Here’s an earlier IEB post on Wadhwa’s research — Don’t Try Kicking Sand In America’s Face.

On another note, Sunita Narain’s at it again — after colas, now it’s edible oils. (HT: Amit Varma, via email)

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)

Though I have never invested in the shares of Reliance Industries, my recently gleaned understanding of the world petroleum scenario has made me respect the company’s vision in its refining projects. As I mentioned once earlier, RIL’s existing refinery, and the one nearing construction, reportedly have unparalleled flexibility to process heavy, high-sulphur (so-called sour) crude, especially that emanating from Iran. This crude sells at a huge discount to other crudes; once it is refined into diesel, though, RIL is able to sell the resultant distillates, especially diesel, into a world market which is thirsty for such products.

Most mature consumers, the US especially, have made no investment in refining capacity over the last 2 decades, and strategic thinkers in the petroleum industry go so far as to say that RIL’s investments are changing the pattern of world flows in petroleum and petroleum products.

For this reason, I have recently turned from a bear on RIL to a mildly positive neutral. Until last week, that is. With Mulayam Singh and Amar Singh all but in the ruling coalition, suddenly life has become difficult for Mukesh Ambani. The first salvo across his bows was a minor irritant, namely the questioning of concessional import duty paid on two private jets.

More significantly, there are now calls for a ‘windfall tax’ on profits RIL is making on its refining operations. Nothing could more arbitrary than such a tax; windfall taxes have been discussed in the US, on the extra profits oil companies make when commodity prices suddenly ramp up – the implicit logic being that the companies have done nothing to earn this extra profit. I disagree with such taxes, in any case, since anyone who invests in an industry, resource-based or otherwise, runs the risk of prices being lower than he anticipated – in which case he is not compensated by the exchequer.

But in the proposal that RIL be taxed, all one sees is the vindictiveness of those opposed to him. If RIL is making higher profits than other refineries, this is due to its far-sightedness in investing in a more complex and sophisticated refinery. The profits accruing from such an operation are far from a ‘windfall’, a term normally used to describe a lottery win, for example.
If this nonsensical suggestion is accepted by the government, it will send out a signal that Indian governance is of the banana republic variety.

Mohit Satyanand is consulting editor at Outlook Money

A recent ASSOCHAM Business Barometer Survey of 258 faculty members of MBA programs in India found that most professors did not know basic facts about the national and global economy.

“89 per cent of the teachers were unable to tell the GDP growth rate scaled by the Indian economy in the financial year 2006-07.

The survey further divulged that hardly 6 per cent of the lecturers surveyed read any business newspaper on regular basis. Moreover, persistent readers of business magazines were negligible”.

The appalling ignorance of these faculty members is symptomatic of an endemic financial and economic illiteracy among wide sections of Indian society, including intellectuals, media, politicians, policymakers, and the bureaucracy.

India’s economic illiteracy explains the pedestrian quality of most discussions about the economy — they rarely reflect an appropriate mental picture of India’s economic structure, its sources of growth and competitiveness, its vulnerabilities and challenges.

As we explain at more length in our Pragati essay, in terms of immediate public policy priorities, incorporation of economics in the education curricula is essential for multiple reasons – to increase the employability of graduates, to help manage social change better, to ensure more effective design and delivery of public services, to obtain a better ROI from budgetary outlays and ensure better governance.

Speaking of governance, for instance: policymakers are not sufficiently held accountable for their poor decisions which display a shameful and at times, willful, ignorance of basic economic principles. A prime example (just one of many) is the National Rural Employment Guarantee Scheme, which ignores the vital concepts of opportunity cost and moral hazard, and is not based on robust empirical evidence.

India’s hopes of moving into the 21st century and its dreams of reaping the so-called demographic dividend are unlikely to fructify unless the education establishment at the Centre and the States rethink the curricula and its priorities.

Questions:

1) Do you agree with Asher & Nandy? If so, how does that square with Ramesh Venkataraman’s view that “today’s electorate is starting to view government less as a mai-baap granting entitlements — seats in colleges, jobs in the public sector, subsidies — and more as an enabler of opportunities.”

2) At first blush, I would have assumed that an economically literate populace was a prerequisite for sound economic policy decisions. However, is that really true of the other developing countries, especially the Asian tigers? Can someone with first-hand experience of those countries comment? And, if they’re as bad as (or not much better than) India in terms of economic illiteracy (as I suspect), what explains their economic decision-making? The East Asian countries’ economic policies may be far from ideal, but I find it hard to believe that they’ve managed to come so far and so quickly on the basis of worthless economic policies.

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).

A table of inflation rates in many countries around the world is beginning to reveal a disturbing picture. The lowest rate is found in Germany – at 3.0%. Many emerging countries that seem to be doing a truthful job are reporting inflation rates in excess of 10% and some in excess of 20%. Others, either out of deliberate intent or methodological deficiencies, report far less. India belongs to the latter category.

