Despite slowing from highs of 8% to 9% growth, India’s economy will grow close to 6% in 2009. Amid domestic and global liquidity crunch, large domestic savings and corporate retained earnings are financing investment. Sluggish labor market and wealth effects have hit urban consumption. But low export dependence, a large consumption base and the high share of employment (two-thirds) and income (one-half) coming from rural areas has helped sustain consumption. Pre-election spending, especially in rural areas, and high government expenditure, are also pluses. Timely monetary and credit measures have played a key role in improving private demand, liquidity and short-term rates and reducing the risk of loan losses. Credit is largely channeled by domestic banks, especially state-controlled ones, which have low loan-to-deposit ratios and little exposure to toxic assets….link

Given Roubini’s track record over the last three years, he’s certainly built some cred. Do you agree with his assessment on India, though?

In the Wall Street Journal, Peter Wonacott says India Defies Slump, Powered by Growth in Poor Rural States.

Rama Lakshmi of the Washington Post said as much last month: Vast Rural India Sparkles As an Expanding Market

About 72 percent of India’s billion-plus people live in rural areas. For years, the poverty of rural India was seen as reining in the country’s economic growth. But today, analysts say, rural India is a critical audience for marketers because it has been relatively insulated from the crippling blow of the global slowdown.

India’s rural destiny still depends on good monsoon rains and robust agricultural production, but four years of bumper crops and heavy government investment in rural infrastructure have given birth to what some analysts call an emerging economy within India.

Last month, Patrick Barta of the Wall Street Journal called it The Rise of the Underground.

Given this, it’s not entirely coincidental that The American, the journal of the American Enterprise Institute wonders how Lalu Yadav managed to turn around the Indian Railways, the world’s 2nd largest employer (the Chinese Army is #1) and in doing so, morph from Huey Long to Jack Welch — The Indian Railway King

Joe Nocera, one of my favorite business journalists, thinks that India’s banking sector has managed to avoid getting dragged down by the financial maelstrom.

Do you agree?

And what is the outlook for the rest of the economy?

So, as we enter November, and a number of Indian indicators start to improve, it is certainly worth asking ourselves, has India turned the corner? Will India lead the emerging markets charge during the next global expansion?

I am not, I am sure, alone in feeling that this is a distinct possibility, and, indeed, a similar view was expressed only last week by Sharmila Whelan, senior economist at CLSA Asia-Pacific Markets.

“We do expect the Indian business cycle to be the first to bottom in Asia. And, it should, in theory, be first to emerge,” Sharmila Whelan, senior economist at CLSA, said “The worst will be over by mid-2009 and by 2010 you should be able to see the next investment-led business cycle taking root.”

To the two reasons Wehlan offers us as an explanation for why we should expect India to do better than most (and, perhaps of particular nore here, better than China) – the fact that Indian trade constitutes only about 32.5% percent of gross domestic product (only about half the China figure – thus India is better protected from fluctuations in global trade) and the fact that India (unlike say Russia or Brazil) will be a large net beneficiary from falling commodity prices – I would add a third, India’s very favourable demographic profile, which will mean that over the next decade India can continue to draw on the benefits of a young and rapidly growing labour force at just the time when 30 years of once child per family policy starts to bite really hard on the new labour market entrant cohorts in China (for example).

Inflation Screeches To A Halt

India’s inflation held near a five- month low at the end of October, seemingly validating the central bank decision to reduce interest rates to bolster economic growth. Wholesale prices were up 10.72 percent in the week to Oct. 25 from a year earlier after gaining 10.68 percent in the previous week, according to the latest data from the commerce ministry.

Of equal importance is the fact that the weekly rate of inflation (week on week) recently turned negative, as energy and commodity prices drop back, and as a result the wholesale price index has now been dropping for eight consecutive weeks after peaking in the August 30 week.

One of the reasons inflation is weakening is of course the fact that Indian GDP growth has been slowing, and the current growth rate is clearly significantly below the 7.9 per cent rate registered in the second quarter (2008 calendar year) a rate which was already notably lower than the 8.8 per cent one reported for the January to March quarter. But with countries from the US to Germany, to Russia and maybe even China (who knows at this point) falling into or near to negative growth, then even a 7% rate looks decidedly healthy to me. What was it they were saying not so long ago about “Hindu growth”? Better a tortoise than a hare in some contexts, but then again, a 7% tortoise is certainly no mean one.

It is interesting to note in passing that the IMF – in revising their forecast down to 6.3% for 2008 – stated that they consider this level to be considerably below India’s potential growth. For the time being, it seems, the old “overheating” debate has become a thing of the past. These days we all love India, now don’t we?

