WHAT'S NEXT FOR THE INDIAN AND GLOBAL ECONOMY? 

By, Adhvith Dhuddu

The dust seems to have settled from the tremors of the Lehman collapse, and the turbulent Sept-Nov period last year. More economists, businesspersons and governments are coming to terms with the true depth and nature of this economic crisis. Markets are still at relative lows even after a substantial rebound, and GDP and trade estimates are still very conservative; but what’s next for the global economy, and how do we know that we are truly recovering? Both here and in the US, volatility indices for major stock indices have subsided reflecting the departure of fear and anxiety in the markets. But here are some critical leading and lagging indicators that will shine more light on the economic picture going forward.

Velocity of Money: Although rarely discussed in the mainstream media, the velocity of money is vital in abetting recoveries all over the globeWW. The G-20 nations recently committed to pumping in billions throughout the global economy hoping to jump start the revival. This huge government spending spree will be ineffective if the velocity of money does not pick up pace. The velocity of money is basically the average frequency with which money is spent in a specific period of time.

The most recent boom periods during the 1990s in the USA and the last decade in India did not happen because of unprecedented government spending, or huge stimulus packages. During these boom periods, even though the amount of money in the system grew steadily, the velocity of money was extremely high leading to healthy growth rates. This is just another reflection of consumer sentiment; when the mood is sanguine, the consumer tends to spend more and save less (which results in a higher velocity of money) but the reverse is happening now. If the billions being ploughed in don’t initiate a rejuvenated spending cycle or if the velocity of money doesn’t garner momentum, this downturn can last a while.

Another vital component of the velocity of money is the money created in the system through securitization and the shadow banking system. The velocity of money increased gradually over the last decade because it was also aided by financial innovation and securitization. Even though it’s 6-7 months after the crisis the shadow banking system is still in tatters and will take time to recover.

Deflationary threat: Going back to the basics, we learn that inflation is caused when more money is chasing a limited number of goods and services. We saw this unfold in an ugly manner at the height of our recent economic expansion. Now, inflation is at zero levels and many speak of a dangerous deflationary spiral. Although our Planning Commission’s Deputy Chairman, Dr. Ahluwalia has dismissed these fears, they are real and present dangers for a simple reason, now there is less and less money chasing the same number of goods and services.

It’s an oversimplified explanation for a potentially complex problem. But this is true for many reasons; no banks here or anywhere in the world can now borrow with 1:30 leverage. In the pre-crisis days, $10 million could result in $300 million worth of investment/spending spread over the globe, and let’s say 25 percent of that is allocated equally to BRIC countries: India would probably see $18.75 million (Rs. 93.7 crore) worth of investments. But now, if investment banks or any investor can secure 1:10 leverage, the same equation would bring only $6.25 million (Rs. 31.2 crore) to India. This trickles down and when there is less money to trickle down, everyone has less to spend and less to save, which starts suppressing prices. This is already happening here and across the world. Consumers are either spending less or delaying their spending plans leading to lower sales and retailers cutting prices.

Recent data from the RBI and other private banks are only rubbing salt to the wound. Despite proactive measures from the RBI, lending growth in the latest fiscal fell by 5 percentage points from 22.3 percent in 2008 to 17.3 percent in 2009, way off their own target of 24 percent (non-food credit by scheduled commercial banks). This is relevant because credit is a form of money in the system; reinforcing the fact that now there is less money chasing the same goods and services.

Stock market rebound: In efficient markets, stock prices are reflective of the future earnings stream but in the current scenario, one needs to accept the global rebound in indices with a pinch of salt. Technical analysis is a passion of mine, and we learn in the basics of technical analysis that when any chart appears heavily oversold, there is eventually a rebound. So this mini-rally across the globe is primarily due to two reasons: It’s a snap back of the spring to rebound coupled with subtle signs of optimism in a few macro indicators. Helping the rebound along the way is short-covering; but this rally will eventually lose steam and test the recent lows of the Sensex and Nifty.

Success of TARP, TALF and PPIP: If a $13 trillion economy doesn’t get going in a $50 trillion global economy, we might have some serious troubles ahead. Yes, there are possibilities that one of the BRIC countries or emerging markets as a whole could dampen the overall blow and lead the way out of this crisis. One must cautiously accept this because it has never happened before and will be an unprecedented and monumental feat if achieved.

This is why the success of TARP (Troubled Assets Relief Program), TALF (Term Asset-Backed Securities Loan Facility) and PPIP (Public-Private Investment Program) is vital. These flagship programs designed by the US government to pull their economy out of turmoil has so far been progressing according to plan which is why US president Barack Obama recently said he saw, “glimmers of hope,” in the economy. 

These and other pivotal factors like better trade numbers, a flight from safe havens like gold and government bonds and how well the reformed securitization market serves the recovery will be keys to the recovery. But one thing is certain; the capitalist system that emerges out of this financial crisis will be regulated more closely, monitored more vigilantly and animal spirits will now have shackles to break. 

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FREIDMAN VS. KEYENS: THE MULTI-TRILLION DOLLAR QUESTION

By Adhvith Dhuddu

 

The global economic crisis has rekindled the classic yet unsettled debate about government intervention, free markets and capitalism. Economists to this day are at loggerheads about this, and the most famous on either side of the debate are renowned economists Milton Freidman and John Maynard Keynes. Although the Economist magazine hailed Milton Freidman as the most influential economist of the 20^th century, Keynesian policies are being adopted all over the world by policymakers and legislators to pull the world economy out of an unprecedented crisis. It’s often said that the argument between Freidman and Keynes has long been settled and globalization, free markets and capitalism have vindicated Milton Freidman’s theories. But nothing less can be said of Keynesian economics as his deficit spending stimulus policies are rampantly being adopted in many industrialized nations as we speak.

