The INR has been the worst performing currency in the last quarter, dropping from ~INR 45 to the dollar to ~53.50 earlier today. The RBI, while prepared to intervene, has indicated that its war chest is not quite large enough and will only serve to dampen the moves. With no respite in sight, India’s import bill is set to rise dramatically. On top of this, with high inflation and rising perception of corruption in the country (India fell from the 87th to the 95th position in Transparency International’s corruption index), capital inflows through portfolios as well as FDI are likely to continue to recede. The Balance of Payments (BoP) situation is likely to deteriorate. To an extent, the currency depreciation is itself an indicator of the rising perception of this. A slowdown in the west which would dampen software/services (IT and ITeS) exports, and an increasing risk-off attitude which accelerates capital flight can combine with the above problems to form the perfect storm.

Unfortunately, policy in India is at a stalemate. The recent roll-back of FDI in Retail is, in my opinion, a very bad sign. Being an economist and a survivor of the ‘91 BoP crisis, Mr. Manmohan Singh probably stays awake at night worrying more about that than the mess that his colleagues in the UPA have created. Unfortunately, he does not seem to be in a position to do anything about it - yet. The RBI, which has been trying to fight inflation for the last one year, unfortunately, is now in a jam. Any more rate increases and it risks a massive collapse in industry. On the other hand, the rate increases seem to have done nothing to stem rapid rise in prices. The RBI has complained that without fiscal discipline (which I read to mean cutting back on populism) on the part of the Government, it cannot handle the inflation problem alone. That brings us to the other big problem. If there is one thing the UPA Government is committed to, it is giving out easy money to keep its electorate happy. So there is little hope of fiscal discipline.

Here’s a summary of all that is scary:
1. the deteriorating rupee - leading to a rising import bill
2. high corruption perception - leading to capital flight
3. slowdown in the west - leading to shrinking demand for Indian exports
4. high inflation - stoked by supply side problems and Govt’s fiscal profligacy
5. industrial slowdown - prompted significantly by RBI’s hawkish stance to curb inflation
6. persistently high oil prices - impacting our import bill (this is the only factor which might reverse trend if a global slowdown materializes)

So is a crisis at hand? If the rupee fails to stabilize even at this level, we could see a dramatic panic and the Government could be forced to push through reforms despite any expected political fall out. The only hope is that they still have the guts and integrity to do so.

Don’t attempt to balance the budget – right now

The current financial crisis has been complicated by the incredible debt overhang in several parts of the developed world. At a time when counter-cyclical deficit spending is most required, doom-sayers are predicting widespread sovereign defaults/devaluations preventing a rational discussion on fiscal policy. I am not arguing that it is alright to have so much sovereign debt (almost everywhere in excess of 50% of GDP, with the US approaching 100% and Japan already well beyond 200% of GDP). However, this is not the time to try and reduce this debt burden. The debate, so far, seems to be stuck at this level – whether deficits should be reduced or allowed to grow. To my mind, that question is moot at this time. The real question should be, if the Government is to spend borrowed money, where should it be spending it.

The point that most supporters of deficit spending seem to have missed is that you cannot keep running deficits perpetually and not care about the absolute debt burdens – not even the US which enjoys the right to print the reserve currency of the world. Like any sensible debtor, debt must be taken on to finance projects which can eventually pay off the debt as well as any accrued interest. In questions of public policy, the increased welfare of the people might sound like enough return on investment but the actual money does have to be returned to the lenders (especially if they are foreigners like China in the case of the US). Therefore, the question should be, when the Government invests in this or that project or programme, would it translate into increased revenues in the future to be able to pay down the debt taken on to finance that programme.

Do not get tempted to create long-term entitlements

In light of the above, it becomes evident that creation of long-term entitlements should not be the focus of deficit spending, especially when the balance sheets of Governments are already so strained. While the immediate effect of increased entitlements may have a beneficial effect on the economy, the problem with entitlements is that they are extremely hard to withdraw. The purpose of deficit spending, as we saw above, is to act as a counter-cyclical force to ensure that the economy does not settle into low-employment, low-production equilibrium. The flip side is that when the economy begins to recover, it should be possible to withdraw this countercyclical force. Entitlements, therefore, do not fit the bill.

The Social Security system in the US, though, is a good example of a counter-cyclical incentive. As the economy slows and employment drops, the social security spending automatically increases as jobless claims increase. Similarly, when the economy begins to grow again, jobless claims drop and social security spending drops. This works well. Medicare, on the other hand, does not seem to have this counter-cyclical nature and therefore would not qualify as a valid programme to support with borrowed money.