Ironically, the current global situation is also making India’s measured pace of economic reform look wiser than before. At a time when Western countries are frantically nationalising banking assets, the Indian government’s reluctance to sell more than 49% in its state-owned banks—which control some 70% of banking assets—now seems reassuring. In addition, India has not yet introduced full capital-account convertibility, which protects its currency, while its careful control of foreign borrowings by domestic companies limits dependence on the global financial system. Regulators have also periodically introduced curbs to slow the formation of potential asset bubbles, such as higher provisioning and prudential requirements on real-estate lending.
The Economist

“For India we have marked our forecast down to 6.3% of 2009 calendar year. That is considerably below what we consider to be India’s potential growth,” IMF deputy director for Asia Pacific region, Kalpana Kochhar said. “There is a specific meaning to “potential” – it is the rate at which you can grow without causing inflation. And for India we estimate that to be 7.5% to 8%. Our forecast of 6.3% would put it quite a bit below the potential,”.

Obviously there are still varying forecasts, with the RBI and the central government being rather more optimistic than most, although India’s central bank did reduce its growth forecast on October 24 down to 7.5 percent from 8 percent for the year to March 31. This prediction, if fulfilled, would mean the 2008/09 expansion would be the slowest in four years, but then in the midst of the largest global recession since the 1930s that doesn’t sound so bad, now does it?

Interest Rates Coming Down and Monetary System Stabilising

The Reserve Bank of India cut its benchmark rate on Nov. 1 for the second time in two weeks, joining policymakers across Asia in lowering borrowing costs to shield their economies from the global financial crisis. For the first time since 1997, India’s central bank on Nov. 1 deployed all three of its main tools to shore up growth after inter-bank lending rates climbed to as much as 21 percent. The move seems to have substantially improved liquidity in the financial system, and overnight call rates fell sharply.

The Reserve Bank of India lowered its benchmark repurchase rate to 7.5 percent from 8 percent. At the same time the central bank also reduced the cash reserve ratio to 5.5 percent from 6.5 percent, and and cut the amount of money lenders are required to keep in government bonds to 24 percent from 25 percent.

The RBI is also considering giving an additional 100 billion rupees ($2.1 billion) each as lines of credit to National Housing Bank and Small Industries Development Bank of India, according to Finance Minister Palaniappan Chidambaram speaking during last week. The idea here would be to increase cash flows for mortgages and for small companies.

Rupee Rises Slightly

The rupee climbed 3.8 percent last week to close at 47.66 a dollar at the 5 p.m. in Mumbai on Friday. The increase represents the biggest weekly gain since March 1996, making the rupee currently the best performer among Asia’s 10 most-active currencies outside Japan.

In addition on the foreign currency front, the Japanese Yen is also dropping back slowly against USD, which means that yen “carry” may be slowly starting to recover. A surge in USD-Yen (and hence yen carry) would be another clear sign some key emerging markets we about to start moving, in my view. As we can see from the chart – unless we have more “turmoil” to cope with moving forward – October 24 seems like it represents some kind of turning point.

Stocks Start To Tick Up Again

The Bombay Stock Exchange Sensitive Index has also rebounded, and is up 17 percent since the bottom on Oct. 27. The index added 2.4 percent on Friday. The MSCI core index for India is also up 6.74% so far this month. After all that falling over the last twelve months, it is that little upturn since the start of November (see chart below) that we would like to see consolidate and continue. Of course, this may be yet another false start, and there may be another shoe to drop, but perhaps there are reasons for just a little more optimism at this point.

And the general MSCI Emerging Markets Index also looks as if it may well have turned.

Emerging Bonds Start To Rebound Too

Emerging market bonds have also started to recover, if we look at the JPMorgan EMBI+ chart, we can see what appears to be quite a robust “bounce back”. Of course for some countries (Eastern Europe, Argentina etc) the worst is still not over, but India may well be relatively insulated from too much fall-out here.

Not Much Sign Of A Rebound In Commodities Yet

On the other hand, with growth in the OECD countries likely to be bordering on negative in 2009, and Russia and China both likely to have substantial slowdowns, there are not too many signs at this point of any recovery in commodities, if we look at the Reuters-Jefferies chart.

But since India is a large net commodities importer, this is hardly bad news. Oil prices were sedentary Friday following a large scale sell-off during the week, – and this despite a forecast from the International Energy Agency that put the price of crude at $200 per barrel by 2030. Light, sweet crude for December delivery rose 27 cents to settle at $61.04 a barrel on the New York Mercantile Exchange, although the contract had dropped below $60 in earlier overnight electronic trading for the first time 19 months. This is all now a far cry from June, when oil was trading at $147.