Keynesian policy dictates that, “private sector decisions sometimes lead to inefficient macroeconomic outcomes and therefore advocates active policy responses by the public sector, including monetary policy actions by the central bank and fiscal policy actions by the government, to stabilize output over the business cycle.” Clearly this crisis has unfolded just as Keynes envisioned: decisions by the private sector (like the over-leveraged investment banks and profit-thirsty mortgage originators) led to inefficient macroeconomic outcomes (declining GDP, rising unemployment, etc) to which governments all over the world are responding by fiscal and monetary stimulus trying their best to stabilize the business cycle.

This is also being echoed from the Obama administration who firmly believes that government is the only institution that can reverse the spiraling and reactionary crisis that is unfolding right now. Their argument is that non-government expenditure has slowed significantly and depleted close to $2 trillion in GDP leaving them no choice but plan billion’s in deficit spending to reverse a contracting business cycle. Although Keynesian policies have its drawbacks, they seem to be gaining momentum around the world as the right approach to alleviate some pain in the world’s economy now.

Keynes’s primary argument focused on utilizing government as a stimulant or a backstop during economic downturns. He claimed that aggregate demand for goods and services will decline drastically during economic downturns that will lead to high unemployment and significant losses in output. In this case only the government can step in to fill the vacuum to improve economic activity by increasing government spending and reducing interest rates. Keynes’s policies were widely adopted during the Great Depression in the 1930s-40s when the world was going through a deep contraction. To this day there are debates about whether or not massive government spending helped or prolonged the depression. Passionate cases can be made for and against the argument.

Freidman on the other hand was an extremely vocal cheerleader of a deregulated and free market economy and highlighted that government should have a progressively smaller role in the economy and the private sector. He vehemently opposed all types of government regulation saying it only contributes to lower productivity and adds costs to businesses. Many of his theories were questioned and challenged initially but in the second half of the 20^th century, the US and UK largely embraced his policies which materialized wholly during the Reagan administration (where Friedman was a top economic advisor to President Reagan) in the US and under Margret Thatcher in the United Kingdom.

His primary criticism of Keynesian policies was the threat of stagflation. He argued that too much government intervention and increased deficit spending will only spur inflation and keep productivity and growth levels very low.

So the trillion dollar question is whether the Keynesian policies adopted around the world will result in stagflation like Friedman predicts or just a slow growth period with little or no inflation. In the recent few decades, Friedman clearly had the upper hand as deregulation, opening of borders and globalization led to a flattened world, with consistent growth. Friedman, who passed away just over two years ago said as late as 2006 that the world economy is in great shape and many more years of sustained growth are foreseeable.

I only wish he lived to witness a rewinding of so many policies that were adopted over the past few decades. There are many disturbing trends that clearly show protectionist inclinations which are very worrying. The global economy is at a very critical point and the next few years might just see tectonic shifts in economic power.

Although we blame government time and again for their inefficiencies and red-tape, it is they who we turn to during times of crisis. But unfortunately, government intervention also means profits getting privatized and losses getting socialized. Friedman’s theories were celebrated, but one theory by another famous analyst, Nicholas Nassim Taleb (who predicted the economic disaster) says famously in his book, “The Black Swan,” that no math model can predict tsunami like economic events like the one we are experiencing now.

So only time will tell if the deficit spending policies being adopted will bear fruit and pull the world economy out of a recession. Personally, these policies are not the best given the current situation but we have no choice but to live with it. 

References: http://en.wikipedia.org/wiki/Keynesian_economics

http://en.wikipedia.org/wiki/Milton_Friedman

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AN UNCERTAIN FUTURE

By Adhvith Dhuddu, Regular Columnist

 

U-Shaped, L-Shaped or V-Shaped recovery?

Governments and central banks all over the world have taken unprecedented steps in the last few months to reverse the global economic meltdown, so far yielding little results. Most economists have accepted that this crisis is so deep that an L-shaped recovery is inevitable. A V-Shaped recovery is close to impossible due to the unfortunate and destructive nature of deleveraging. What started off as deleveraging at investment banks and writing off bad loans has morphed into a colossal global economic, finance and trade crisis. GDP's are being revised down, international trade and investments are falling, confidence levels are at record lows and the tentacles of this crisis have extended to affect even philanthropic and aid packages. A U-Shaped recovery cannot be ruled out, but for this to happen; the animal spirits of corporations, capitalists and bankers all over the world have to be rejuvenated and trust and confidence in the system must be restored.

Usually when governments try to, "help," economic recoveries always slow down and take time. And with billions being pumped in by governments, it seems clearer that global economies will take a long period to recover. 

Disturbing statistics

It's widely accepted that the root of this economic debacle was a decline in US home prices. Even though real estate prices in the US and around the world have taken a beating, more downside is inevitable if home prices have to revert back to long term means. In the US, home prices rose at an annualized rate of 0.7 percent from 1930 to 1997, and at a startling rate of 8 percent per annum from 1998 to 2006. This coupled with the outrageous trade and fiscal deficits that the US is burdened with will only aggravate the current crisis. Total US debt as a percent of GDP is increasing at unprecedented rates and savings of households in the US is at near zero levels. Knowing how indebted the US consumer is, it's only more discouraging when you realize that 70 percent of the US GDP is consumer driven.

The current crisis is already dampening consumer spending, but as time goes by deflationary pressures could have even more aggravating affects on consumer spending. Deflation is a vicious cycle that leads to lower wages, lesser spending, less capital expenditure and a depressed economic environment. Wages and incomes are not rising anytime soon, and it will only be a matter of time before employees are willing to accept wage cuts instead of a total job loss. This is when a deflationary cycle initiates, and lower consumer spending forces businesses to cut prices. Anticipating price cuts, both consumers and businesses will postpone spending which will only lead to a depressed economic environment.

