Friday, April 30, 2010

A Ray of Hope…

Mr. Anand Sharma, Minister for Commerce & Industry, said yesterday that the RBI need not intervene in the Forex Market to counter Rupee appreciation “right now”.

This, despite the Rupee appreciating by close to 5% since the beginning of the year. His statement offers a ray of hope, but the “right now” restricts it to just that… a ray.

Is the REER model of any use?

Every day, in the context of Exchange Rate management in India, one comes across proponents of a model called REER. REER has been, and continues to be used to justify a weak Rupee without regard to the fact that it is an inherently flawed model which has been abandoned across the world. However, knowledge of these flaws doesn’t stop influential proponents like Dr. Shankar Acharya  (Indifference about the big rupee rise?, Business Standard, April 22, 2010) from screaming murder whenever the Rupee appreciates.

The Real Effective Exchange Rate model, or the REER model, allows relatively closed economies a means to value their currencies on a relative basis. Not only relative to other currencies, but also relative to the domestic currency’s own value at some point in the past. It works by adjusting the value of the currency by the inflation differential between the domestic economy and the reference economy, supposedly factoring in the incremental cost differences experienced by the domestic economy vis-a-vis the reference economy.

For example, let us assume the USD/INR rate at the beginning of 2009 was Rs. 40/USD. If in the year 2009, inflation in India was 9% and inflation in the US was 4%, the REER model would indicate that the value of the Rupee should reduce by 5% (9%-4%) to adjust for this inflation. Therefore, according to the model, at the end of 2009, the INR/USD rate should be Rs. 42/USD, a depreciation of 5% for the year.

In effect, the REER model is an incremental Purchasing Power Parity (PPP) model. It can only account for changes in the purchasing power of one currency when compared to another on the basis of inflation differentials in the two economies.

The two major flaws of this model are,

1) Assumption of “base rate” accuracy: The REER model can only indicate the required change in the value of the currency relative to another currency (or a group of currencies) over a set time period. It assumes that the “base rate”, or the earlier exchange rate used to calculate this change is accurate. In the above example, the rate of Rs. 42/USD at the end of 2009, as calculated by the model holds true only if one assumes that the rate of Rs. 40/USD at the beginning of 2009 was accurate. If not, REER only compounds the error but cannot rectify it.

In India’s case, the Base Year for REER model used by the RBI is 1993-94. So, in essence, all REER calculations made by the RBI, and the ones Dr. Shankar Acharya refers to, assume that the exchange rate in 1993-94 was an accurate representation of the purchasing power of the Indian Rupee at that time. Nothing could be further from the truth.

All of us who have vivid memories of the 1991 crisis remember that India was on the verge of a foreign currency obligation default which was staved by pledging our holdings of Gold. We also remember that the Rupee was devalued very sharply in the run up to this default and immediately after it. From a value of Rs 12.75/USD in January 1988 to the artificially pegged value of Rs. 31.37/USD in January 1993, the Indian Rupee lost close to 60% of its value in this period. The number doesn’t do justice to the magnitude of this movement because of the manner in which currencies are quoted. To put things in perspective, a move of similar magnitude would result in the Rupee quoting at Rs. 109.5/USD in 5 years time.

This movement was not caused by inflation differentials, but by an acute shortage of foreign exchange, a demand-supply gap. Now that this shortage has turned into a surplus, sometimes of unmanageable proportions, it is only fitting that this devaluation be reversed to restore the purchasing power of the Rupee to its pre 1988 levels. But by taking 1993-94 as the base, the RBI and it’s followers only legitimize the devaluation as one caused by inflation differentials. My suggestion to all proponents of REER would be to calculate it by taking 1987-88 as the Base Year. It would solve at least a part of the problem, but not all of it. The second flaw in the REER model would still be as much of an issue.

2) Circular Causality: The REER model suffers from a fatal flaw called circular causality. This enigmatic term is easier explained by using the chicken & egg example, but not in the traditional manner. In this case the existence of a chicken (if it is what came first) leads to eggs, which hatch into chickens resulting in more eggs. When REER uses inflation differential to cause an adjustment in currency value, this change in currency value results in further inflation differential, requiring a further adjustment in currency value. When domestic inflation is higher, the resulting devaluation of one’s currency causes the price of all imported goods to rise in the domestic market. In the case of a country like India, which imports almost all of its Oil, this price increase translates directly into inflation across the spectrum of goods available in the domestic market due to higher transportation costs, apart from the direct impact of higher fuel prices. Higher inflation then shows up as currency overvaluation in the model, requiring another devaluation and the cycle starts all over again.

While the first flaw of the model is surmountable, as mentioned above, the second can only be overcome by the use of extremely complicated adjustments which remove the impact of imported inflation from total inflation, and take only net domestic inflation as input for REER calculations. This has proved close to impossible so far.

Using REER as a reason for currency devaluation is devoid of all rationality. It can be a guidepost if implemented properly, but can never be the bedrock of a nation’s exchange rate policy. It is time that REER was given just the respect it deserves and nothing more.

After almost 2 decades of misplaced trust the Indian Rupee, and India, deserve better.

This article was featured on Business-Standard.com on April 26, 2010.

Wednesday, April 28, 2010

Backdoor Monetization?

In fiscal and economic policy parlance, monetization of fiscal deficit is broadly defined as the creation of money by the Central Bank to fund the fiscal deficit of the Government. The money so created is normally provided to the Government by the Central Bank against special securities created for this purpose, or through the purchase of general Government Debt, which would otherwise be sold in the open market.

Monetization of the fiscal deficit is frowned upon by economists primarily because of the inflationary impact of the money created to fund it. There is also the fear that if the deficit is funded at low or no cost, the political class may be tempted to ignore fiscal prudence and expose the country to large deficits ultimately resulting in uncontrollable inflation. 

Until 1993, fiscal deficit in India was automatically monetized through the issue of special securities called Ad-Hoc Treasury Bills issued by the RBI on behalf of the the Central Government to itself, that is, the RBI at a fixed rate of 4.60%. After the crisis of 1991, this form of monetization came under severe criticism and following an understanding between the Central Government and the RBI, it was discontinued completely in 1997. All outstanding Ad-Hoc Treasury Bills were converted to Special Securities carrying an interest rate of 4.60%.

However, the RBI was still able to monetize the fiscal deficit by buying general Government Securities directly from the Central Government as and when required. This loophole was sought to be plugged by the Fiscal Responsibility and Budget Management (FRBM) Act in 2003, which envisaged a phasing out of this activity. Thereafter, the RBI could not create and hand over money directly to the Central Government. The focus of monetization then shifted to liquidity management

Since the RBI is also entrusted with the task of managing the Government’s Borrowing programme, it is responsible for ensuring that it is accomplished every year. After 2003, the RBI changed its strategy to ensuring that the domestic money market had enough liquidity to support government borrowings. RBI’s intervention  in the open market took on an urgency that did not exist before. Both, the domestic debt market, as well as the Foreign Exchange market were used towards this end. Since then, under the label of accumulating FX Reserves, the RBI intervened in the FX market to inject rupee liquidity into the system. This also served to keep the Rupee weak, which was thought to be a desirable outcome from the economic point of view.