India’s Foreign Exchange Reserves Continue to Fall

India’s foreign exchange reserves declined again at the end of October – for the sixth consecutive week – and fell by $5.532 billion to reach $252.883 billion for the week ended October 31. India’s reserves have fallen by more than $31 billion in the past one month alone, and are now well below their $318 billion April peak. But on the other had they are still substantial and not far different from what they were 12 months ago, following a very substantial rise over the previous nine months. So if they do not fall too much further, then it isn’t evident that there is any real problem at this point.

Sustained dollar selling by the Reserve Bank of India in the forex markets, huge amounts of FII outflow from the domestic equity markets, and the revaluation of the reserves have been the main factors pressurising India’s reserves, but all these factors are symptomatic of the general pressure which has come to bear on “higher risk” emerging market economies as a whole as the financial turmoil and associated uncertainty have raged in the United States and Europe, and there is little real evidence of “India specific” factors at work here, indeed Indian exceptionalism would rather be in the fact that – absent commodity export dependence – India’s reserves have not been taking the same sort of pounding Russia and Brazil’s have.

The Reserve Bank of India (RBI) also said on Friday that it will lend foreign exchange – via foreign excahnge swaps – to banks with overseas operations to help them meet their lending requirements, a move that many Indian banks had been asking for, and which should help ensure adequate funding for their foreign subsidiaries. Following the central bank’s announcement, banks will buy dollars from RBI at the reference rate plus three-month forward premium and will return dollars to RBI after three months, in case of three month swaps.

Additionally, the central bank has also extended a lifeline to banks for funding the swaps by allowing them to borrow through its regular liquidity adjustment facility (LAF). The LAF is the window through which it lends to or accepts money from banks, for the corresponding period at the prevailing policy rate.

Banks borrow through the LAF window by pledging government bonds. They are required to invest at least 24% of their lendable funds in government bonds; this portion of their deposits is called the statutory liquidity ratio, or SLR. In view of the tight liquidity conditions, RBI reduced the SLR by 1% to 24% on 1 November. RBI also said on Friday that if a bank did not hold enough government securities to pledge, it would consider relaxing the SLR requirement if the bank approached it.

The use of swaps helps banks obtain cheaper funds for buying dollars because they can now borrow from the central bank repo window at 7.5%. Previously banks needed to convert their rupee deposits – raised at a rather costlier 10.5-11% – into dollars.

India’s Industry Resists The Global Slowdown

Despite the fact that India’s industrial output plummeted to a 1.3% year on year rate in August, there are some signs that the situation may be improving. The first of these are the September performance indicators for the coal and cement sectors, the rise in which pushed up the growth in output in the core infrastructure industries to 5.1% in September. According to government data made public on Friday, coal production was up by 10.7% in September 2008 while cement production rose by 7.9%.

Core sector growth in August was just 2.3% – and the six core industries have a weight of 26.7% in the index of industrial production (IIP). On the other hand growth in electricity generation remained weakish – at 4.4% – in September. If compared with the growth rate in August this year, electricity generation was the worst performer among the six sectors, with an abysmal growth of 0.8% in August 2008. Of the six core industries (crude oil, petroleum refinery products, coal, electricity, cement and finished carbon steel), only coal and cement really registered strong growth rates in September 2008. So I guess we have to wait till mid-week now to see the complete September figures.

However, despite what may well turn out to be an improvement in September IP over the August number, it does looks very much as if activity at Indian factories fell to its lowest level in three and a half years in October as the global financial crisis and slowing export demand hit the country’s manufacturing sector. The ABN AMRO Bank purchasing managers’ index (PMI), based on a survey of 500 companies, slumped to a seasonally adjusted 52.2 in October, its lowest since the survey began in April 2005 and sharply below September’s 57.3. A reading above 50 signals expansion while a figure below 50 suggests contraction, and the manufacturing PMIs are interesting, since they do offer us a sort of “real time” snapshot of what is actually happening.

“The outlook for the manufacturing sector appears to be bleaker in the backdrop of tough local and global economic conditions,” said ABN AMRO Bank N.V. senior economist Gaurav Kapur.

So the point here would not be that Indian industry is in absolutely perfect condition (it is obvious that it isn’t), but rather that, at a time when global manufacturing generally is taking a huge beating, Indian industry is hanging on in, by its fingernails, but it is hanging on in.

In comparison, the JPMorgan Global Manufacturing PMI posted 41.0, its lowest reading since data were first compiled in January 1998 and a level below the no-change mark of 50.0 for the fifth month in a row.

Output, total new orders and new export orders all contracted at the fastest rates in the survey history in October. With the exception of India, which again bucked the global trend, all of the national manufacturing surveys posted declines in output and new orders. The impact of the downshift in global market conditions also had a far-reaching effect on international trade volumes. Although new export orders fell at a slower rate than total new business, all of the national manufacturing sectors covered by the survey (including India) saw a reduction in new export orders.