 

The Indian picture

It'll be interesting to watch how corporate India and the country as a whole manages this downturn. This economic slowdown is the first significant and full-fledged slowdown striking the Indian economy after liberalization. We have experienced consistent growth over the last 18 years (since liberalization) and have not been confronted by anything of this scale and magnitude. We were relatively immune to the Asian financial crisis during 1997-98, and the dot com bust of 2001 helped rather than hurt our economy.

The resilience of our economy will be tested and decreasing foreign inflows and trade, will also measure the power and sustainability of our internal consumption levels. But we are far better positioned than many other emerging economies and will not be victimized by downgrades on government debt, etc, like Spain or Greece. The era of cheap capital came to an end in the summer of 2007, and countries around the world will have to access to capital at a much higher cost. Again, we will partially be immune to this because our foreign exchange reserves will help pad any significant impact. 

There are many aspects that affect an economy at any given time, and although it is challenging to quantify future foreign investments and assess the overall confidence in a country’s economy, our own Home Minister (and former Finance Minister, P. Chidambaram), once outlined major factors that affect a foreign investors’ decision making process. There could not be a better time to revisit these factors and assess them individually to see how well positioned India is to tackle this crisis.

The eight major risk factors are: Political risk, Security risk, Policy risk, Commercial risk, Legal risk, Legislative risk, Judicial risk and Regulatory risk. Let’s briefly examine each one.

Political Risk: With general elections less than 5 months away, political risk does exist and is an important factor. The outcome of 2009 general elections will decide who will lead India out of an unprecedented global economic crisis. The possibility of a third-front at the center not only adds instability to the government but uncertainty in corporate India’s mind as to what policies will be pursued. During these testing times, a steady hand is required at the helm.

Security Risk: Without doubt the Mumbai attacks elevated security risk to a new level. The magnitude and audacity with which the attack was carried out sent shivers down all our spines. This crisis can be used as an opportunity to improve our security apparatus to thwart future attacks. But unfortunately security risk remains high and this is not a very comforting factor.

Policy Risk: Although policy risk is not as directly tied to general election results as legislative risk there will definitely be some impact on policy making with a new government. While our fundamental long term growth policies are deeply rooted, many policy changes will be driven by the new government and might affect the way certain sectors of our economy function. For example, the different ministries like, the petroleum ministry, telecommunications ministry, ministry of power etc, largely affect how businesses in those sectors function. So any drastic changes that significantly affect our long term policies will be unwelcomed.  

Commercial Risk: Commercial risks exist everywhere and the general risk of being in business and succeeding is something that the business owner or proprietor largely controls. However, the general business environment when it pertains to corruption, level of transparency, accountability, etc, has drastically improved from a decade or two ago. This should not be a deterring factor.

Legal Risk: In the wake of an extraordinary corporate governance failure at Satyam Computers, all eyes are currently on the legal and judicial system in India. Although some commendable action has been taken, it’ll be important to watch how the legal proceedings of the case unfold. The magnitude and extent of the Satyam saga will mean the decision taken by the courts will leave a dominant precedent. The only other factor in this area is the ability to enforce laws well. Having world class laws means little if they are not enforced with authority due to fear of retribution. 

Legislative Risk: Legislative risk is again interrelated with political and policy risk. All these three factors, legislative, political and policy risk hinge on the outcome of the general elections in the next few months.

Judicial Risk: Judicial risk largely pertains to how our courts apply and interpret the laws of the land. This is driven by how well separated the judiciary, the legislative and executive branches of government are. Although it is generally accepted in India that there is some intermingling between the three branches, over the years, the judicial independence practiced has improved dramatically. So even though a factor, it would definitely not be a risk.  

Regulatory Risk: The biggest fear given the current global economic scenario is widespread protectionism for India or any other economy. This will drastically affect the progress of our economy, and take us backward rather than forward. If populous policies are followed and over-regulation or misguided regulation takes over, then our economic growth will slow down and eventually stagnate. Although a valid fear, over the years the loosing up of regulators and the freedom given to the markets is an encouraging sign.

So one can think, analyze and assess for themselves how India ranks in all these categories and come to a conclusion as to how well we are positioned for short and long term growth. 

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How Wall Street’s crisis affects the Indian economy
By, Adhvith Dhuddu

Wall Street’s landscape and the face of the US economy changed dramatically in the past few months. It’s famously known that when the US sneezes, the world gets a cold, and it’s looking ominously similar this time around. Despite the resilience and growing strength of the Indian economy, these changes will significantly affect Indian business, trade and commerce. It’s also becoming clear that our economy is in fact intertwined with the world economy and has not decoupled with the US economy in any way.

Risky leveraging by investment banks and a slump in the real estate markets in US were the root causes of this quandary which put the financial system in peril. In the last few years, the ability to leverage gave institutions on Wall Street access to ample capital and increased their risk appetite (which increased fund flows to emerging markets). Momentum built up in leveraging was felt across the globe as capital was pumped continuously into emerging markets and unconventional assets. But this financial fallout and recent government intervention has forced many firms to deleverage and use cash conservatively. The ability to raise $600 million with $20 million collateral (1:30 leverage) is a thing of the past and this will drastically impact capital inflows to India. We will see a significant slowdown in foreign capital inflows and foreign direct investment as a direct effect of deleveraging, inaccessibility to new capital and higher cost of credit in the US and Europe.