Inflation is the world’s number one problem. Governments are pretending to respond. In the UK, Mr. Gordon Brown wants to assemble experts to debate solutions. The Indian finance minister says that western nations are diverting land for producing expensive bio-fuels to replace the expensive crude oil. Surely, that is part of the problem. But that does not explain the jump in the price of rice. Rice is not diverted to bio-fuel production.

In India, the response has been to reduce import duties, impose export caps and accuse manufacturers and distributors of collusion and cartel-like behaviour. Different ministers speak in different voices. Together, these pronouncements do not constitute a policy whole.

In simple terms, prices reflect the balance of supply and demand of something. When prices go up, it is a reflection – and not a consequence – of supply going down or of demand going up or both. When it happens for just one or few commodities, it is possible to blame middle-men of hoarding or manufacturers of cartel-like behaviour. When it happens in many commodities, it is futile to blame one industry or a few producers.

Usually, the source lies in some policy measures and their implementation. To make it clear, we are not dismissing the importance of factors like climate change, diversion of land for production of bio-fuels and more importantly, stagnation or even outright decline in agricultural productivity in countries like India and China. Again, they explain inflation in food and agriculture commodities. These factors do not explain inflation in crude oil and copper, for example.

If we have to identify a single or the most important explanation for the recent development in prices of many commodities, the answer lies in examining the behaviour of global central banks.

Of course, in any broad-brush analysis or conclusions, there is the risk that we miss the exceptions who behaved differently and correctly. For example, within the constraints imposed by the political system, Reserve Bank of India has done a very good job of trying to shield the Indian economy from the cycles of boom and bust. Similarly, if the Australian and New Zealand economies still face the risk of boom and bust, it is not because of their central banks but in spite of their best efforts.
The bulk of the blame has to be assigned to the American Federal Reserve and the People’s Bank of China. In the case of China as in the case of India and in many other developing countries, the central bank is not independent. It is subject to political influence. The Federal Reserve Board of America is, in some ways, a similar predicament. It is subject to the oversight and pulls and pressures of the democratically elected Congress members. Further, since it was founded by banks actually, it ends up coming to the rescue of banks sometimes to the detriment of the public.

In 2001-2003, it cut the Federal funds rate to 1.0%. It thus rescued the economy from the collapse of the technology bubble in 2000. Thus, it replaced the stock market bubble with a housing bubble. When the housing bubble appeared to be weakening, it refused to tighten regulations and allowed it to continue. Too many loans were made to people who should not have been lent. That is the root cause of the present problem.

In order to address the resulting loan defaults, stress on banks and their balance sheets, the Federal Reserve has allowed banks to borrow at cheap rates from it. Money is available to banks in the open market but at higher cost. Some of the banks might not have survived. But, that would have also left a lesson for other banks that they would not have forgotten for a long time. Excessive risk-taking would have been curbed. Instead, the cheap money is perhaps being channelled into speculation on commodities prices. After all, banks are not going to create more mortgage loans at least for quite some time.

Somewhat different has been the behaviour of China but it achieves the same result. China has kept its currency cheap. Keeping the currency cheap requires interest rates to remain low, in comparison to other countries but also in relation to economic growth. China has done that. Low interest rates means capital is plenty. So, capital-intensive growth has flourished. That has placed tremendous demand on resources worldwide such as crude oil, coal, steel and other industrial metals. It continues to import rising quantities of iron ore, copper and crude oil. Incidentally, it has also led to China supporting many tyrannical regimes in Africa including that of Zimbabwe. Recently, it sent a shipment of arms to Zimbabwe but faced an avalanche of protest and had to recall that shipment.

Perhaps, it is possible that American banks know that there won’t be any change in China’s demand for commodities in the near future, at least until the end of the Olympics. China may be reluctant to change course fearing unknown and uncertain consequences. If so, it argues for further rise in the price of commodities. Both their behaviour and bets might be feeding off each other. That is not good news for the rest of the world.

After all, we cannot influence the Federal Reserve. So, how should policymakers respond? Unfortunately, the answer is that they should respond differently from what they have done until now. Banning exports of agricultural commodities exposes the hollowness of farmer-friendly policies. Farmers should be allowed, with appropriate guidance, to sell to the highest bidder – local or global – and derive the maximum gains from the global shortage. Such a price signal would also encourage productivity improvement in farmland and hence boost crop production. More land would be brought under cultivation. At the same time, poor households – rural or urban – could be directly subsidised with cash transfer to be able to pay the higher price.

The same principle can be extended to the price of hydrocarbon products such as petrol, cooking gas, diesel and kerosene. Consumers and producers should receive the price signal. Without that, their respective behaviours would not change and shortages or glut would persist.

At the same time, since supply of food and other commodities would take time to respond to price signals, central banks should be allowed to restrain demand in the short-run with tight monetary policy. That means higher cash reserve ratio or higher interest rates or both. That might be unpopular or politically unacceptable. But, effective medicines never taste sweet. Only placebos do.