However, reserve accumulation took on a life of its own and with exporters crying foul every time the Rupee appreciated, keeping the Rupee weak became a goal in itself. As a result, liquidity injection became just a desirable side effect and quantum of FX intervention no longer bore any relation to market liquidity requirements. There were times when the liquidity injected was far in excess of that required to support government borrowings and for these times, the RBI devised an instrument called Market Stabilization Bonds under a scheme called the Market Stabilization Scheme.

These MSS Bonds were issued by the Government of India to suck up additional liquidity. The funds so raised were kept in a separate account and were not available to the Government in the normal course. These Bonds acted as a store of liquidity and were extremely useful when liquidity conditions were tight. The Government could buy them back as and when required to ensure the amiable conduct of its normal borrowings. This was most evident in the year 2009-2010, when close to 1/3rd of Government Borrowings for the year were financed through the liquidity created by buying these bonds from the market.

Whichever way one looks at this, it is clear that liquidity created through FX intervention is being utilized to fund the fiscal deficit. Monetization is still a reality, albeit through the Foreign Exchange backdoor. The cost of this monetization to the Government is now market linked, but that does not detract from the fact that money is still created by the RBI to ensure that the Government’s borrowing needs are met. One can even say that the interest rate at which the Government borrows is also influenced by this monetization, since it’s clear that without this liquidity, the Government would have to pay a significantly higher rate of interest.

Of the two reasons why monetization is frowned upon, only one has been tackled through all these years of supposed regulatory improvement. Since the Government now pays “market” rates for this monetization, the idea that its a free ticket does not exist. However, the inflationary impact of liquidity creation is still a reality. Monetization of the fiscal deficit, even through a backdoor, is still monetization.

The current year will prove the truth of this premise. In the absence of a significant stock of MSS Bonds with the market (most of them were bought last year), the only way in which liquidity will be maintained at an adequate level will be through FX intervention. Given the gap between the Government’s borrowing requirement and estimated domestic liquidity, one can expect the RBI to buy at least USD 25 bln. through the year to fund it. Since the first few months of the year look to be comfortable from the liquidity perspective, one can expect this to start sometime in the second quarter of the fiscal year and intensify in the second half.

In case capital flows are in excess of this requirement, more foreign exchange will be bought, and MSS Bonds issued to sterilize the liquidity and create a stock for future needs. In case capital flows are lower than required, one would expect SEBI (in consultation with the RBI, of course) to increase the limit for FII investments in Government and Private sector Debt to the extent required.

And the RBI will monetize the Government’s fiscal deficit for another year. And say that it stopped doing it in 2003.

This article was featured on Business-Standard.com on April 26, 2010.

Thursday, April 22, 2010

RBI’s Religious Approach to Monetary Policy

A strange title, I know, but it seems that the RBI’s approach to monetary policy is closer to religion than to economics.

The Trinity in Hinduism comprises of Brahma, Vishnu and Mahesh. Hindus believe that the key to a good life is to be on the right side of all three. If even one of the Trinity is upset or displeased, well, it just doesn’t make for peaceful existence. Of course, there are scores of other Gods as well. Some based on form, but most on function. However, the Trinity is supreme.

Fortunately, it’s possible to please all three of them simultaneously. One doesn’t have to choose between them.

In Monetary Policy, however, this approach doesn’t work. The trinity here comprises of Interest Rates, Exchange Rates and Inflation and it’s just not possible to control all three simultaneously. One does have to make choices. And that could be the key to RBI’s disastrous approach to monetary policy.

In trying to control all three aspects of monetary policy together, the RBI seems to be going around in circles. Managing one upsets another. And when the other gets too upset, the RBI switches sides and tries to manage it upsetting the former.

Interest rates are an instrument that every central bank uses to control inflation and the pace of its economy. However, since interest rates are the preferred tool, most mature Central Banks (as opposed to Central Banks in more mature economies) prefer to let the Exchange Rate float. But the RBI’s approach is to manage all three in the belief that “upsetting” even one wouldn’t support peaceful existence.

On the face of it, the RBI likes to portray that it’s primary objective is to contain inflation. And it’s true. As a issuer of the Indian Rupee, nothing should be more important than preserving its value. But, lets take a closer look at the RBI’s inflation fighting credentials.

Ever so often, we hear that the RBI has to increase interest rates because inflation has risen and needs to be tamed. But why does inflation rear its ugly head every now and then? And why doesn’t the RBI spend as much time and effort preventing inflation from rising rather than act after it has risen?

Its because when inflation is benign, the RBI spends far too much time and effort managing the Exchange Rate. And “managing” is a polite way of saying weakening or debasing.

What the RBI does, in order to ensure that an appreciating Rupee doesn’t cause sleepless nights for our beloved exporters(who account for just 13% of the Indian Economy), is to buy US Dollars and sell Indian Rupees. Since this transaction happens in India (The Indian Rupee cannot be legally traded anywhere else) the label given to it by the RBI is that of “FX Reserve Accretion”. But its impact is nothing close to the “feel good” connotations of the label. Its impact is to inject Indian Rupees into our banking system, which show up in the form of excess liquidity and have a direct impact on aggregate demand, leading to inflation. Also, a weak currency means that any product or commodity whose price is affected by the international market becomes (or stays) more expensive when measured in Indian Rupees. And this holds true not only for imported products like oil, but also domestic products whose price is decided by the international market, like iron ore or copper and even food-grains.

So when inflation is benign, rather than ensuring it stays that way, the RBI is actually working furiously to ensure that it rises. And when it does, the RBI acts as if this re-emergence of inflationary pressures happened by itself. It then starts to increase interest rates (which in an open market would result in rupee appreciation, as more foreign exchange would flow in lured by higher interest rates) and absorb the very liquidity that it injected. And god forbid, if this happens at a time when the economy is doing well, it keeps on buying the US Dollars that are attracted by this growth and injecting fresh liquidity at the same time. The period April-December 2009 could be a case in point. Inflation was high through this time, but this did not stop the RBI buying USD 11 bln in this period. The additional liquidity injected into the market due to this was close to Rs. 50,000 crs.