It’s extremely important to recognize that the accelerated growth in our economy was driven significantly by foreign investments, which are sure to dry up in the short to medium term. Not because India is a less attractive investment destination, but because of insufficient capital and inability to leverage available capital. When investment banks, hedge funds and high net worth individuals could borrow $1 billion with only $50 million in collateral (1:20 leverage), the $1 billion could be distributed to India, China, Brazil and Middle East into equity, real estate, commodities and fixed income assets. But when the amount available is only $50 million (no leverage) or $250 million (1:5 leverage), any amount of distribution to emerging markets and asset classes translates to less capital inflows into India and other emerging markets. This credit crunch, or more appropriately, “capital crunch,” forces us to realize that there is less capital available for disposal around the world.

Consequences of this fallout will be far reaching and be felt in emerging markets at least temporarily. The US is a consumer driven economy (70 percent of GDP) fueled by credit and buoyed by cheap imports; Asian economies that export heavily to the US will feel the pain as spending slows down and credit gets expensive. Here in India and in Bangalore, IT bellwethers, who garnered major portions of their business from financial companies, could feel the brunt when US corporations delay IT spending plans. Financial firms are struggling to capitalize even their daily chores, so this environment will undoubtedly create less spending and reserved capital expenditure plans.

Not only will this crisis dampen the mood of investors, but will send many of them into hibernation. A lot of wealth has been eroded in this financial crisis, and investors in the US are worried more about wealth preservation than wealth creation for now. More individuals and funds will look for steady returns with less volatility leading to more conventional and safe haven assets. A rush to quality will attract many investors to established economies like the US, UK and Japan. One argument is that companies in emerging markets are undervalued now and offer good bargains which should attract investors. But this is also true in developed markets where global giants like GE, Boeing and Microsoft are trading at extremely attractive PE ratios (Click Here: DOW 30 stocks with quotes, charts and key ratios like PE, EPS, etc). The only bright spot from a foreign investor’s perspective is the weak Indian currency. This is the only factor which could attract investors to India. The fall in the Rupee is a classic sign of foreign investors exiting India, at least temporarily. This decline doesn’t necessarily imply a weak Indian economy, but underscores the temporary rise in demand for the US dollar, as assets are sold all over the world and money is sent back to US to recapitalize banks and companies.

The drastic weakening of the Rupee (Click Here: US Dollar-Indian Rupee Chart) will be short lived as federal intervention and an increase in money supply will eventually dent the US dollar. The US dollar’s rise is temporary and is not being driven by a strong fundamental economy. Usually when any country around the world has a financial crisis, it’s cost of borrowing sky rockets, except for USA. When the US was in a full blown financial and economic crisis, the cost of borrowing for the US government was at an all time low, reflecting the raw power of the US, and the fact that humongous amounts of debt are transacted in US dollars.

Companies should incorporate this outlook into corporate plans and use this opportunity to rein in spending, accelerate cost cutting and optimize assets and resources in their organization. The future isn’t all that grim as a slower growth rate of 6-7 percent per annum is much better than no growth or negative GDP growth which the US has to confront soon. Many factors like increased local consumption, favorable demographics and a driven population will keep our economy and nation buoyant.

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FKCCI ARTICLE: JUNE/JULY 2008 ISSUE

GOLD WILL CONTINUE TO GLITTER

By Adhvith Muralidhar Dhuddu, Regular Columnist

There’s been much hullabaloo about investing in gold and gold related companies in the last few months. Although gold has historically been a low yielding investment in the long run, it has run up spectacularly and more than doubled in the last few years. With the stock markets in India, China and the USA in shambles right now and other asset classes drastically underperforming, investors are exploring safe havens like gold, silver (and other precious metals and commodities) to park their funds. But let’s look at some basic drivers of supply and demand for gold to see if it will continue to shine.

1. Inflation and Gold as a safe haven: Inflationary periods are detrimental to any economy and if high inflation persists for long, it consistently erodes the value of a country’s currency. Going back to the basics of money, we recognize that the primary function of money is: (a) to preserve value, (b) to be a medium of exchange and facilitate easy transactions, (c) to be a unit of account to help measure the value of an economy. The second and third function can be taken for granted as this is fulfilled irrespective of the type of currency or money used. But the most important function of money is to preserve and store value. If Rs.10 could buy you 5 tomatoes a few years ago, but can only buy you two tomatoes now, clearly the purchasing power of the currency has declined and it has failed to preserve value. Governments and central banks use politically appropriate verbiage and label this inflation.

When this phenomenon unfolds there is a rush to accrue assets that don’t decline in value and historically gold has been that safe haven. Gold is traditionally identified as a safe haven investment that preserves capital and increases in value gradually. But what is unfolding now is monumental because not only are emerging economies experiencing high inflation, slowly the US and the European economies will face inflationary problems. When this occurs, the rush to accumulate gold will drastically drive up the price with an increase in demand.

2. Gold investments via ETFs, ETN’s and increased access to retail investors: The only access individual investors had to invest in gold was jewelry and coins making it an illiquid and untradeable asset. But this is rapidly changing. Now, investors can buy, sell and trade gold with ease with the introduction of Exchange Traded Funds (ETF’s) and Exchange Traded Notes (ETN’s).

The boxed portion of the gold supply demand table below clearly reflects the rise in demand for gold by retail investors via ETF’s and other similar products. This is poised to increase tremendously as the demand to invest and trade gold continuously increases. The rise in popularity of these ETF’s and ETN’s is evident in the US markets and as other emerging countries’ financial markets mature to provide these instruments, the demand and popularity for them will increase. Another vital factor is that gold is considered a safe haven not just by US investors or households in India, but every individual, bank, and fund manager knows that gold is a safe haven investment and as access, liquidity and tradability increases, there will undoubtedly be more demand.

