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

On the recent deregulation of petrol prices, the PM had this to say:

““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.

Parijat Uncategorized Economics, Policy, Politics