But a better case is made by the year 2007. Through 2007, the RBI added USD 94.74 bln to FX Reserves, close to 10% of the USD 1 trillion GDP for the nation. Of this, USD 35.36 bln were bought in the last quarter of 2007 alone. And inflation jumped up from just over 3% in October 2007 to a 16 year high of 12.44% in August 2008. The RBI then proceeded to increase CRR to absorb this liquidity and increase interest rates to cool down domestic demand created by this liquidity surge. In characteristic style, they went too far with this as well, and caused a liquidity crunch so severe that the country almost went into a recession. This was October 2008.

Based on the RBI Governor’s recent monetary policy statement and comments after that, we can look forward to a continuation of this confused regime. While inflation will come down, purely due to mathematical reasons, we can be sure that the RBI will be working hard to ensure that it increases again.

Tuesday, April 20, 2010

RBI’s Monetary Policy Statement – A Critique

The RBI’s monetary policy statement did not surprise many people. Increases in the Repo, Reverse Repo rates and CRR were well within the markets expectations. While there was no urgency or clear need for these measures, there was, and is, an urgent & clear need for structural adjustments which the statement has ignored completely. These have been covered in earlier posts here and here.

In ignoring these issues, the RBI has made its task of managing the Indian Economy in coming days significantly tougher. Overnight Rates will remain choppy due to the large difference between the Reverse Repo & Repo rates. This in turn will prevent rational asset pricing in the Debt Market resulting in additional costs for all borrowers, including the Government.

Most significantly, however, the justifications given by the RBI for raising rates do not survive basic scrutiny. A few examples of this are given below.

“core measures of inflation in EMEs, especially in Asia, have been
rising.”

With large scale currency manipulation resulting in weak currencies in the region, this is to be expected.

“Clearly, WPI inflation is no longer driven by supply side factors alone. The contribution of non-food items to overall WPI inflation, which was negative at (-) 0.4 per cent in November 2009 rose sharply to 53.3 per cent by March 2010.”

Non Food Items as described above include natural produce like Cotton, Rubber, Metals & Minerals. The prices of these haven’t been rising due to domestic demand pressures, but because of a pickup in global demand. Again, through a weak currency, we have imported inflation in this segment of the WPI.

“What was initially a process driven by food prices has now become more generalised.”

Clearly. Increase in Food Prices will lead to an increase in the price of processed food as well, which is a part of the Manufactured Products group in the WPI. Excluding this, inflation in Manufactured Products is 4.72% for the last 1 year.  Also, this would include the impact of increased transportation expenses due to higher fuel prices. Neither Food nor Fuel prices are demand driven, so how does one use this to justify higher interest rates?

“The Base Rate system of loan pricing, which will replace the BPLR system with effect from July 1, 2010, is expected to facilitate better pricing of loans, enhance transparency in lending rates and improve the assessment of monetary policy transmission.”

Well done! This will go a long way, I’m sure. But before you ask banks to set their house in order, why not look inwards, sir? Overnight rates under the current interest rate regime can move in a band of 150 bps due to minor changes in system liquidity. This isn’t a “corridor”, its more like a six lane expressway. With extreme volatility in overnight rates almost assured by this structure, how does one expect Banks to price their loans? No wonder the gap between the overnight rate and the 10 year GoI is 425 bps, close to twice the long term average.

“However, as the overall liquidity remained in surplus, overnight
interest rates generally stayed close to the lower bound of the LAF rate corridor.”

And on the few days that it moved away from the lower bound, it moved directly to the higher bound which is 150 bps points higher. If this were to continue, and it will as the RBI hasn’t addressed it’s cause, market participants including banks will price loans based on their estimate of liquidity along with RBI’s policy rates leading to inefficient transmission of monetary policy measures.

“Meanwhile, inflationary pressures have also made it imperative for the Reserve Bank to absorb surplus liquidity from the system.”

Wrong, inflationary pressures have made it imperative that the Reserve Bank stop injecting liquidity into the system through intervention in the FX market, which not only results in inflationary pressures through excess liquidity but through a weak currency as well.

“Consequently, on a balance of payments basis (i.e., excluding valuation effects), foreign exchange reserves increased by
US$ 11 billion”

That’s close to Rs. 50,000 crs. of liquidity that the RBI injected into the banking system. Now that we don’t need this liquidity, why not sell these USD 11 billion? Not only will it suck rupee liquidity out of the system which will serve to contain domestic inflationary pressures, it will cause the Rupee to appreciate reducing the impact of global commodity price increases. Right now we have an inflationary Exchange Rate Policy and a disinflationary Interest Rate Policy operating simultaneously. What’s the point?

As usual, the regulatory measures laid out in the document are good and cannot be faulted. This is consistent with the view that the RBI is an excellent regulator, but not much of success when it comes to the conduct of monetary policy.

In defense of Libertarianism

By delaying a Treasury Department report on the US's trading partners, the Obama Administration has helped China dodge a bullet. But has it left China off the hook?

For the last 16 years, the US has avoided labeling China a currency manipulator. This, despite substantial evidence to the contrary, has given China the impression that it's free to value it's currency as it sees fit. China's case has also been supported by an outcry by pseudo-libertarians who would like the world to believe that they are disciples of the great Ludwig Von Mises.

Libertarianism, or the Austrian School of Economics is a school of thought that, amongst other beliefs, believes that Governments should not be granted the right to dictate what currency it's people use. Instead it believes in monetary competition, allowing multiple private sector participants to create money and consumers choosing the one which offers greatest value. While logic in this case is strongly in their favor, the current breed of libertarians promote a belief that defies all logic. They would have the world believe that just because the current monetary system allows governments to dictate a national currency, it also gives them the right to decide it's value vis-a-vis other currencies. This belief isn't just illogical, but is against the core principles of libertarianism which abhors government intervention of any form.

This outcry and fallacious justifications used to promote this belief only serve to underline a blatantly partisan agenda. Libertarianism is consumerist by nature, but it does not promote consumer interest at the cost of producer interest. In an ideal libertarian world, the absence of fiat currencies would ensure that all currencies are independently valued by a free market. No resource cost benefit is long lasting as free trade ensures its neutralization and producers all over the world retain basic competitiveness at most times. Additional competitiveness comes only from higher productivity and quality improvements. In this environment, resource costs equalize as well, ensuring amongst other things, equal opportunity for wage earners across the world. This pure form of libertarianism works in consumer interest as well as producer interest and does not value one of these activities above the other.

In contrast, the current proponents of libertarianism, or what they profess to be libertarianism, believe only consumers matter. And if consumer benefit is served by outsourcing all manufacturing activity to another country, even one which manipulates it's currency to keep it's products cheap, so be it. The jobs exported by them along with production don't bother them as long as consumers benefit. And they are ready to sacrifice a cardinal principle of their chosen discipline to justify their position.

These so called libertarians aren't intellectuals who want an open debate on their beliefs. Sarcasm and ridicule take the place of logic in their arguments, failing which they resort to outright insults and threats. They call anyone who opposes their thoughts "mercantilist" while themselves supporting blatantly mercantilist currency manipulation by countries like China, Japan and India.