“October manufacturing PMI data reinforce the stark retrenchment that the sector is currently facing, with production, total new business and new export orders all falling at record rates. The latest Output Index reading is consistent with a fall in global IP of almost 8%. The only positive from the surveys was a decline in input prices for the first time since August 2003.”
David Hensley, Director of Global Economics Coordination at JPMorgan

Returning finally to India, perhaps somewhat significantly the export order index in the PMI survey contracted for the first time in the survey’s history, coming in at 49.7 in October, compared with 53 in September. Manufacturers blamed poor global financial and economic conditions for the result. But this should not surprise us too much either, since India’s exports grew at their slowest pace in 18 months in September. Overseas shipments, which constitute about 15 percent of the Indian economy, were up 10.4 percent (to $13.7 billion) from a year earlier, following a 27 percent gain in August. Imports also increased – by 43.3 percent to $24.4 billion, with the result that the trade deficit widened to $10.6 billion.

“The global financial and economic headwinds adversely affected foreign demand for Indian manufactured goods,” said Gaurav Kapur, an economist at ABN Amro Bank in Mumbai. “The growth of total incoming new work to the Indian manufacturing economy lost considerable momentum.”

So, in conclusion, I am not saying that everything in the Indian garden is simply perfect, rather I am simply pointing out that during times which are hard for everyone, India has some advantages to lean back on, and looks set to have a lot less serious downturn than many other emerging economies may experience. So to end, almost where I started, with CLSA’a Sharmla Whelan, I do expect the Indian business cycle to be the first to bottom in Asia, and I would most certainly agree that “it should, in theory, be first to emerge”.

Mira Kamdar’s recent piece in the World Policy Journal illustrates this well. By Ms. Kamdar’s account Indians are heading down an inevitable path to doomsday. Malthusian population pressures, resource scarcity, global warming, environmental degradation, industrial capitalism, and political corruption have combined with an inherently fractured society that is likely to erupt in caste, religious, and class warfare, terrorism, and self-destruction. Mix in the recent US-India civilian-Nuclear deal and the presence of unstable neighbors – Pakistan, Bangladesh – along with an aggressive China, and Ms. Kamdar offers up all the ingredients for a nuclear holocaust. The only uncertainty we are left with is: which doomsday will India break into first — internal implosion or external explosion?

And if this is not enough, Kamdar has one more concern: Indians are taking to cars rather than following the example of bicycle aficionados in Amsterdam, Paris, and New York.

All this, because Ms. Kamdar wishes to disabuse her readers of taking too seriously the rosy-scenarios painted for India in the 5 year old Goldman Sachs BRICS (Brazil-Russia-India- China) report. Perhaps the BRICS authors expected a less fundamental critique of their growth-accounting models? Instead, Ms. Kamdar offers her own BRICS dream in the very last para of her piece: India’s under-class and lower castes having finally usurped political power will magically transform Indian democracy, to root out corruption, poor governance, and “…will have delivered quality education and healthcare, housing, clean water and sanitation…. Its policies will reflect the active civic engagement of an informed electorate, becoming a model for the world of the advantages of truly democratic governance. Now that is what I call dreaming with a BRIC.”

An ongoing doomsday scenario in India that ends in a future utopian vision for India: Ms. Kamdar offers no intellectual bridge from here to there. So how can one trust the reality of either worldview?

Perhaps if she had considered the half-century lost under the unproductive haze of the License Raj; or the pernicious harm done to Indian polity by a caste based reservation system that actually reversed upward caste mobility and institutionalized caste divisiveness in Indian society — an outcome that ironically is the one real ingredient in Ms. Kamdar’s utopia; or, if Ms. Kamdar had considered the woeful neglect of land markets in India instead of choosing to paint the Nano plant site controversy in West Bengal in class-warfare terms; or, that even assuming the worst case global-warming outcome and its impact on agricultural productivity in India, opening up the rural economy to trade and investment offers the individual farmer more, rather than less, options – of goods, technology, and mobility – when dealing with a changing environment.

All of the problems Ms. Kamdar touches on are real and require incremental but genuine responses – to be provided by markets, entrepreneurship, leadership, and good governance. And these responses will by necessity emerge from what India is and not from some radicalized new society that Ms. Kamdar dreams.

Too bad Ms. Kamdar has chosen to neglect the reality and promise of progress in India, while conjuring up wild lurches between doomsday and utopia. One can only hope that the readers of WPJ are more grounded than the author.

Guest post by Nimai Mehta, Assistant Professor of International Trade and Business at American University, Washington DC.

On September 19th, the U.S. Treasury Secretary Paulson issued a statement in which he said that the Federal government “must implement a program to remove these illiquid assets that are weighing down our financial institutions and threatening our economy”. He called it the ‘Troubled Asset Relief Program’. Many have taken to abbreviating to TARP and from there, it is a short leap of imagination to call it a TRAP. The government had sent the legislation to the Congress for approval and it might be approved any time soon. We have something to say about it later.

