Looking Out Across The Horizon

The INR took a massive hit yesterday and overnight after the latest IIP figures finally established what many already knew - the economy is hurting, and its bad. Industrial Production came out lower by 5.1% y-o-y and equity markets soon followed it down, shedding over 2% of the index value after the numbers were announced at 11 AM. But if it were only about equity markets, it wouldn’t mean a thing. The problem is the currency; and the politics.

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.

Parijat Uncategorized Economy, Finance, linkedin, Politics

When John Maynard Keynes propounded his General Theory of Employment, Interest and Money in 1936, the world was in the throes of the Great Depression. Market forces had failed to do anything to revive the economy. Even Roosevelt’s attempt at public works and subsidies were not having effect – partly because he was still trying to “balance the budget”. The fundamental point of Keynes’ theory is that free markets do not necessarily result in full employment nor in the economy producing at potential GDP. When the economy slows and confidence gets eroded, the Government needs to step in with deficit spending to keep the wheels moving. With the starting of the Second World War in 1939 and with the US itself jumping into the fray in 1942, deficit spending was forced upon the Government and the economy. And while humanity suffered, the economy recovered. We are at a similar junction of a slowing (or very slowly recovering) global economy; and to my mind, what needs to be done is reasonably clear, if not straight-forward.

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.

Parijat Uncategorized Economy, Finance, linkedin, Politics

The world markets as well as politicians are watching the Eurozone very closely recently. Many are waiting with bated breath to see if Germany and France will be able to lead the Eurozone out of its current sovereign debt crisis and chart a stable course going forward. However, that is not what this note is about.

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.

Parijat Uncategorized Economics, History, linkedin, Politics, Society

I just came across an interview PBS conducted with Mark Mobius (for some weird reason the transcript is not dated but the interview doesn’t sound like being very recent It was conducted in May 2001). So anyway, Mark Mobius has an interesting twist on the Passive Portfolio Investor vs the Strategic Investor/FDI-type investor. He makes out that the international passive portfolio investor is in some ways better than the strategic investor because he is letting the management do their thing and is only providing money while letting them do what is right for the local economy etc as opposed to serving the purpose of the strategic investor. This is also related to the hot-money question so often raised in emerging market economies. Here’s the actual excerpt:

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]

Parijat Uncategorized Finance, Investing, linkedin

John Maynard Keynes coined the term “Technological Unemployment” back in the 1930s in a letter “Economic Possibilities for our Grandchildren”. The term implies the unemployment that is generated because of the replacement of manual labour with technology. When one puts it like this, it sounds like a bad thing. However, this is not the complete picture.

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”.

Parijat Uncategorized Economics, Education, Government, linkedin, Policy, Technology

The IMF Regional Economic Outlook (Asia and Pacific) published in April basically suggests that the recovery in Asia is on a decent track with regional and domestic demand playing an important role in the recovery. Chinese and Indian economies “are presumed to expand by 9.5% and 8% respectively … with important spillovers for other countries… , particularly through demand for commodities.”

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?

Parijat Finance commodities, currencies, Economics, linkedin, mining

A step many thought should have been taken much earlier has been perfectly timed by China as it sold off over $70B worth of US treasuries in May. I would see it as the ultimate contrarian move. At a time when the Euro was taking the worst beating in over a decade of its existence and US treasuries (and bonds) were at astoundingly low yields, China dumped some of its holdings into the frantic treasuries market and switched to European bonds instead. The timing couldn’t have been better as they were able to sell their treasury holdings with little impact, something which has always been a worry. On the other hand, they picked up european bonds at their worst with a Euro which was at multi-year lows. Will this diversification continue/quicken and is China really picking up more and more in Gold reserves? We’ll have to wait for another announcement from the CCP.