Focus on capital development projects which were ignored during boom-time

The free market economy, with its narrow self-interest, will often fail to build infrastructure that requires widespread coordination or to provide goods or services to those most in need of those things. For instance, when rural connectivity is poor or incomes are low, service providers shy away from investing in infrastructure that can service those poor areas. Through Government intervention, however, the seeds can be sown that eventually make it feasible and worthwhile for the private sector to supply services there, indeed make phenomenal profits. Case in point is the insistence of the Government of India that banks have at least 25% of their branches in rural areas. To begin with, this might be money loser. However, as these areas get better integrated into the banking system, they might participate in the national economy much more effectively. With an increased ability to pay for goods and services, these areas suddenly become attractive to the rest of the private sector. A virtuous cycle is set in motion.

The lesson is clear. The Government should focus tax incentives (and other subsidies) towards the creation of infrastructure that was heretofore ignored by the free markets. Transportation networks, communication networks, power delivery, banking, logistics etc. This infrastructure creation can stimulate altogether new activity, which might not have existed even during the previous up-cycle. Increased revenues from heightened activity and productivity could eventually pay off the for the subsidies and tax incentives provided.

Should the Government itself get into the business of building this infrastructure. I find it hard to agree. Even though it seems to be easier to do it oneself than to incentivize the private sector, the dangers of waste, delay and leakage are far too great in Government enterprises to merit serious consideration. The National Rural Employment Guarantee Scheme in India is one such example.

Ensure mechanisms of scaling back as private sector takes over

The last, and most often forgotten aspect is the necessity of the scaling back of deficit spending as the economy recovers. As the economy moves into recovery and then to the cyclical boom, the Government should strive to run a surplus to pay down the debt put on during the slowdown phase. The hand off to the private sector should be built into the project proposals so that future political bickering and strength is not required to do the needful. Entitlements, as discussed above, rarely allow for simple scale backs. Even temporary tax incentives are difficult to suspend although not as hard as entitlements.

In this context, the insistence of Republican lawmakers in the US that the deficit be reduced is sensible but badly timed. The deficit reduction should be back-loaded with little to no reduction currently. On the other hand, the spending itself should be refocused towards development projects instead of the creation and expansion of entitlements like Medicare, etc. Similar ideas apply to all countries struggling with this problem. The specific projects they undertake, of course, would depend on specific circumstances.

Conclusion

The markets work fine under normal circumstances and the role of the Government, at these times, should be that of an enforcer of the rule of law and a passive observer. When the economy slows and market failures become evident, the Government must act as a countercyclical force, with a longer term view which private individuals and corporations may not have. Programmes must be designed which stimulate the economy in the short run but also ensure an adequate return on investment to be able to pay down the borrowed money and the accrued interest. These programmes must also be designed with an ability to be scaled back as the economy gets back on track and free markets can run on their own strength. This is a complicated dance but, in my view, the only way to have stabler economies and societies.

This note was originally written for the clients of Third Wave Solutions Pvt. Ltd., on September 9th, 2011.

The Eurozone crisis has now put us on a really important historical pivot. Historical in the sense of millennia, not decades. Human civilization has come a long way from hunter-gatherer groups of yore. Members of these groups were relatively friendly to each other and extremely hostile to outsiders. By and by, trade was discovered and these groups became less hostile as trade made friendliness to strangers necessary. Life improved and group sizes increased. It grew into clans and then to small villages (with the advent of agriculture). “Politics” was limited to the village with the elders making rules and adjudicating over disputes.

With time, plain barter was replaced with shells and pretty stones. Trade increased and began happening over longer distances. Trade routes took shape and became important. As distances increased, pretty stones and shells were replaced with precious metals. As trade became easier, the world became a smaller place. Cities turned into city-states with spheres of influence spreading out further and further. After centuries of having city-states came the inevitable consolidation – the nation. While it can be argued that the emergence of countries was a socio-political development, it was as much a consequence of economic factors as anything else.

The present Eurozone (or European Union) is the next step in that evolution of civilization. It is a grand experiment for taking the scale of aggregation to the next level. The result of this experiment, which was set in motion about 60 years ago with the Treaty of Paris in 1952, will tell is if we have the ability to live in larger political aggregations as human beings. Arguably, we already live in larger aggregates (India’s population is almost twice that of the European Union as it stands today). However, the question is whether it is possible to stitch together these incredibly diverse populations into one centrally governed entity. Indeed, is it possible to stitch them together even in a suitably federal structure?

Were the Eurozone experiment to fail, we will be set back by decades if not centuries in our quest for greater and greater cohesion amongst the residents of this planet. And if we succeed, we could see a flurry* of aggregation, ASEAN, SAARC, Organsation of African Unity (OAU). We live in interesting times indeed.

* In the context of political reorganisation, when I say flurry, I’m thinking on the lines of a 100 years rather than a decade.

This note was originally written for the clients of Third Wave Solutions Pvt. Ltd., on August 22nd, 2011.