3. Role of Central Banks, Sovereign Wealth Funds and Foreign Exchange Reserves: As more wealth is created in third world and emerging economies and as foreign exchange reserves of export oriented countries continue to swell the demand for gold will continue to rise. The US Dollar’s recent decline has hurt the value of foreign exchange reserves forcing policymakers to identify another stable currency or any other form of capital preserving asset. And many central banks are slowly transitioning portions of their funds to gold, silver and other precious metals. Not only is gold turning out to be a safe haven for retail investors, even central banks and sovereign wealth funds want to park their funds in gold.

Nobel Prize economist Joseph Stiglitz clearly delineated in his book, “Making Globalization Work”, the flawed single currency reserve system. Many of the fears he outlined are slowly unfolding with the US dollar becoming a less favorable reserve currency. Allocators of forex reserves are prudently diversifying their funds by exploring other currency options like the Euro and Yen and safe haven commodities like gold and silver.

4. The Dollar Factor: The weakening of the US dollar has significantly affected the price of gold. Like crude oil, gold is a dollar denominated asset and its relative price has risen with the fall in the value of the US dollar. At least 15 to 20 percent of the price rise in gold can be attributed to the weakening of the US dollar.

Although the US Dollar/Indian Rupee relationship has been choppy, the overall strength of the US dollar (measured best using the US Dollar Index), which compiles the US Dollar exchange rates with the Yen, Euro, Pound, Swiss Franc and other major currencies has significantly declined. So the USD’s comprehensive weakness in the last few years helped inflate the price of gold, silver, steel, copper, crude oil, natural gas and many other US Dollar denominated commodities. Hence, going forward, the movements of the US Dollar will considerably impact the price of gold.

5. Universal demand and supply: Given below is a table outlining the worldwide supply and demand for gold in the last ten years. A comfortable balance can be observed in the supply less demand column which fails to explain why the price of gold has increased so much. What’s important now is not what the historical relationship was, but what will the supply demand relationship will look like going forward.

The increase in demand for gold going forward cannot be denied. Going forward, demand for gold to use in electronics, dentistry, and other industrial applications will only increase. But the supply picture for gold does not look very bright. Gold supply has increased at an average rate of 2-3 percent historically and this number is not about to change any time soon. One has to remember that the supply of gold is limited to how much gold is mined which limits the availability of this commodity.

6. Extreme Cases: Some economists have boldly predicted that the days of fiat currencies are numbered and the world will return to the gold standard. This could unfold if a major currency like the Dollar, Euro or Yen completely collapses or if inflation in developed economies like US reaches the stratosphere rendering paper money to be completely valueless. Although these are extreme cases nothing can be ruled out. In this case, the value of gold will also reach the stratosphere trading at eight to ten times of its current price.

Clearly, the current dire economic scenarios around the world, and other favorable factors outlined will send the price of gold higher. One should explore to see how they can diversify to include gold in their portfolio.

Federation of Karnataka Chamber of Commerce and Industry: April 2008 Issue
INFLATION’S LOOMING THREAT GOING FORWARD,
by Adhvith Dhuddu, Regular Columnist

The first four years of our Finance Minister’s term unfolded with buoyancy and resilient growth in most sectors. GDP grew handsomely, rising household incomes pleased the masses, corporate profits scaled new highs, the stock markets ventured into uncharted territory and prices across the board were relatively stable.

But the recent and sudden spike in prices exacerbated the looming inflationary threat and is creating jitters in the Finance Ministry, Commerce Ministry, RBI and more so at 7, Race Course Road, the PM’s Residence. Speculation about early elections is alive and well but even the regularly scheduled May 2009 elections could be marred with high inflation and outrageous price rises. This recent price rise is merely a preview of the agony faced by the electorate if appropriate measures are not taken to prevent further price rises and curtail inflation.

Recent measures taken during the damage-control mode seemed to have assuaged some pressures but pivotal factors which determine inflation (discussed below) are still at bay. Our FM, PM and RBI governor have vocally pledged that price stability

In a great nation like India, it is quite a pity when a starving family and has to make a choice between food and medicine when somewhere in the country food reserves in godowns are rotting.

is a high priority objective and are even willing to sacrifice growth to suppress inflation; a positive sign. But let’s examine what the FM has said before about inflation, price stability and monetary policy to measure him against his own benchmarks and analyze some root causes of inflation to tackle unfavorable price rises in the future.

Economist John Maynard Keynes said, “Inflation is a form of taxation which the public find hardest to evade and even the weakest government can enforce when it can enforce nothing else.” This invisible tax eats into the savings and incomes of the rich and poor alike, but impacts the lower rung more. In a developing economy like ours, the absence of a social security safety net and absence of income and employment insurance in the unorganized sector (which employs a significant portion of our population) severely aggravates the inflationary consequences for lower and lower-middle class families. The published inflation rate clouds the all important rate of increase in the price of basic food which affects the majority of our population. For example primary articles (which comprises 22 percent of the WPI and contains food articles) registered a growth of close to 9 percent at March end.

Many attribute the current spike in inflation to global externalities like widespread commodity price rise, supply shortages, demand increases, etc. This is true only to a certain extent as these trends have been in place for sometime (1-2 years). There are some reasons unique to India which is driving up inflation and needs to be tackled. Here are some of the fundamental macro issues causing inflation (and will continue to do so if they are not confronted).

1. Outrageous Money Supply: Going back the basics of inflation you learn that it is primarily caused by money supply issues. A continuous increase in money supply creates a situation where more and more money is chasing the same number of goods and services and this automatically drives up prices (irrespective of the supply-demand equation of the product). The importance of this characteristic cannot be stressed more because it has been the primary cause of high-inflation periods in recent economic history. USA (1973-1982), Germany

A continuous increase in money supply creates a situation where more and more money is chasing the same number of goods and services and this automatically drives up prices.