Another favorite tool used by them is to switch from macro to micro or vice versa to justify an argument. For example, Donald Boudreaux, a Professor of Economics at George Mason University ridiculed another academic who sought to make a case against China's currency manipulation by comparing trade between countries to them buying each others books. One wonders about the knowledge he imparts while remaining oblivious to the difference between trade amongst individuals and trade between countries. But then, it's an easy route to take when one doesn't much care about the logic, but is intent on ridiculing an opponent.

The case made by this group is representative of their true loyalties. They use their position to promote self interest above all else. They make a case which suits their profile as pure consumers, ones who do not participate in the production of goods. So do the other proponents of this "theory" including bankers, academics and politicians who are consumers but not part of an industry that has lost jobs to another country.

They represent themselves, not a school of thought.

Saturday, April 17, 2010

April 20… Expectations & Suggestions

At the cusp of the Credit Policy review on April 20, it seems that the RBI is faced with some difficult choices. Difficult, because the circumstances this review is being conducted in are complicated and amenable to conflicting interpretation.

The two monetary policy measures likely to be undertaken, changes in interest rates and CRR, will be decided largely by inflation and inflation expectations in the current environment. The latest data puts inflation at close to double digit levels triggering calls for interest rate hikes and monetary tightening. However, an analysis of the underlying data reveals a different picture.

The items which constitute the Indian Wholesale Price Index (WPI) are divided into 3 broad categories. Primary Articles which account for 22.02%, Fuel Group(Fuel, Power, Lights and Lubricants) which account for 14.23% and Manufactured Items which account for the balance 63.75%

The latest comprehensive data available for March 2010 indicates the following,

imageData from eaindustry.nic.in (Office of the Economic Adviser to the Government of India, Ministry of Commerce and Industry). Rounding off errors are to the tune of 0.01%.

At first sight itself, its obvious that a bulk of current inflation is accounted for by Primary Articles & the Fuel group. But some media reports have expressed concerns about inflation in Manufactured Products which is currently 7.13%. Even here, if one drills down, one would see that a large part of this 7.13% is caused by the Food Products sub-group. In fact, if one were to remove the Food Products sub-group from the Manufactured Products group, inflation for manufactured products would drop to 4.72% for the last 1 year. And some part of this is definitely caused by increased transportation expenses as a result of fuel price increases.

As mentioned in earlier posts here and here, not only has inflation has peaked for now and expected to start a slow downward journey in coming days, but Food & Fuel inflation cannot be remedied through interest rates. It would not only be futile, but dangerous for the RBI to attempt this. This is also accepted by other experts and certain segments of the policy making brigade as stated here and here.

However, the probability of the RBI heeding this advice is minimal, so one would be well positioned to expect a hike of 25bps in the Repo and Reverse Repo rate.

The other possibility is a hike in CRR, which is essentially a liquidity absorption tool. At the moment, there is no evidence of large systemic liquidity surpluses, so the RBI would do well to leave it alone. Increasing CRR at this point could cause overnight rates to jump to the higher end of the Repo-Reverse Repo rate “corridor”, the equivalent of a 150 bps hike in itself. If the RBI were to hike CRR, it would be an indication of forthcoming intervention in the Foreign Exchange market to weaken the Rupee, which involves selling Rupees to buy US Dollars. Given the Rupee’s recent strength, this is very likely, but would be counterproductive for inflation control. A weak Rupee would only worsen inflation.

In summary, the ideal policy at this time would do nothing to interest rates & CRR. In addition, the RBI should guard against the temptation to intervene in the FX market.

There are structural issues that need urgent attention from the RBI. Even though these may involve some change in existing rates, these are essentially changes which are needed to make RBI policy actions more relevant than they are at present, as detailed in an earlier post here. These measures would also go a long way in making the debt markets robust and dependable enough to absorb the Government’s borrowing program. This would be a good time to deal with these issues.

Thursday, April 15, 2010

Is CII an exporters’ lobby?

Reading this (CII seeks RBI's intervention in currency markets, Business Standard) statement by the CII, one wonders what role it wishes to play in the Indian Economic landscape.

Asking the RBI to intervene to keep the Rupee weak is the most biased position that a general industry body can take in any scenario. Especially one that supposedly represents the largest cross section of industry in India.

In the current scenario, the impact of their demand will be amplified. Commodity prices are rising again; Oil prices have almost doubled in the last one year and so have the prices of most metals. Some metals, like copper, have shown price jumps of more than 200%

Any intervention to weaken the Rupee will result in higher inflation as it would translate directly into higher domestic prices for fuel, metals etc. Allowing international price inflation to translate into domestic price inflation at this time would wreak havoc in the domestic economy. 

Prices of almost all manufactured items will rise, forcing the RBI to hike interest rates (which CII would oppose). This, in turn will result in subdued domestic demand, and hurt our domestic economy which, incidentally, is over 4 times our exports. More details are available in an earlier post, Fallacies… I.

So when the CII asks for RBI intervention to weaken the Rupee, it is effectively lobbying for a measure that will benefit exports at the expense of the domestic economy. It seeks to make a “special interest representation” with the credibility of its general industry credentials.

It can’t have both.

Tuesday, April 13, 2010

Fallacies….IV

Fallacy 4) "The Rupee exchange rate is market determined"

Every once in a while, with some degree of regularity, the RBI feels the need to tell everyone that the exchange rate for the Indian Rupee is "market determined". I wonder why...

If it was a fact, would such a statement be required? Does Hindustan Unilever's management need to tell us that it's share price is market determined? Or for that matter, any other company whose shares are traded by our equity market. They obviously don't because their shares are traded in a market completely free of their influence.

I wonder how investors would feel about investing in equity shares of a company which not only regulated most of the participants in the equity market, but also had the right to issue shares as it wished, creating them out of thin air, without any asset to back them. I wonder how we would feel if this issuer were to issue shares whenever it felt the need to beat down its share price and keep it at a level which it thought was correct. I would imagine no investor in their right mind would want to touch these shares.

And yet, when the RBI steps in to manipulate the price of the Rupee, we the people; all stakeholders in the value of the Rupee, not only stand by as mute spectators but cheer it on. In the name of supporting exporters and ultimately supporting the Indian economy, we encourage the RBI to reduce the value of our currency any time it feels it's "over-valued". (read Fallacies...I for a more detailed analysis)

Yes, there is a Foreign Exchange market in India and yes, the exchange rate for the Rupee is determined by this market. But is it a free market? The largest participant in this market is the RBI, which steps in to buy foreign currencies whenever it feels that the market is overvaluing the Rupee. To do so, it creates Rupees out of nothing and sells them to buy foreign currencies, reducing the price of the rupee in the bargain. Apart from that, it also regulates almost all participants in the Foreign Exchange Market and works hard to keep entities it doesn't regulate out of it. Since the Rupee is held by every citizen of our country, everyone is affected by it's exchange rate, but strangely has no say in it's management.