There’s another factor which I think is very important, and I think that is between direct
strategic investors and portfolio investors. We are portfolio investors; we are passive. For the most part we’re passive investors. And in the case of the direct investors—who are the major multinationals who come in, build a plant, and take majority control—we’re quite different, because we are actually empowering the local management. We’re telling them: “Look here’s money; you do with it whatever you will. As long as you make this company prosperous we will be happy, because we are partners with you.” In the case of the strategic investor, they say: “Look, get out of here. We’re taking control. We will run this company, and we will do whatever we want, and if we don’t want local people around we can do so; we can throw the local people out.” So there’s another very important distinction to make, which is the reason why very often we’re in conflict with strategic investors is because their interest may not be aligned with the domestic companies’ interest.

Am I in agreement with him? Not quite. His own thought-process might be that of a long-term partnership but I have little doubt that a lot of the FII flows, especially the ones being seen currently in EM economies is purely liquidity driven seeking high returns instead of the artificially low rates in their home countries. Once the monetary stimulus in the US (and EU) is withdrawn credibly, we will likely see a dramatic drop in prices. The flows that come back after that.. those are the ones that might have the stamp of long-term partnership.

[Given that the interview was 10 years old, its likely Mark Mobius also believes the current flows are unsustainable. So I don't disagree with him as much as I think that there will be nicer investment opportunities as the taps are turned off half-way across the globe]

As Matt Ridley points out in his recent book - The Rational Optimist - improvement of technology allows the creation of goods and services at lower costs and lower investment of man-hours. This makes goods cheaper in the economy making more money available for creating demand for completely new goods and services. Labour, which has been freed up by technological innovation can then go about providing these goods and services. Everybody wins and standards of living rise. There is one catch though.

The creation of new goods and services by the same labour force assumes that the individuals of the labour force are capable of acquiring the skills required to provide these new services. This is not an ordinary requirement. Decades earlier, a person could go to school (or join an apprenticeship) to acquire a skill in early years and then reasonably expect to be able to live off that skill for the rest of his life. This is no longer the case today. As Alvin Toffler points out in his seminal work - Future Shock - the pace of technological change in society has increased to the point where it begins to have an impact due to its sheer speed, irrespective of the direction it takes. The future can arrive too quickly for too many people. A skill acquired today can lose its value in well under a decade. Someone who learned to use the internet (even email) in the mid-90s probably had a significant “edge” over his peers. Today, it barely counts as a skill.

While the necessity of continuous skill acquisition and upgradation becomes ever stronger, it simultaneously becomes harder to pick up new skills. Education is vastly more specialised and intricate today and takes longer to acquire (courses in medicine can take almost a decade in some countries). What is required is a radical transformation in the way education and skills are delivered to students. At a more fundamental level, the organisation of knowledge itself has to be transformed in a way as to make it more accessible for non-specialists. The millions of specialised branches have to be re-organised in a manner so that cross-fertilization of ideas across specialisations becomes easier and more effective. On top of this transformation in knowledge representation, the education system has to develop methodologies to teach students to exploit this restructured knowledge-base more effectively.

At a policy level too, Government and policy-makers have to stop fretting about jobs being lost to technology. There also has to be a push to reduce incentives for people to remain stuck in low-productivity jobs - for instance farming in India. Policy-makers are doing a great disservice to the country and to the farmers themselves by directing fiscal spending towards recurring subsidy programmes instead of focusing on alternate skill development within rural communities. The skill-development approach alone can help these people escape permanent poverty while enhancing their productivity and helping the country reap the anticipated “demographic dividend”.

Indian business houses are already going for Australian mining assets with considerable aggressiveness, building railway lines from the mining hinterlands to ports which are also in some cases being developed by Indian companies (Adani group comes to mind). Does this mean that we can expect a sustained improvement in the Australian and Canadian dollars.. basically commodity currencies? And what does this mean for the competitiveness of other Australian exports? The strengthening currency should also lead to greater import demand further hurting domestic manufacturers. Can Australia slip under the standard curse of mineral resource rich countries?

The prevailing exchange rate system is lopsided. China has essentially pegged its currency to the dollar while most other currencies fluctuate more or less freely. China has a two-tier system in which the capital account is strictly controlled; most other currencies don’t distinguish between current and capital accounts. This makes the Chinese currency chronically undervalued and assures China of a persistent large trade surplus.

Most importantly, this arrangement allows the Chinese government to skim off a significant slice from the value of Chinese exports without interfering with the incentives that make people work so hard and make their labor so productive. It has the same effect as taxation but it works much better.

““People are wise enough to understand that excessive populism should not be allowed to derail the progress our country is making”

This coming from a PM whose Government is running a 50k crore NREGS scheme and has waived off 70k crores in farm loans, amongst other things.

I’m all for deregulation of fuel prices but this should have been accompanied by a decrease in the ridiculous Rs. 14+ excise duty and Rs. 7.5+ sales tax that the Government collects on petrol. Given that the burden of issuing oil bonds would reduce (or go away completely) with this deregulation, the tax burden should be reduced too. But of course, that is not going to happen for who will then finance their profligate populist schemes that they use to buy their precious votes at the polling booth.

The State should not tear apples from the tree of economics. What it should do is help to grow our apple orchard…