But, even before the bill is passed and its ramifications known, stock markets around the globe heaved a sigh of relief and rallied hard towards the end of last week. It is a delightful irony that most markets showed a flat profile from Friday, September 12th to Friday, September 19th at the end of an unprecedented week. It is not so much the news of the proposed U.S. government bailout that stock market investors welcomed. The squeeze on short-sellers that regulators around the world applied worked its magic.

Short-selling banned but SEC created the conditions

Bulls are taken by their horns but I do not know how bears are tamed. Try banning short selling. Well that is what authorities in the U.S. and the UK did on Thursday. UK banned all short-selling of financial stocks up to January 2009. The Securities and Exchange Commission (SEC) in the US banned all naked short-selling in all stocks. Hedge funds have to swear under oath their short positions. Canada, Germany, Ireland, Holland, Taiwan and some others have joined. That is a shame. There was no reason for many authorities to impose restrictions on short-selling. It is not only unprecedented but also largely unnecessary. Even now, with history and experience behind us, human beings remain capable of making collective mistakes. That is scary.

Forgotten in this persecution of short-sellers is a matter of tiny detail that in 2004, the SEC made two important changes to its rules on the amount of leverage that broker-dealers could take on. One, it removed the discounts (haircut) it applied on the assets that these institutions own, in calculating their net capital. Two, it allowed five broker-dealers to increase their leverage from 12:1 to 40:1. Those five were Merrill, Lehman Bear Stearns, Goldman and Morgan Stanley. Three of them are not around any more.

(Source: The Big Picture)

It is not clear what role the institutions themselves played in this rule change. It appears that the retribution for the egregious errors of the regulators and the regulated entities would be paid by the shortsellers who seek to throw a spotlight on such behaviour. Strange are the turns that American capitalism has taken in the last few years.

Banning short-selling is to akin to blaming the mirror for the ugly image. But then, these days, one is a suspect capitalist if one does not cheerlead rising asset prices even if the means are not exactly fair. Steve Randy Waldmann asks if selling short into a financial panic was not done, then isn’t going long into an asset price bubble equally wrong. In their defense, of course, authorities are justified in doing so if they suspect financial terrorism akin to the unusual activity seen in airline and financial stocks before the 9/11 terrorist attack in New York. But, Carl Sagan, as quoted by Paul Kedrosky of ‘Infectious greed’ says that extraordinary claims require extraordinary evidence. The authorities have not produced any.

However, for this writer, conviction remains firm that any recovery in global equities and the U.S. dollar would eventually turn out to be a comic interlude in an, otherwise, tragic drama except that the comic interlude could last long enough to make us all feel like we were watching a new play all over again.

Incentives to take on excess risk remain

Some argue that there is nothing called a stable financial system. As long as human greed and fear exist, financial systems would periodically become unstable. According to them, it is just in the nature of things for financial systems to fall into crises. The only avoidable cause, in their view, is to avoid reckless monetary and credit expansion that many central banks either deliberately or unconsciously permitted in the last several years (See, for example, Michael Pettis). Such excessive monetary and credit expansions do not end without extracting their price in terms of financial institutions’ failures and economic stagnation or worse.

Of course, while monetary policy and regulatory prudence is at the heart of the stability or instability of the financial system, that does not mean that other known or identified problems should not be addressed. Some of them might end up vastly amplifying the consequences of monetary excesses. One such problem is the role of incentives and reward-punishment structures in the financial industry. Simply put, far too little punishment is directly borne by the wrongdoers for their errors. Most executives are rewarded for successes or with golden parachutes if they fail while losses are borne by the shareholders and the society at large. That applies to executives at the top and at other levels. Returns are rewarded while risk is socialized and worse, since it appears with a lag, it is not even recognized and traced back to the acts of omission and commission. Even in late-2007 well after the crisis had broken out, compensation packages were not tailored to incorporate risk considerations in evaluating executive performance.

In fact, incentives in the financial industry need to be addressed not just for reasons of financial system stability alone but also to ensure a fair deal to shareholders and clients of such institutions. Nick Leeson, who was responsible for the collapse of the Barings bank in Singapore, writes that he was offered five credit cards as soon as he had returned from Singapore, having been responsible for incurring GBP862 millions of losses in 1999 (See The Guardian).

U.S. Treasury announces a plan on Saturday

In an email exchange with friends in the industry in April, when I was asked whether the world would unravel via inflationary boom and bust or through a straight deflationary bust, I said that the outcome would eventually be deflationary and that, in the interim, inflationary solutions would be attempted. In other words, we would get there finally but through an inflationary route.