Parijat Uncategorized Finance, linkedin

Gold price hit an all-time intraday high of $1266.50 per troy ounce even as stock markets around the globe continued their recent upward journey. This is one of the two scenarios I had said were possible in the markets; the other of course being a rising stock market with falling gold prices. Unfortunately, the former is what is happening right now and that, to me, is not good news. Many have written about the equity markets being driven by liquidity, there is an even more interesting way to look at it.

The S&P 500 index closed at 893.04 on June 22nd 2009 while gold closed at a price of $920.6 per troy ounce. That would peg the index at being worth about 0.97 ounces of gold on that day. A year later on June 18th 2010, the index had risen over 25% to close at 1117.51. However, gold had far surpassed that by rising a massing 36.5% to close at $1257.2. The index, measured in gold now stands at 0.88 ounces of gold. So even though the index has risen, the investor has been left poorer. My interpretation is a little different though. I’d say that the entire (or substantial) rise in the index has been driven by liquidity provided by the various central banks, primarily the US Fed and the ECB as has been most of the rise in gold. However, the excess 11% rise in gold price is probably a good measure of the fear for further inflation, or rather currency devaluation which the easy money policy is pointing towards. How much further gold will rise depends on how far the fears will be exaggerated and how long the central banks take to start increasing interest rates. I will only feel confident about any real recovery when the momentum in gold slows down and the S&P 500 recovers to somewhere over 1 ounce of gold.

In India, the story works a little differently. While interest rates in India are also being kept fairly low, gold in INR terms hasn’t appreciated as much because of the contrarian effect of FII money inflow which keeps the rupee bouyant and gold prices a little in check. The increased liquidity is showing up elsewhere though, with food inflation staying stubbornly over 10% for over 2 years now. Right until the middle of 2009, the Government refused to admit to inflation at all with persistent reports of low inflation citing the wholesale price index which was close to zero for much of this period. When food inflation was finally recognized as a problem, it was attributed mainly to supply side problems citing low output in the previous year. Towards the end of 2009 and early 2010, the supply side problems had supposedly eased but food inflation doggedly continues above the 10% mark with the actual number for April 2010 standing at 14.8%. While this has led to increased speculation that the RBI shall move to increase interest rates soon, Governor D. Subbarao has maintained a stance that interest rates will not be hiked immediately as “other measures” have been taken to control liquidity in the market. My concern remains that even though liquidity may have been mopped up by issuance of Government bonds to finance the deficit, the deficit spending itself is a crucial source of the persistent inflation, not least being the spending under the National Rural Employment Guarantee Scheme.

While central bank madness continues in Europe and in the US, I think quick steps need to be taken to increase interest rates even at the risk of slower economic recovery in India. Even though we depend on western demand to a certain extent, I think prudent monetary and fiscal policy can make India the preferred destination for external capital and hence can sustain our recovery even with higher interest rates domestically. On the other hand, economic recovery at the cost of skyrocketing food prices does not bode well for the internal security of the country. Any increase in economic activity can quickly be offset by social unrest if food inflation is not checked soon.

Parijat Uncategorized Finance, linkedin

Since the Greek/Euro crises broke out in earnest some time last month, the German Bunds and US Treasuries have seen increasing demand (and falling yields) as people pull out money from “risky assets” and park them into “safe havens”. This has been the typical behavior in all recent panics, but somehow, this time around it makes little sense to me.

US 2-year treasuries are currently yielding about 80 basis points (or 0.8% per annum). Not only is this ridiculously low for ordinary times, it sounds even worse given the extent of Quantitative Easing being undertaken by the Federal Reserve. As the Fed puts more and more money into circulation, I’d expect severe inflationary pressures; or equivalently for international investors, a severe deterioration in the value of the US Dollar. Except against the Euro. Which brings me to the German Bunds. The case of German Bunds is even more baffling. The reason why German Bunds are in favour right now is because of panic for the Eurozone and the Euro itself. In my mind, that is precisely the reason why German Bunds are a bad investment, particularly at low yields of 2.65% p.a. for the 10 year bond. With a currency facing potential deterioration of 20% or more (the Euro hitting parity with the US Dollar is an oft-discussed possibility), why would someone invest in a fixed income security yielding 2.65%? One reason would be that for a lot of institutional investors in the Euro-zone, investing all (or most) of their corpus in European instruments might be mandatory. They have nowhere else to go and so they buy debt from the least-likely-to-default Eurozone country. But what about others? I’d imagine that they should be buying commodities and gold. That is probably the only safe bet at this point.

