwalia, inflation is in 'worrying' zone. Apparently, it's not worrying enough...

The purpose of Exports - Part III

As is normal with any developing nation, India exports its choiciest produce. As a result the best fruits, vegetables and industrial goods produced in our country aren't available to our own citizens, but exported to other nations. One would think that this would be enough to allow India to import all that it needs. but it isn't. As far as physical trade is concerned, we still have a trade gap, which means that we import more than we export.
So how does a nation in our position reach a stage where we are able to balance the two? Most definitely by drafting policies that support an increase in exports. Which would lead us to conclude that our economic and monetary policymakers are on the right track. Or are they?
It is laudable to support an increase in exports, but only to the extent that our ability to import isn't hampered. Any policy that ends in a reduced ability to import is, by definition, violative of the underlying aim of our exports itself. But this seems to be completely lost on our policymakers, resulting in policies that support exports at the cost of imports.
Which brings us to the most important aspect of this discussion, which is the value of the INR.
A weak currency is good for exports, yes. But a weak currency does violent damage to the nations purchasing power and hurts its ability to import. In addition, as long as we import more than we export, a weak currency would be an added burden to the economy. In the next part, we'll look at this in numerical terms, for easier understanding.

Monday, March 15, 2010

The purpose of Exports - Part II

It is generally accepted that a weak currency is good for exports. But what are exports good for? Again, conventional wisdom would have us believe that exports are good for the economy. But from what perspective? Yes, exports give us access to a larger global market, but is that a end in itself, or a means to an end. It it's the latter, then what is this end.
In this context Professor Paul Krugman, winner of the 2008 Nobel Prize in Economics says,
"International trade is not about competition, it is about mutually beneficial exchange. Even more fundamentally, imports, not exports, are the purpose of trade. That is, what a country gains from trade is the ability to import what it wants. Exports are not an objective in and of themselves: the need to export is a burden that the country must bear because its import suppliers are crass enough to demand payment."
In other words, exports are 'means' which allow a nation to import, which is the 'end'. Given this wisdom from an unimpeachable source, it is obvious that economic & monetary policy should be designed to allow the nation to IMPORT whatever it wants to, and support EXPORTS to the extent required to do so.
This is in stark contrast to the design and structure of our economic and moentary policies. And the unwitting victims of this travesty are the citizens of India.

Sunday, March 14, 2010

The purpose of Exports - Part I

Being the first post of my blog, I thought that it would be best that I start off with a topic that is often discussed.
Exports in the Indian context have taken centrestage in Economic Policymaking for for over 2 decades now. Successive budgets have granted valuable exemptions to exporters including income tax relief, soft loans and most importantly, India's weak currency policy.

Regardless of what the RBI would like us to believe, the value of the Indian Rupee is not determined by a free market. Let me take you through the steps that lead to this conclusion,
1) When the RBI buys US Dollars(USD) for Foreign Exchange(FX) Reserves it is, in fact, selling Indian Rupees(INR).
2) Our FX Reserves have risen almost continuously apart from a few stray quarters when they have fallen. This means that over the last decade or so, the RBI has been selling more rupees than it's buying back.
3) With the sole creator of INR selling it virtually incessantly, the market for the currency is distorted.
4) The exchange rate for INR is an outcome of these distorted market dynamics and not a result of free market pricing.

This FX 'intervention', apart from weakening the currency has many other undesirable outcomes which have a direct impact on many aspects of our day to day existence. But before we begin to discuss these, it is important to discuss and understand why we do it in the first place. ...... Continued in Part II

A comeback! Well, sort of...

It's been a while since I registered this blog and made my first, and last post. Almost 9 months, really... No, I won't make a quip about babies at this point, but it is definitely about time that I started writing.

The idea behind this blog is very similar to the idea behind most blogs. I have things to say and no one seems to give a rat's backside when I try to do it in the traditional manner.

The title of the blog should ideally convey what I would like to write about, and I hope it does. But just so that there is clarity, I want to write about both Economics and Life, but most importantly, I want to write about the space in between. The space where either one touches the other.

To start afresh, I've deleted my first post, not because it was irrelevant, but because it was just too long to be one. Am posting the first part in the next few minutes and the rest will follow in time.

Till later then...