In that sense, the Paulson plan is not a surprise. It was always on the cards. Policymakers are not going to give up without a fight. Under the plan known informally as TARP, the Treasury is authorized to purchase USD700 billion worth of mortgage-backed securities from U.S headquartered institutions at an unspecified price and price mechanism. Decisions made by the Treasury under this special legislation have no judicial recourse. The Treasury would buy assets issued or originated on or before September 17th. By Monday (Sept. 22nd), this has been extended to non-America headquartered institutions and to many types of assets including commercial mortgages and non-mortgage assets. Macroman might succeed in selling his wooden cabinet to the U.S. government, after all!

For now, the proposal has no provision to help homeowners who are struggling to keep up with their mortgages. Also missing is any proposal to re-capitalize institutions that might find themselves undercapitalized once the Treasury buys its assets over at a price that could be less than the price at which the institution carried the assets on its books. Those wanting to understand these issues better could see here and here.

Further, the stunningly simple and yet sweeping nature of the authorization sought from the Congress has made many compare this to the “Authorization for Use of Military Force, the infamous bill that gave the Bush administration the green light to invade Iraq” (see NYT). In fact, some find it plausible that the U.S. government allowed Lehman Brothers to fail to bring the system to the point of total collapse so that Congress could be steamrolled into authorizing the Treasury to do as it pleases, without judicial review.

Regardless of the merits of such a hypothesis, the mere possibility of it should make Congressmen move cautiously on the proposal and build in safeguards against abuse of power.

Different problems if the plan works

Even as a plan that focuses on the financial system, it is incomplete. The million-dollar question is if this plan would boost loan demand. The hope is that as mortgage rates come down, households would be able to refinance their mortgages and thus find the wherewithal to continue to spend. U.S. households have zero savings rate and those born around the World War II face immediate retirement. They need to save. To the extent any reduction in rates alleviates their conditions without a change in behaviour, global imbalances would remain. The U.S. would be saving too little and Asia too much. Second, return to spending habits by U.S. households would boost commodity prices and thus raise the specter of inflation all over again. Even if inflation were to return slowly in the U.S., it might return faster in Asia where the economies have barely cooled and where policy, on average, is still too loose. The world has, for the moment, run out of resources to support synchronized growth. Oil and gold have jumped already on Thursday and Friday.

If, unfortunately, inflation returned to the U.S., what happens to interest rates and would households really benefit then?

Then, there is the question of how the Treasury would find the money to do this. As a perceptive hedge fund insider pointed out, it was one thing for Asian nations to buy Treasuries and mortgage agency debt and accumulate reserves when they were deemed AAA credits. Can they do so even now and how would their public react? Of course, it is a stretch to think that most East Asian nations respect popular wish but it is not a stretch to state that they would fear the inflationary consequences of going back to reserves accumulation and thus entrench currency weakness.

Truth and reconciliation in America

Steve Randy Waldman’s two thoughtful pieces on his blog, ‘Interfluidity’ titled ‘To whom and for what’ (September 19, 2008) and ‘Inequality and credit crisis’ (August 31,2008) are worth reading. He also makes a compelling case for truth and reconciliation in America. Not just billions of dollars have been lost but also trust in America. He says that the process of rescuing financial institutions with government money should be transparent and institutions must come clean on the models and the prices that they had used in their books until the Treasury bought them over. This would enable the world to know whom to deal with in future and whom to avoid. He is right but the chances of this happening are fairly slim, however.

The mood in the financial market now is not to ask these uncomfortable and important questions. Whatever makes them live for another day is good enough now, for the industry and for investors. Once Congress approves this bill, investors, instead of feeling chastened, might feel that they have survived a bad crisis and that could embolden them to take on more risks unless regulators begin to take their jobs seriously. That is why I feel that stock markets, in the next few months, would do well. Reality would begin to bite again in 2009, as expectations are too high for economic growth and corporate profits. Enduring floor stock markets is a long-way off. Hopes over the miracles expected of the plan would turn to disillusionment. Market turmoil would return.

It is important to remember that what have been impaired are not just mortgage related assets but also trust in the U.S. financial system and capitalism, across the world. The consequences of that are not easily identifiable and would linger on long after this crisis is over. It is equally important to remember that the Treasury rescue plan contains nothing to repair the impaired trust and integrity.

A year ago, in an interview to Bloomberg, I had said that, by the time the crisis ended, the world of investors would be sick of stocks and real estate. Judging from the market reaction in the last two days, we are far from that point. I stand by that forecast. To that, I would add two more: by the time this is over, the U.S. dollar would no longer be the world’s reserve currency and America would have lost its AAA credit rating.