Gold indeed seems to be attracting massive attention as it reversed it recent short downtrend and is back at $1215 per troy ounce having fallen to $1170. In Rupee terms, the story is much worse with prices reaching new highs of over Rs. 18,600 per 10 grams. It is here that I think there is some madness again. Part of the reason why fresh highs are being made in INR terms is the bulk pulling out of FII investments from the equity market, which is pushing down the INR against the USD. So while I remain bullish on gold in USD terms, I have mixed feelings about it in INR terms, mostly because I see INR weakness as only temporary and would expect a reversal if/when saner minds take over the market and money flows back out from the insanely over-priced US treasuries and returns to economies where genuine growth is taking place and long-term investors can get the biggest bang for their buck.

Of course, I don’t expect sanity to return too soon and I’d expect to see the INR trade atleast between 49-50 to the Dollar before money flows back in.

Parijat Uncategorized Economics, Finance, linkedin, Markets

The fall Gold has taken from its recent high of about $1248 to a current level of $1170 is baffling. That is not to say that it hadn’t taken a real run-up over the previous few weeks. The point is that while equity markets continue to head south and US Treasury and Bund yields continue to get compressed, Gold, which should be the ultimate inflation/currency hedge is also taking the fall. Over the week ended 14th May 2010, I had expected one of two things to happen. One, Gold continues to head higher/stays stable at 1230-1250 levels while equity markets rise on low volumes. Such a scenario would have been a good time to sell into the rising equity market as Gold as a sentiment barometer still reflected serious risk-aversion. The other scenario would be a rising equity market with falling Gold. That would probably be a sign of recovery, or at least an improvement in sentiment and so the equity rally could be sustainable. Nothing, however, had prepared me for a falling equity market with a simultaneously falling Gold price.

From the Indian perspective, however, things make more sense as the recent Gold fall in USD terms has hardly translated into a fall in INR terms, while the benchmark stock market indices continue to fall. The principal reason is of course the departure of FII money from the equity market, which pushed the USD higher against the INR.

My own view is that this flight of capital into “safer” US Treasuries is the expected short-term behaviour. However, once things settle down into the “new normal”, whatever that may be, we should see a significant return of overseas interest in the Indian (and other Emerging) Markets. Unless we hit another wave of “irrational exuberance”, I’d expect capital to flow to countries with more transparent administrations, stronger enforcement of property rights and more predictable regulatory environments*.

The EUR/USD pair has also shown puzzling behaviour overnight with the EUR rising back from a low of below 1.22 back to 1.26 overnight. One explanation is the given the major Swiss National Bank intervention for defending the Swiss Franc, the ECB might do the same for the Euro. The shorts probably covered their positions and took their profits home. A fresh wave of panic might push it down again soon enough, though. The other important point is that we tend to forget that this is a currency “pair”. Two months ago, EUR/USD was a proxy for the USD against “a foreign currency”. Over the last two months, that changed into a proxy from the Euro against the world. However, given that things don’t look good either for the Eurozone or for the US, the pair is now looking like a see-saw trying to figure out which one goes down first, and harder. We should be finding out soon enough.

* The recent recommendation by the TRAI for linking the 2G spectrum fees to the bids received for the 3G spectrum are just one example of the regulatory unpredictability in India. Particularly for industries with hugh capital requirements like telecom, such fickleness would scare away a lot of long-term investors. Such behaviour needs to be kept in strict check if we want to be the preferred destination for foreign capital.

Parijat Uncategorized Economy, Finance, linkedin, Markets