(during the 1970s) and Japan (1971-1980) experienced high inflation during the periods mentioned. All these were caused due to an increase in money supply and the central banks of all these economies had to drastically reduce money supply and increase interest rates to squeeze inflation out of the system.

Looking at the numbers from the recently released Annual Policy Statement 2008-09 from the RBI (abbreviated as RBI-APS-0809 for future references) proves the above point. According to the report, money supply (M3) increased by 20.7 percent in 2007-08, and 21.5 percent in 2006-07. Supply of money in the form of bank credit to the commercial sector increased 20.3 percent and 25.8 percent in the preceding two years respectively. All these increases are above the long term average rate of money supply growth in India. In fact later in the report RBI even acknowledges that, “money supply has risen above indicative projections,” and hence has decided to slow the printing presses. They plan to moderate monetary expansion (i.e. money supply) this time around only at 16.5-17 percent. The RBI deserves restrained applause because this is a step in the right direction and the problem is being tackled at its root. This is just the start and there should be a continued effort to control the supply of money, or we could see multi-year inflationary periods like the ones experienced by USA and Germany in the 1970s.

A common argument that is cited to support the increasing money supply numbers is the increase in net capital inflows. I will discuss this in detail later.

2. Inefficient Food Distribution Channels and Farming Techniques: Anyone blaming the supply-demand mismatch for recent price spurt in food articles needs to think twice before making that claim. The Ministry of Agriculture recently released numbers stating that, “total food grain production is expected to increase to an all-time high of 227.3 million tonnes in 2007-08 from 217.3 million tonnes in 2006-07.”

So, if the increasing disposable income of families is being reflected in the increased demand and supply of food is at record levels, why is it that food prices are going through the roof? It’s a simply because of horrendous and outright awful supply chain management and distribution techniques (or lack of them) that is driving up prices. The various middlemen coupled with rotting grains in the warehouse automatically decrease supply and increase the prices. No rain God, clearing of debts, increasing of fertilizers, giving free electricity or water, increasing/decreasing all sorts of taxes and duties, banning and placing limits, etc will solve this. It’s been tried repeatedly and has failed miserably. It’s pretty abysmal when our farmers are toiling hard in the fields only to see significant portions of their crop rot in godowns because of inefficient food and crop management.

In a great nation like India, it is quite a pity when a starving family and has to make a choice between food and medicine when somewhere in the country food reserves in godowns are rotting. We boast of churning out quality engineers, being home to IT behemoths and rich industrialists, but these are insignificant if we cannot feed our own people well. India’s food economy has to be strengthened and some basic steps like improving distribution channels, optimizing supply chains improving storage facilities must be undertaken. Knowing the unreliable nature of our government especially in the agricultural sector, the best way of doing this is to introduce competition. This should be a long term commitment and will eventually be undertaken when there is a crisis, like how the

Artificially keep the Indian Rupee (INR) undervalued vis-à-vis the USD by pumping in billions of dollars is analogous to pouring money into a bottomless pit for short term happiness. This flawed approach to undervalue the currency to improve growth is wrong and unsustainable in the long run.

foundations of our economy were reformed during a crisis. When a patient’s veins or arteries are clogged hampering the blood circulation, the doctor does not pump in oxygen, replace a leg or a hand, or improve the condition of the blood, he tries to open up the arteries first to improve blood flow and then tackle other issues. This is what needs to be done in the agricultural sector in India.

3. Misguided Currency Management: The misconception that a weak currency vis-à-vis the US dollar (USD) is good for Indian businesses because it serves as a backbone for export oriented businesses is widespread in India. The cheer leading from export oriented industries and export lobbies to artificially keep the Indian Rupee (INR) undervalued vis-à-vis the USD by pumping in billions of dollars is analogous to pouring money into a bottomless pit for short term happiness. This flawed approach to undervalue the currency to improve growth is wrong and unsustainable in the long run.

I agree that advocating an absolutely hands-off approach could be detrimental and make our currency extremely volatile creating ripples in the economy. Instead there should be a slow process of decontrolling currency valuation to allow the market forces to operate with relative freedom and enable price discovery. Another option is to allow the value of the INR vis-à-vis the USD to rise faster.

Besides helping the fight against inflation a strong local currency is beneficial in other ways. A stronger INR will automatically reduce food exports, keeping more food at home, hence increasing supply. Our strong currency will also increase imports

There should be a slow process of decontrolling currency valuation to allow the market forces to operate with relative freedom and enable price discovery.

of food because the same currency can now buy more hence increasing supply again. The government can then refrain from the ancient and unsuccessful policies of raising and lowering duties, banning and limiting stocks, etc. The increased purchasing power of the INR will be able to buy more products for the same amount of money. All this will automatically reduce inflation because of an immediate increase in supply and stronger currency being able to purchase more. There are some caveats associated with this technique but if executed with precision, it can work well.

Coming back to the argument that money supply should grow to support net capital inflows, we can see how a stronger currency can solve this too. According to RBI-APS-0809, “net capital inflows surged by 172 per cent to $81.9 billion during April-December 2007,” requiring the RBI to increase the supply of Indian Rupees. In lay man’s terms, over the last few years the demand for our currency has gone up but that strength is not reflected completely at the current price of our currency. Its common sense that demand for a certain product increases in the financial markets when the market perceives it to be undervalued and slowly reduces when the market thinks the price is fair.