Assuming that the RBI has the faintest clue about the "correct" value of the Rupee is another fallacy. Possibly the biggest all of us suffer from. How does the RBI know the value of the Rupee? Can it be calculated like that of an equity share or a mutual fund unit, where you take the total value of assets, reduce liabilities and divide it by the total number of shares/units outstanding to arrive at a specific value? Well, that's not possible anymore as there aren't any assets to begin with. But yet, we believe that the RBI mysteriously knows this value and is also absolutely right in intervening in the market to make sure that it trades at this price.

Of course, they have models that tell them what the value should be, but all these are relative value models which can only ascertain theoretical change in the Rupee's value over a specific time. These models, like Real Effective Exchange Rate or REER, need a correct value to start from which, of course, is the one determined by the RBI. Apart from this, models like REER are inherently flawed because of cause-effect circularity, which means that when a change is undertaken based on the models output, that change itself becomes the cause of imbalance and hence, further change.

If the RBI was a corporate entity, its presence in the market would amount to fraud. Punishable with the highest possible penalty with investors, regulators and politicians all baying for blood. So does the nature of the intervention change because the RBI isn’t a corporate entity?

If not, when do we start baying?

Monday, April 12, 2010

Fallacies… III

Continuing with the series once again. Something all of us are extremely tuned to hearing over and over again.

Fallacy 3) “Inflation has gone up, so interest rates will have to be hiked”: There are various types of inflation. Interests rates in specific can deal with only one type which is Demand pull inflation in discretionary items of consumption. But what are discretionary items of consumption?

Well, household consumption can broadly be divided into two parts. One part would include necessities, like food, fuel, electricity, cooking gas, etc., typically items which  a household would need to exist. These are classified as non-discretionary items of consumption as a household has no choice but to consume them. The other part consists of wants, not needs. This includes an own home, car, motorcycle, television, entertainment, eating out etc. These are typically expenses which a household wants to undertake to improve their quality of life, but aren’t really essential to exist.

The classification between these two categories differs from one city to another & even from one time to another. For example, own transportation is not a necessity in Mumbai because of its efficient public transportation system. But it may be considered a necessity in the National Capital Region. In a few years, once the Delhi Metro covers all corners of the NCR, own transportation will cease to be a necessity.

As far as non-discretionary items of consumption are concerned, these do contribute to economic growth, but not in any manner that can be codified into a model or law. For example, economic growth can lead to higher consumption of food-grains, but the relationship isn’t one that is predictable. One can look at how consumption patterns change when other countries went through a similar stage of growth to arrive at some idea of how it works, but predicting it with any accuracy is impossible.

Discretionary items, on the other hand, contribute directly to economic growth as incomes increase. There is more certainty and predictability her than in the case of non-discretionary items.

Coming back to inflation, to decide on a monetary policy response to it, its necessary to understand what its main causes are. If prices of discretionary items are rising due to an increase in demand without a corresponding increase in supply, interest rates are the correct tool. If interest rates are hiked, credit linked items like homes, vehicles, white goods, become more expensive in EMI terms which can lead to a fall in demand. In addition, the incentive to save rises which also results in a fall in demand. In this scenario, the prospects of demand cooling and prices coming down is very real as the right monetary policy toll has been used.

If on the other hand, the primary contributors to inflation are essentials, the monetary policy approach has to be different. It is impossible to control this form of inflation through interest rates. In fact, increasing interest rates in this environment is extremely harmful to the economy. If one assumes that income remains constant but the price of essentials rises, the amount of money available with households for discretionary expenditure is reduced to that extent. This would cause a drop in demand without any monetary policy action*. At this stage, to increase interest rates is to compound an already harmful situation. Demand, which is already depressed, will fall further and can result in a slowdown which will be extremely difficult to reverse. Also, monetary policy has an extremely small role to play in influencing the prices of these items. As mentioned in an earlier note, Inflation and the RBI, Neither will global oil prices change due to a change in India’s oil consumption, nor will people eat less if interest rates were to rise. Without any possible demand or price impact, using interest rates to control this kind of inflation is futile.

Unfortunately, the “law” requires and demands that the RBI act and it does. The RBI’s belief in this fallacious law has lead to many “incidents” in India’s economic history. Unfortunately, because of the RBI’s stubborn refusal to learn, we may be in the middle of one again.

 

* the recent increase in the price of Petrol and Diesel would increase expenditure on fuel by close to Rs. 2,400 cr. per month. This would have been otherwise available for discretionary expenditure.

Friday, April 9, 2010

Fallacies of Simple Conclusions – II

Continuing with the previous post on fallacies created by simple conclusions that get codified into '”law”, another one of these fallacies comes to mind almost immediately.

Fallacy 2) “The RBI knows best”: Why? Why does the RBI know best? There can be only two explanations for this “law”. The first is that the RBI has the best brains in the country working for it. Or the RBI knows more than the market and hence it’s decisions are based on better information.

As far as the RBI having the best brains in the country is concerned, I would guess that the private sector has people who are as good, if not better than those in the RBI. Today’s private sector is not the one that existed a couple of decades ago. It has the ability to attract and retain qualified & knowledgeable individuals who have the ability to hold their own as far as economic policy making is concerned. So any assertion that puts their ability in doubt is suspect at best, and criminal at worst.

The second possibility is that the RBI knows more. Once again, the question to be asked is, Why? Why does the RBI know more? Or rather, why isn’t the information available to the RBI also available to the market? What harm could it possibly do if the market was aware of everything that is going on with the economy? One possible harm would be that the market would then have the ability to question the RBI’s decisions and probably judge them to be wrong. Something that is prevalent in more developed markets where not only basic information, but minutes of all decision making committee discussions are made available to the public and the market.

This fallacy is especially harmful as it allows the RBI to exist as an autocratic institution in  a democracy. It allows it’s decisions to go unchallenged and absolves it of any accountability to the people, which should be the bedrock of all arrangements in any democratic form of government. Central Bank '”independence” cannot, and should not, be construed to mean that the Central Bank isn’t accountable for it’s actions. Yet, one disaster after another, the RBI gets away without explanation, because “the RBI knows best”.

I am not suggesting even for a moment that any individual knows better than the RBI. But the market certainly does. The RBI cannot claim monopoly of wisdom to the extent that it believes itself to be smarter than the collective wisdom of the markets.

There are corollaries to this “law” which are almost as prevalent, if not more. It will take at least a couple of days to enumerate and explain them, which I will try and do in coming days.