(These are Dr Anantha Nageswaran’s personal views)

Indian companies have on the whole risen above the meanderings of government, and in so doing have provided a platform for their shares to do likewise.
………

Granted, unlike some of its Asian cousins, India will remain a frustrating place for investors, as sensible policies one week are followed by emotional, knee-jerk decisions the next. But India has never really been a top down story, and anyway, the corporate world has learnt to deal with such vacillation.

Investors should focus on areas that are not dependent on reforms to come but those that have benefited from achievements attained. In essence, these are the general embrace of capitalism over the past 15 years and the state’s change of focus, from monopolising wealth creation to a focus on its redistribution.

Do you agree with Young’s optimism?

(A thanks to reader Vijay Dandapani, who forwarded us this article)

Vikram S Mehta, chairman of the Shell Group of companies in India, provides the structure of the price build up for petrol and diesel by the public sector companies in India.

Indian Oil Corporation (IOC) calculates inter alia the landed import duty paid price of petrol and diesel every fortnight. This calculation is based on a formula that is linked to international prices. IOC’s landed price of petrol in Mumbai for the second fortnight of May was, for instance, Rs 38.1 per litre and for diesel Rs 48.8 per litre. The marketing companies had to, in other words, pay this amount to the refiners to buy the products. Next, the Central government imposes an excise and educational cess on the purchase cost. In May, this was Rs 14.4 per litre and Rs 0.4 per litre for petrol and Rs 4.6 per litre and Rs 0.1 per litre for diesel respectively. The total cash required by the marketing companies to purchase petrol and diesel in May was, therefore, Rs 52.9 per litre for petrol and Rs 53.6 per litre for diesel. The companies then sell these products at the ministry of petroleum mandated price of Rs 49.7 per litre for petrol and Rs 35.6 per litre for diesel (Mumbai prices). As such, they lose Rs 3.2 and Rs 18 for every litre of petrol and diesel sold respectively.

That, however, is not their total loss. They have to also pay sales tax to the state governments. In Mumbai, this tax is Rs 10.6 per litre and Rs 7.1 per litre for petrol and diesel respectively. Thus, the total cash loss suffered on account of the sale of 1 litre in Mumbai is Rs 13.7 and Rs 25.1 for petrol and diesel respectively. This is, in other words, the amount by which prices would have to be increased at the retail outlet for the companies to simply break even on a cash basis. Such a hike is, of course, out of the question.[Indian Express]

Many in the public domain believe that the imbalance can be redressed by reducing the central and local taxes to make the public sector oil companies profitable. However, it is actually not about reducing the taxes to bring the prices down. That is just an indirect way of maintaining the subsidies. On one hand, the balance sheets of the oil companies might look healthier and higher profits might allow theme to disburse handsome dividends. On the other hand, the government revenues would come down and higher revenue deficits will bring the finance ministry into the FRBM dragnet. It is not a Morton’s fork but a Hobson’s choice for the government — to link the retail rates of petroleum products with the market rates.

In case of most other commodities, the high consumer price checks demand. This helps restore the supply-demand balance. As prices are not linked to the rising market rates, oil demand is not checked commensurate with the price change. It obviously creates an asymmetry in the supply-demand balance and can be only restored at much higher prices. By then, it might be already too late for the Indian economy.

Now let us look at two sensible, yet asynchronous, viewpoints on resolving this pricing conundrum. In the same piece, Vikram Mehta prescribes the policy framework for a comprehensive petroleum policy.

First, we should accept that high oil prices are here to stay. This does not mean we will not see sharp declines from present levels. What it does mean is that we will not see prices stabilising at levels significantly below a triple digit number. Second, we must create a mechanism that leads to a ‘graduated’ reduction in subsidies, an orderly alignment of domestic prices to international levels and a more efficient disbursement of financial support to the poor. Third, we must reverse ‘dieselisation’. And finally, we must recognise that the sine qua non of energy security is a robust and competitive domestic petroleum and energy sector.

Fellow blogger Atanu Dey has a much simpler, but more innovative solution to offer to redress this perverse subsidy for the rich.

The basic economic truth is that there is really no such thing as a free lunch. Today’s subsidy comes at a cost that will only grow larger the longer the delay in pricing petroleum products at full cost. It is fairly simple to remedy the situation. Raising the price at the pump is the simplest but the most politically risky. The UPA government knows that and will definitely not risk losing power even if raising prices is for the larger benefit of the economy.

But those subsidies have to be reduced, if not totally abolished overnight. A start could be made immediately to reduce the subsidy to the rich while continuing it for the poor. A mechanism for doing so would be to impose a tax on car owners which would reflect the full cost of the petrol they use. Depending on the size of the engine and average fuel consumption, an annual fee could be assessed which has be paid to maintain registration. So if a particular make and model of car typically consumes, say, 1,000 litres of petrol a year, the tax could be Rs 10,000.