But, in the case of the Indian Rupee, because the value of the currency has been artificially suppressed, the demand for it doesn’t seem to go away. The government ends up fighting a battle on two fronts: it has to continue to keep the Indian Rupee undervalued (to help exporters) by pumping money, but also try to decrease the demand for

Increasing the currency’s strength will mean less money needs to be printed to support net capital inflows, less money needs to be printed to support artificial currency valuation and less money needs to be printed as the purchasing power of our currency increases, eventually also helping tame inflation.

the currency so that market forces don’t overwhelm governmental force suppressing the price of the Indian Rupee. Finally the government has to continue printing more money to support the required payments to keep the INR undervalued. As capital inflows increase, as demand for local investment increases, and in general as the demand for INR increases it should be reflected in the currency, but it is not. So allowing the currency to strengthen will automatically relive the pressure to continue increasing money supply at high rates. Increasing the currency’s strength will mean less money needs to be printed to support net capital inflows, less money needs to be printed to support artificial currency valuation and less money needs to be printed as the purchasing power of our currency increases, eventually also helping tame inflation.

Consider this practical case: A year ago the central bank was making a valiant effort to keep the Rupee at 44-45 levels (vis-à-vis the USD), but eventually gave in when they were overwhelmed by market forces (and also the rising cost of suppressing the INR) and stepped back to allow a 10-15 percent appreciation of the Rupee to 39-40 levels. What about the approximately $120 billion pumped in to keep the Rupee at 44-45 level? It’s gone, wasted and will never come back (i.e. being held in USD denominated assets); in fact its value has now decreased because the US dollar has depreciated vis-à-vis the Rupee (imagine if this money could be used in more productive ways). History has shown repeatedly that as an economy strengthens, over the long run the value of its currency will rise. It is basically pointless to continue pumping money continuously to keep the currency at an artificial level. Think of the same situation two years from now when our government will again struggle to keep the Rupee at the 39-40 level by pumping in money and again give up to let it rise to the 35-36 level. With the democratization of finance and integration of financial markets over the globe it will become increasingly difficult and expensive to control currency values.

4. Flawed analysis that banning exports, tweaking import/export duties, fixing stocks levels, etc will solve the inflation problem: For some reason, our politicians and bureaucrats don’t seem to understand that these temporary tweaks will not solve inflationary issues in the long run. Generally, a complete scrap of import or export duties is good, but banning any kind of exports or imports, mandating stock levels, etc is unacceptable in a capitalistic and forward looking economy like India and is synonymous to going one step forward and two steps back.

On monetary policy, the FM said a few years ago that, “Unless we bring the fiscal deficit down to 3 per cent or below, we cannot gain mastery over inflation.” The finance ministry along with the RBI has worked diligently to achieve this number and have to be given credit for their efforts. On last count, the Gross Fiscal Deficit (GFD) for 2007-08 constituted 3.1 percent of GDP (from RBI’s Annual Policy Statement 2008-09). A significant assist from increased tax revenue cannot be denied and definitely contributed to this achievement.

There is another crucial reason that inflation needs to be brought under control. High inflation rates usually results in an ultra-low or negative net savings

But our Finance Minister certainly deserves credit for his ability to be able to balance the demands from the left and the right, the aam admi and the corporations, the public and the private sectors.

rate. According to our own Finance Minister, “High inflation and a negative return for depositors/savers make for an explosive combination, when key elections are round the corner.” (November 2^nd, 2003). Let’s see how our captain navigates this ship going forward.

It’s a relatively stress free job to analyze numbers, rely on theories and suggest remedies for the problems facing the economy right now. But our Finance Minister certainly deserves credit for his ability to be able to balance the demands from the left and the right, the aam admi and the corporations, the public and the private sectors and still manage to keep India’s growth intact and its flag fluttering proudly in the sky.

Money WhizDom: Demystifying the Bear Stearns fallout: The week that prevented global financial calamity.

By Adhvith Dhuddu, Regular Columnist

The US hasn’t been confronted by an economic tsunami of this proportion since the Great Depression. Although the downturn in the Indian stock markets was evident, the global repercussions could have intensified if the Fed’s antidote was considered insufficient. Many around the world failed to realize the gravity of the crisis because the Feds actions prevented a sudden and sharp downturn.

Never before has the US economy been confronted by so many issues that are affecting their fiscal and economic report cards, businesses, individuals and government. Its facing declining stock and real estate prices, increasing food, commodity and energy prices, weakening dollar, trade and fiscal deficits, increasing unemployment and inflation, decreasing investment, stagnant productivity levels, low confidence levels, decreasing consumption, low saving level, increasing cost of debt in a credit dependent economy, and to top it all off the failure the world’s fifth largest investment bank, Bear Stearns.

Many on Wall Street were aware of the pessimism surrounding Bear Stearns, but the severity of the fallout was what shocked investors and caught them by surprise. The implosion of Bear Stearns indicated a lot more than the dampened psychology on Wall Street. This fallout clearly showed how financial engineering and innovation outpaced the federal financial market regulators who were caught off guard, desperately trying to save face and avert a lock down of the financial system in the country (and around the world).

To understand what exactly happened at Bear Stearns, one has to put together a few pieces of the puzzle. The crisis that unfolded here was primarily driven by a liquidity crunch or in simple terms a lack of cash to meet day to day activities. Complex financial trades performed by investment banks require them to put up and receive large amounts of money (tens of billions) on a day to day basis, making them heavily cash dependent. The fluctuating values of its investments are why large sums of money flow in and out daily.