Fallacies of Simple Conclusions - I

Every day, in almost every aspect of life, we come across "laws" based on simple conclusions. These are more prevalent in economics than any field because of the very nature of the science. These simple conclusions which become codified into "laws" can prove to be extremely harmful, especially when fed as pre-digested wisdom to powerful people who fail to grasp the multi-faceted nature of economic decisions.

Many of these "laws" have been haunting India through policy makers who believe them to be true. Many times, there's no disputing their truth. What is harmful, is the fact that there is more than one effect of any economic decision, and the rest of the impact is completely ignored in favour of that one "dominant" truth. Let's take a look at one of these today...

Fallacy 1) A strong rupee hurts exporters, and is therefore bad for the economy: This is actually two simple conclusions bundled into one. The first is "a strong rupee hurts exports". The second is "what is bad for exports is bad for the economy".

Looking at the first, well yes, a strong rupee can hurt exports. But only if that's the only advantage offered by our products. The Price. Its been close to 40 years now that India's followed a weak currency policy, engaging in competitive devaluation with most countries in Asia and some on the other side of the world. If after all this time, all we can compete on is price, then our export industry hasn't really done enough to deserve any of the advantages that it gets. Like Tax exemptions and a weak currency. Having said that, however, let's look at the "law" without judging it's beneficiaries. A strong currency can hurt exports, that part can be held as true. But other effects of a strong currency include cheaper imports, increased domestic purchasing power, low inflation and enhanced faith in the currency. A strong currency reduces the price of all imported products and also those where the price is dependent on international prices. So fuel prices, metal prices, imported fruits and through some adjustment mechanisms, foodgrains all become cheaper when the rupee strengthens. This increased domestic purchasing power benefits the domestic portion of India's economy, which is incidentally, more than 4 times the export oriented part. But no one says this when thay say "a strong currency hurts exports".

The second "law" is "what is bad for exports is bad for the economy". Once again, a statement that taken by itself sounds intuitively true. But fails to address a basic question. What are exports good for? Why does the country need to export? There are questions that I have answered in detail in my earlier notes, The Purpose of Exports. To summarize, a country needs to export just to earn the foreign exchange needed to pay for imports. Of course, a country can gain access to other markets through exports, markets which are larger and have have more purchasing power. But the primary aim of any economic policy should be to increase domestic purchasing power, not sacrifice it to gain access to external purchasing power. Exports are a means to an end, not an end in themselves. When The "law" tries to tie export growth to economic growth, it does not warn against export oriented strategies that damage domestic growth. Or the ability to import.

Looking at the "law" now, we can see how false it's premise is. A strong currency hurts exports, but benefits the doemstic economy. It makes exports more expensive for foreigners but makes imports cheaper for our citizens. It can reduce inflation, increase domestic purchasing power and support growth in the domestic economy, which is many times the size of our exports.

But no one will ever tell you that.

Monday, April 5, 2010

For lack of anything better to do...

Finally, our revered Prime Minister has woken up to the fact that our debt markets need some attention. About 19 year too late (well, he was Finance Minister then) and 4 years after the report he wants to act on was submitted.

While it may turn out to be good news for the debt market, it would have been definitely better if this was an initiative taken because they thought it was a priority. On the contrary, if one is to believe this, it's obviously something that has been taken up for lack of anything better to do...

That is not to say that it isn't needed. In fact, much more is. The corporate bond market is a small section of the debt market in India. So small that it draws attention to itself and cries for reform. But truth is that reforms are needed more in the government securities market than any other segment.

In any country, government securities are considered to have the best credit quality. This is simply because the government is the only entity in a country that can create money and in the event that it finds themselves constrained to a point that it can't pay either interest or principal, it can create the required amount of money and pay. No other entity has that kind of power. And thank God for that.

Because of the above, one can assume that the government can borrow limitless amounts without a problem. In reality, that isn't the case since reckless creation of money can lead to extemely high inflation and no government would take that risk with it's population.

Thus, the government securities market which trades government debt for maturities ranging from 14 days to 30 years defines the structure of interest rates for investments with zero credit risk. Based on this term structure, rates for corporate lending can be decided based on the credit quality of the issuer. This becomes, in essence, the corporate bond market.

But for the corporate bond market to be efficient, it is essential that the government securities market is. Without that, any reform of the corporate bond market will be futile. If foundations are weak, structures built on them can never be stable.

So what is wrong with the government securities market, one might ask? It is, after all, the most liquid of all debt market segments. It not only has the highest outstanding amount, it also has high transaction volumes on a daily basis.

But just these facts don't signify perfection. Or anything close to it as well. Volumes and liquidity are restricted to 5-7 securities out of the close to 100 available. And these change every year. While there is a certain amount of predictability as to which security will become liquid every year, it doesn't make the situation necessarily better.

What makes the situation worse, on the other hand, is the fact that yields on the more illiquid securities are substantially higher than than those on the liquid ones. This, in effect, pushes up the barrier for corporate lending and sometimes can have an impact on the cost incurred by the government as well.

While there are various reasons for this illiquidity, the most common of these are,

1) Low floating stock: This is when the issued amount of the security is small. Much like a small cap stock, there are very few holders and hence low level of interest in trading them.

2) Large premium or discount: This is when the security has been issued with a coupon rate, or interest rate, which is very different from that prevailing at the time of trading. If the coupon rate is higher, the security will trade at a premium. If lower, it'll trade at a discount. There are certain circumstances in which these do trade well, but these aren't either frequent or consistent.

3) "On the Run" securities: These include securities that have a maturity which is close to a benchmark maturity, have a reasonable outstanding quantum, have a coupon rate which is close to the prevailing yield and have either been issued recently or are expected to be issued in the near future.

Because of these liquidity characteristics, the yield curve is not smooth. The kinks in the yield curve not only make it difficult to price corporate bonds but also to derive a zero coupon yield curve. Without a zero coupon curve, the debt market is effectively reduced to a spot market, which results in lower liquidity and inefficient price discovery. In the absence of a robust swap market, participants cannot hedge their positions if they believe interest rates will rise. The only option left in these circumstances is to sell their holdings of government securities within applicable regulatory constraints. This can result in a rush to sell causing extreme volatility and the possibility of market liquidity drying up.

For any reform to be effective, it has to focus on the development of a robust zero coupon yield curve. This will result in more efficient price discovery and pricing. It will also support the development of a derivatives market which will throw up hedging options. Also, a simple to understand yield curve will support retail participation in the government securities market. This wider participation will also have a beneficial impact on pricing.