This type of a mechanism would leave all two-wheelers, three-wheelers, and buses untouched. Since it is usually the common man who uses public transportation, the common man would continue to enjoy the subsidy.[Deeshaa]

One can only wonder if Rs 200,000 crore in oil subsidies, nearly 2% of India’s GDP, is not alarming enough for the government to pay heed to such sensible opinions.

What is interesting in Daniel Yergin’s FT piece is that he deftly sidesteps the question of predicting the future for oil price—near-term or in the long-term. In recent years, he has been proven wrong. His Cambridge Energy Research Associates (CERA) has been bearish on oil since 2004-05.

More important rather than interesting are his comments on the skyrocketing cost of everything from rigs, to ships to technical and skilled personnel. Clearly, for many reasons, the world needs to slow down. Central banks (or more precisely, governments) are unwilling to let that happen. The result is going to be more inflation (for a year or two) and less growth and eventual deflationary bust.

There is no dearth of commentary that predicts an imminent end to oil price. Usually, things happen unexpectedly, just as the rise of oil price itself to present levels. Now that every one and his dog is praying for or predicting a collapse in oil price, I wonder if it would happen now.

In any case, here are two samples of commentaries that call the oil price unsustainable:

In fact, John Hussman finds the contango in crude oil futures as heralding a big slump just as it did in 2006 when the price of oil dropped from around USD 80 to USD 55 per barrel.

He has exited his position in crude oil and has reduced his position in precious metals to 2%. How he proposes to reconcile that with his bearish stance on equities in the U.S.A is something that I have not been able to ask since I do not have his email address. Then, there are the comments by Mr. George Soros. He blamed it on speculators. One Michael Master in his testimony to the US Congress on the oil price spike. He has said that it is caused by index investors.

I do not recall hearing of him before this testimony. Suddenly, his name is everywhere.

It is not clear if these prognostications confuse wishful thinking for forecasts, for buried within its crevices, the Wall Street Journal carried an article on the oil producers shipping less crude than before.

This article refers to the rising consumption in Saudi Arabia and the rapidly declining export from Mexico. It is an interesting read and manages to finish on an optimistic note, somewhat inexplicably (i.e., that is falling oil price). Brad Setser makes an interesting point that this article was buried too deeply in the inside pages of WSJ than it deserved to. See this interesting post by Brad Setser.

Talking of inexplicable conclusions that did not flow from the discussions that preceded it, this paper by researchers by the Federal Reserve Bank of Dallas does the same thing. It argues, explains and convinces us that oil prices are justifably high. Then suddenly it concludes that sustaining triple-digit prices would be difficult.

It is funny and a different story that different people have different persons in mind for “speculators”. If you add them up, just about every one would be deemed a speculator while, of course, all those who invest in stocks that sustain Wall Street are fundamentally driven, analytical and rational.

I think America does not want to see the price of oil to drop so much that it angers the Sheikhs in the Arabian sands so much that they stop writing cheques for bankrupt Wall Street institutions.

See this article for confirmation on America speaking with forked or multiple tongues on this matter. And see this too.

The first line is a gem: “Hank Paulson, the US Treasury secretary, will invite oil producers to invest their petrodollars in the US while urging them to take steps to curb the price of oil in the medium term on a tour of the Gulf that begins on Friday”.

Once America has finished re-capitalising its financial institutions, it would not be averse to seeing the oil price collapse. In fact, it might even actively conspire to bring that eventuality about for biting the hand that fed them is part of longstanding Western tradition.

Geopolitical gains are not trifle if the price of oil continues to remain high, it would also put paid to any fledgling ambition of China (or even the distant India) to overtake America. At the very least, it would push the time-frame out by a few years and with some luck, few decades:

Credit Suisse’ s Dong Tao wrote in their “Emerging Markets Economics Daily” dated May 30, 2008 that Xu Xianchun, deputy director of the National Bureau of Statistics, has suggested that inflation might not peak until 2009 (p. 15).

The longer the oil stays elevated, the longer the persistence of inflation in China and the greater the policy challenge. In the meantime, more money would keep coming into China in search of appreciation.

Brad Setser estimates the rise in monthly reserves in China at USD 74 billions in April. Given that dollar appreciated in April, the actual sum could be about USD 82 billion, nearly a trillion dollar annual rate! There is no need to analyse this. China’s policy is totally and utterly rudderless. Brad Setser is way too polite on this one.

So, for what it is worth (you might be better off tossing a coin to decide), my forecast is that the price of crude oil would drop to about USD 110-115 or so. That is about it. It would then go back to 150 to drive one final nail into Asian economies, shower riches on West Asia and re-capitalise America. Then, once it has done its damage, the missile would be allowed to extinguish itself or burn itself out (pun intended).