Investment banks are unique in their practice of using extremely high leverage to maximize their returns. A Lehman Brothers or a Goldman Sachs can approach a bank, put up $1 billion in assets as collateral to receive say $30 billion dollars to invest with, and this would be 1:30

This fallout clearly showed how financial engineering and innovation outpaced the federal financial market regulators who were caught off guard, desperately trying to save face and avert a lock down of the financial system in the country (and around the world)

leverage. Although it sounds outrageously risky, investment banks thrive on this luxury, something that banks and investment firms in India don’t completely indulge in. Bear Stearns in particular was highly leveraged, as high as 1:40 in some sections of its business.

The commercial banks like JP Morgan, Bank of America or Wachovia, who provide highly leveraged cash, can anytime call upon the investment bank to put up more collateral if they feel the investment bank has immersed itself in bad investments that are rapidly losing value.

Bear Stearns was whacked with a double whammy, when distressed investors started to pull out cash and some of their investments started to decline rapidly, the commercial banks demanded more collateral. Bear Stearns slowly drained their cash reserves to meet collateral demands, handicapping them on a daily basis. Their cash reserves declined from $17 billion to less than $2 billion in just four days, sparking a bank run. Having run out of cash they couldn’t clear trades on a daily basis, were unable to provide more collateral and couldn’t repay many investors.

This is when the Federal Reserve stepped in via JP Morgan to bail them out by providing emergency funds to continue daily activities, without which the complete financial system could have gone into a seizure.

It's important to distinguish an investment bank from a commercial bank to understand JP Morgan's involvement. Individuals park their savings in commercial banks which are insured in USA by the Federal Depository Insurance Corp (FDIC) for up to $100,000 per account. It’s common knowledge that the central bank of a country (in this case the Federal Reserve) is the

After starving off a bankruptcy at Bear Stearns and realizing the severity of the liquidity crisis surrounding investment banks, for the first time in 95 years (since its inception in 1913), the Federal Reserve opened the discount window to investment banks.

primary source of money and the lender of last resort, but only commercial banks have direct access to these funds via the discount window (i.e. rate at which they can borrow from the central bank). Commercial banks can borrow directly from the Federal Reserve, something an investment bank cannot do. Investment banks are not closely regulated by the government, which is why they cannot borrow directly from the central bank.

This is precisely why the Fed had to allow JP Morgan to borrow massively, who then turned around and lent to Bear Stearns just to keep the company alive. The Feds couldn’t have lent to Bear Stearns directly and had to lend via a commercial bank. One could ask why not Citigroup or Wachovia or Bank of America, as they are also commercial banks. Unfortunately, these banks were preoccupied with cleaning up their own sub-prime mess, and JP Morgan was the only unscathed banking still standing tall on Wall Street.

When JP Morgan acquires Bear, it will primarily be for Bear Stearns' highly successful prime brokerage and clearing businesses. The two other divisions: investment banking and investment advisory are of little value to JP Morgan as its own investment banking division is a world-class setup. There was a lot of clamoring when the takeover price of $2/share was announced (now increased to $10/share), saying the company has been tremendously undervalued. Many critics might be proved wrong because the amount of garbage on the balance sheets of Bear Stearns might actually mean the company is negatively valued at say negative $10-$15 billion affecting JP in the future. But because JP Morgan has a $30 billion backing from the Fed, it might siphon off all the bad investments onto the Fed and retain the good ones eventually having little to no affect on JP.

After starving off a bankruptcy at Bear Stearns and realizing the severity of the liquidity crisis surrounding investment banks, for the first time in 95 years (since its inception in 1913), the Federal Reserve opened the discount window to investment banks. This revolutionary move has so far warded off failures at other investment banks and also reflects enormity of the crisis. Clearly the Fed realized that desperate times call for desperate measures.

Regulating investment banks and hedge funds is extremely tricky. The quantitative and mathematical nature of their operation requires them to trade equities, bonds, debt, forex, futures and options in large quantities at lightning speed. The positions on their balance sheet change literally every day making the risky and highly leveraged nature of their positions complicated for regulation. Although the Federal Reserve knew of the threats posed by this due to their closely intertwined nature to the financial system, they never saw the need to regulate because of the high level of counterparty surveillance at investment banks and hedge funds. The

The most apparent global impact is the severe dent on the psyche of the investors from Wall Street to the Great Wall. Besides the increased cost of debt, the cost of insuring and securitizing debt has also gone up.

last time counterparty surveillance failed was the 1998 collapse of Long Term Capital Management hedge fund. Although the Bear Stearns collapse was primarily driven by a liquidity crisis, it can partly be blamed on failure of counterparty surveillance.

The impacts of this event have been widespread. The increased cost of capital has had a major blow on the investment banks forcing them to decrease their leverage significantly in the recent weeks. The most apparent global impact is the severe dent on the psyche of the investors from Wall Street to the Great Wall. Besides the increased cost of debt, the cost of insuring and securitizing debt has also gone up. Decreased liquidity in these markets is also a valid concern.

One disturbing parallel this crisis draws with the Great Depression is that in both cases banks caved in. The Great Depression saw widespread failures of commercial banks (this is when the FDIC was introduced) and this time an investment bank which specialized in advanced investment strategies like sub-prime mortgages and quantitative trading fell through. Despite their functionary difference, in both cases they perilously threatened to crumble the complete financial system and freeze liquidity. Note that the Great Depression witnessed widespread failures of banks; in this case, we have only seen one investment bank fail. Any more nasty surprises could cripple the already strained financial system, fueling speculation of a depression or a longer-than-anticipated recession.

History has proven that the US economy is one of the most resilient and nimble structures around the world. It has braved diverse problems from accounting scandals to bank failures and continued to roar forward. This is largely attributable to the strong foundations and competent regulatory institutions. Although this down phase is looking different one can be sure that when the bad times pass, investment opportunities will open up.