RBI's attempt to resucitate their initiative of Seperate Trading of Registered Interest and Principal Securities or STRIPS is not enough to achieve this. Despite the supportive statements, most participants remain lukewarm to the initiative primarily because it will be traded outside the institutional Negotiated Dealing System (NDS). While the RBI has announced steps to ease the conversion from regular bonds to STRIPS, participants are not likely to undertake this in a significant manner. Also, if the institutional market trades regular bonds, the likelihood of a robust retail market trading STRIPs remains remote as the connect between the two shall remain tenuous. The retail market will not be able to drive pricing in the institutional segment due to low volumes. And since the two markets will trade different yield systems, the retail market may not be able to determine the connection between the two. This will result in mispricing of the retail instruments and possibly profiteering. If retail volumes remain low, it is unlikely that this profiteering will be traded out as the level of interest will remain low as well.

For trading of strips to be effective, it is essential that both the institutional market and the retail market trade them. And for this to happen the solution will have to be far more creative than the voluntary stripping of a few securities.

The involvement of the Ministry of Finance in its capacity as issuer will be essential and it is due to that reason alone that the time to undertake more meaningful reform is now. It is unlikely that once the government gets back to legislating, it will have the required attention span to undertake this. Even if this is done because there is nothing better to do, it will most certainly be a giant leap forward.
Location:Nashik,India

Saturday, April 3, 2010

Time for a New Currency System?

The modern currency system has it’s roots in the Bretton Woods System which was instituted by representatives of 44 Allied nations towards the end of World War II. Prior to this, Currencies were normally issued against holdings of Gold Reserves. Exchange rates were not required as all international settlements were made in Gold, which was the accepted common currency.

The Bretton Woods System sought to move away from this system to a system of ‘negotiated exchange rates’ which were fixed in term of Gold and countries were required to maintain this peg within certain pre-defined limits. An International Reserve Currency was proposed, but shot down by the US which insisted that the US Dollar should be nominated as the Reserve Currency. To convince the other nations, the US undertook to exchange USD for Gold at a fixed rate of USD 35 per ounce.

However, inherent flaws in the system saw it go through many pangs and adjustments. And on August 15 1971, President Nixon announced that the USD would not be directly convertible to Gold except through the open market. This decision was taken by the US unilaterally and was the equivalent of sovereign default. The countries holding their reserves in USD, who till the day before believed they effectively held a certain quantity of Gold, were left holding just another currency. While more attempts were made to tweak the Bretton Woods System to make it work, the loss of its very foundation saw it fade away and by early 1976, most currencies were ‘floating’.

Through the Bretton Woods agreement, the US pursued expansionist monetary policy that saw the ratio of its Gold Assets to total outstanding currency fall steadily. The US Congress had however, specified that this ratio could not fall below 25%, but removed that restriction in early 1968. At the time of the default, the coverage ratio was 22%.

After the Bretton Woods System faded away, Central Banks across the world realized that in the new order of things, their currencies did not need assets to back them. It was thought that no central bank would risk issuing too much currency for fear of it weakening against other ‘floating’ currencies and domestic inflation. A real peg had been replaced by an ‘ethical’ peg.

But as the US continued to expand monetarily through the following years, other countries could follow suit primarily because (i) it wouldn’t change the value of their currencies vis-a-vis USD as the US was doing the same and (ii) because if they didn’t they would miss out on the ‘progress’ that this additional money offered. There was great reward without any downside.

This global order worked to the US’s advantage as well, as the world, instead of rejecting it’s currency in the face of this monetary expansion, joined it. Currency issuance across the world had been unfettered. Not only from underlying assets, but from the value of these underlying assets as well.

But this outcome gave Governments & Central Banks unprecedented power over the value of their respective currencies. Currencies which did not ‘float’ had also been delinked from assets, but were not priced by a free market. Instead their value was what the Government decided it was. Armed with this power, under-developed nations undertook voluntary devaluations of their respective currencies in a bid to increase their competitive advantage in the global market. But once the cycle started, it could not be stopped. Over time, nations sought to devalue their currencies just because their competitors did so, and the competitors followed them. The race was on and no one wanted to come in second.

Of this pack, a few nations (Japan, being the largest) also took essential steps to free their manufacturers from restrictive regulations and allow them to compete globally. This was a link that other countries like India missed completely. Japanese success in gaining significant market share in the US inspired others in the region. The Asian Tigers undertook meaningful reform, but the Dragon did it the best. India undertook reforms grudgingly, and only after faulty fiscal and monetary policy drove it to the brink of default.

But the underlying trend of competitive devaluation which had started almost immediately after the collapse of the Bretton Woods System hasn’t lost it’s followers. China is today one of the biggest currency manipulators and holds its currency at an artificially weak level. It learnt this trick from Japan, which started currency manipulation much earlier, but has been left behind by China in sheer magnitude.

The mechanism of devaluing one’s currency would not have been available if currencies needed to be supported with real assets. But since they were unfettered, a Central Bank can create a virtually unlimited amount of it’s own currency without any restriction. This allows it to sell it’s own currency in the market and buy foreign currencies (the currency of choice here being the USD due to it’s exalted status). It can then suck the excess domestic currency liquidity so created by mechanisms such as increasing reserve requirements. But this is possible only because there is no way left to arrive at a value for the currency. No assets, no free markets. These currencies are valued by Central Bank diktat.

While the US enjoyed the benefits of the USD’s status as a Reserve Currency when the going was good, Currency Manipulation by China has hurt prospects of a quick recovery from the effects of the financial crisis. On April 15 2010, a scheduled report by the US Treasury Department may label China a Currency Manipulator, something it has been avoiding for the last 15 years. If it does, it will give legitimacy to a bill supported by 130 US Senators seeking to institute measures designed to force China to allow it’s currency to appreciate. Amongst these, is the proposed levy of a penal import duty of 25% on all Chinese products.

While China’s currency policy is as protectionist as the proposed levy, China’s manipulation is perceived by many to be a domestic issue. However misguided this view, imposing an explicit levy is likely to be perceived as a very aggressive stance, which may trigger off a trade war.  As I mentioned in an earlier note, “Is it time for De-globalization?”, this trade war will change the world as we know it.

Apart from other things, it will certainly give the world the required incentive to discuss a new currency arrangement. A currency arrangement which will not allow the blatant manipulation of a currency’s value by it’s Central Bank. A system which insists upon a ‘real’ value for currencies, instead of allowing Central Banks to create it out of thin air. A system which would result in currencies worth more than just words.

A Real Currency, for a change.

Friday, April 2, 2010

Now that's what I call a comment! I'm a Demagogue, no less...

"The whole tirade is mercantilist, hypocritical, short-sighted demagoguery."

This is a reaction to yesterday's post in one of my forums. Actually, the last sentence of a long message which was considerably milder to begin with, but got really intense towards the end... The first sentence read "Although interesting I cannot agree with your post." Halfway through it was "Pin(n)ing low growth or poverty to China’s peg would be madness." and in the end, I was a shortsighted, hypocritical, mercantilist demagogue!

But that's typical of the intense reactions generated by this topic. Mine was intense as well, I admit. But my intensity could be a geyser to the response's volcano. Pretty much like Stephen Roach wanting to "take a baseball bat to" Paul Krugman. And that has been said as well...

My critic, Merlin from Albania, says

"Let’s look at the undervalued rembibi for what it is: a tax on internal producers in China and a subsidy to export-oriented industries. So, by keeping a pegged currency, China is diverting resources from internal production to export. That’s all. It is not getting richer, rather poorer that it would be without the peg."

How true! But only if China had a domestic market for all that it produces. It obviously doesn't and thus, when China exports, it gains a market. Also, when it subsidizes exports, it does so not at the cost of it's own populace(since it imports wages when it exports goods), but at the cost of it's clients' populace. A weak currency increases the price of imports and increases the realization from exports. For a nation running a trade surplus, the latter is always larger than the former resulting in a net benefit. In addition, the jobs created for export production would not exist without exports, if the domestic market isn't large enough. So how do weak currency driven exports make China poorer?

Merlin then goes on to say,

"The latest financial crisis was “made in the USA” not at all in China, although should the rembibi be floated tomorrow there would be a shift in resources form export to internal production world-wide. Whether that would be considered a ‘crisis’ depends on how much undervalued is the rembibi right now. I myself do not thing that any country on earth could ever come close to undervaluing its currency so much as to induce anything more than a minor readjustment on the world economy. Yet the important thing to see here is that those who fearing a crisis should advocate the strengthening of the peg, not its abolition."

Well, yes the crisis was made in the US. It wouldn't have been possible without the rampant de-regulation of financial intermediaries. Cheap goods from China and misguided monetary policy only provided the required environment. And I haven't said anything to the contrary in yesterday's note as well. But saying that the Renmimbi (Yuan) isn't undervalued is just refusing to acknowledge that the mountain of FX Reserves held by China exists. Would the Yuan be traded at the same rate today if the Chinese Government hadn't intervened in the market and amassed it's FX Reserves? Obviously not. As for the extent of the undervaluation, I don't think any one person can judge the right value. Hence, the demand for free market pricing and abolition of the peg. The one part I didn't get (well, there are other parts too) was how can the purported fear of a crisis result in the advocacy of a strong peg? Anyone?

It was at this point that the comment's credibility really started crumbling. As I said earlier, there were other parts that I didn't get and most of them came after this point.

The comment is an example of how divisive this topic has become. There is logic at one end and abuse at the other. Those who support China's currency manipulation have been, so far, more abusive than logical. Merlin from Albania calls me a mercantilist, even though all I ask is for Chinese protectionism to end. These "proponents of free trade" support a Government's right to intervene in a market, but condemn another Government for asking it not to. How the logic pans out in their heads eludes me.

As for being a demagogue who, according to H L Mencken, is "one who will preach doctrines he knows to be untrue to men he knows to be idiots", even in the unlikely event of me saying what I believe to be untrue, I'm sorry Merlin, but I haven't come across any other idiots.

Thursday, April 1, 2010

Currency Manipulation: China's Greed & India's Need

A lot has been said recently about the manner in which China manipulates it's currency, the Yuan. But China wants to hear none of it. In his annual press conference, Mr. Wen Jiabao, China's Prime Minister said that he was "a staunch supporter of free trade" and denied that the Yuan was undervalued. (The Economist, March 18, 2010)

Such denials are reflective of what the world is dealing with. An issue, which should have unified the world against China has, over time, become one which has divided it between Free Trade Proponents and "Protectionists". And amazingly, China is in the Free Market camp.

Ever since Paul Krugman proposed the controversial 25% levy on Chinese Imports into the US, eminent economists like Donald Boudreaux, Greg Mankiw and most recently, Stephen Roach have launched vicious attacks against him labeling him a protectionist who would not only stop world trade, but probably cause World War III. 

But before we decide where virtue lies, lets examine the arguments.

Free Trade relies on free markets to be effective. By intervening in its currency market, China has demolished the very foundation of free trade. If Mr. Jiabao is a staunch supporter of free trade, as he professes, the Chinese government should let the currency float and allow a free market to determine its value. In other words, China needs to act like it supports free trade, not just say it. Also, the self appointed guardians of free trade need to examine the logic of supporting government intervention in the currency market while espousing free trade. 

If the Yuan were to float, it would appreciate against the US Dollar and all other free float currencies because of the trade surplus that China enjoys. This appreciation would make manufacturers in other countries more competitive and reduce China's trade surplus. In other words, the markets would restore equilibrium and free trade would continue unhindered. This equilibrium is unattainable if China intervenes to decide the price of its currency.

China's currency intervention is the most blatant form of "market protectionism" that has existed and needs to be recognized as such. It benefits China at the cost of it's trading partners and leads to a transfer of wealth from the importing nation to China. But does China need a weak currency? Or does it just desire one.

With its trade surplus, China benefits tremendously from a weak currency. Since it exports more than it imports, a weak currency makes it richer by increasing the value of its exports more than it loses due to increased value of imports. The magnitude of the trade surplus implies that China doesn't need a weak Yuan to compete in the world, but its stance on the currency proves clearly that it desires one. What China gains from a weak Yuan is clearly understood, but in the absence of need, the only explanation for its obstinacy is Greed.

As one of the first proponents of "Competitive Devaluation", China used the currency market to gain a competitive advantage against its peers. Over time, with command policies supporting exports, China established itself in the major markets of the world and then proceeded to compete effectively with domestic manufacturers. The dis-inflationary impact of Chinese imports allowed the US and other importing nations to follow expansionist monetary policies, which created an impression of increasing wealth. However, asset bubbles, supported by a misguided de-regulation of market intermediaries, resulted in a disastrous crisis. A detailed discussion of this is available in an earlier note, China's Currency Policy, The Financial Crisis and the Future of Financial Reform.

But the financial crisis is not the only problem that China contributed to. By keeping the Yuan weak, China effectively ensured that every country competing with it would need to do the same with their currencies. India was, and continues to be, one of them. Except that in India's case, the trade balance is unfavorable and currency weakness actually costs India more on its imports than it's benefit to exports. In essence, currency manipulation by China enriches itself but impoverishes India.

For India, the impact of Chinese currency manipulation along with inherently faulty monetary policy has led to at least one economic crisis. If the Yuan were to appreciate vis-a-vis free currencies, it would result in an environment where most of the past wrongs can be corrected, at least prospectively. More details can be found in an earlier note, Inflation and the RBI. Whether the RBI will have the wisdom to take that opportunity is a question that can only be answered then.

China's greed has sucked wealth from its trading partners and its competitors. The financial crisis of 2008 has called many practices into question and presents an opportunity for the world to unite against China and ask it to play by the rules. 

If it's free trade that it wants, it has to respond with free markets.