The chances of such sound policies being pursued are close to nil particularly as many democratic governments, including India, approach elections soon. Authoritarian governments do not care much for public opinion.

Given such a low chance for sound economic decision-making, prospects for a sustained decline in inflation should be judged remote. That is not good news as it is a stealth tax on the public and erodes their purchasing power. Consequently, it reduces affordability for many assets. As demand drops, inflation affects revenues for companies and squeezes margins through cost pressures. That does not augur well for the stock market.

The stock market in India has performed well in recent times. Many other global markets have staged a similar recovery. That is due to misplaced optimism on the American economy. As discussed above, right policies would be missing and hence the anticipated quick economic turnaround in America would be elusive. Consequently, risky assets globally would retrace their recent gains. Therefore, Indian stocks would fail to build on their recent gains. On the other hand, the likelihood of continued high global and local inflation would result in a resumption of the uptrend in gold price that has been recently disrupted. Therefore, investors who do not expect inflation to recede know exactly what they should be selling and what they should be buying.

Here lies the crux of the matter. If use of new seeds, fertiliser use, irrigated land, cropping intensity, and private capital stock growth are not rising fast enough, then where is this credit going? To put it another way, what is the Indian farmer doing with the extra credit if he is not using it in seeds, fertiliser, water, capital or land? [IE]

As he himself says on the matter:

The rupee’s rise may be less dramatic than that of the Philippine peso, Brazilian real or Turkish lira. But it is uncomfortable nonetheless.

Quite so, just like a strong vindaloo without the de-rigueur mango lassi accompaniment a rising currency produces its own kind of dispeptic discomfort. But hold on a second, mightn’t a rising currency in India actually be good news, and in any event inevitable? Nothing it seems is ever considered to be unmitigated good news where India is concerned in the eyes of our valiant correspondant, since everything needs to be tinged with its due and measured dose of schadenfreund.

What then is all the fuss about? Well the rupee certainly is rising. As the Economist India corresponent points out, India’s currency has strengthened by about 15% against the dollar in the last year alone, and by over 10%, on an inflation-adjusted, trade-weighted basis, since August 2006. And why is this happening, or why is it happening just now? Again our hero is pretty much to the point:

This vigour is due to a strong inflow of foreign capital, some of it enticed by India’s promise, the rest disillusioned by the rich world’s financial troubles. The net inflow amounted to almost $45 billion in the year to March, compared with $23.4 billion a year earlier.

So he is pretty much to the point here – India’s enchantment is in part a question of disenchantment with others – although I can’t for the life of me understand why the latest data he has to hand is from back in March. Can’t this guy ever do a professional job? Data up to the start of December is readily available on the Reserve Bank of India website here, and fascinating reading it is. Since this is a moment of almost historic proportions, perhaps my colleagues on this blog will be understanding and permit me a small break with tradition in actually posting an exhibit-A type chart.

As we can see, and bearing in mind that the net inflow of external funds in the year to March – as proxied by the level of foreign exchange reserves held at the Reserve Bank of India – was $45 billion, the net inflow between 31st March 2007 and the start of December has been around $74.4 billion, or not that far from double the total amount that entered in whole fiscal 2007/2008 in just 9 months (and $41 billion of this since 9 August, more on why this date is important later) and fiscal 2006/7 was itself a very strong year for fund inflows, as we have already mentioned. All of this is, of course, simply staggering, but unfortunately, it seems, you aren’t going to read about just how staggering it is in the pages of the Economist since over there we are still looking at last years data (the last time I cricised them they said I was cross, this time I am angry aren’t I, does it show?). As can be seen directly from the chart, the money really started to flow in from mid-September and continued flooding in at a very fast rate until roughly mid November.

The locus classicus on this whole state of affairs is without a shadow of a doubt Morgan Stanley’s Chetan Ahya, and really it was this post of his which alerted me to the extent and significance of what was that was happening in India.

Over the seven weeks ending November 2, 2007, India’s foreign exchange reserves have increased by US$34 billion (annualized inflow of US$250 billion). Indeed, the trailing 12-month sum of FX reserves has increased to US$100 billion. This compares with the average annual increase of US$38 billion over three years prior to these seven weeks. With the current account still in deficit, the increase in reserves is being driven largely by a spike in capital inflows and to a very small extent because of conversion of non-dollar reserves into dollars. During the last seven weeks in which FX reserves have shot up, we believe that capital inflows would have been US$35 billion. Out of this, not more than 10% has been on account of FDI inflows. Non-FDI inflows including portfolio equity and external debt inflows form a major part of these inflows.

While the inflows are pouring in at the annualized run rate of US$250 billion, in our view, currently the country can absorb only about US$40-50 billion of capital inflows annually without causing any concern on attended risks of overheating. The key question policy makers are grappling with is how to manage these large capital inflows. As the strong growth in domestic demand has resulted in overheating of the economy recently, the central bank does not want to leave such large capital inflows fueling the domestic liquidity. Not surprisingly, the central bank has accelerated the pace of the sterilization by way of issuance of market stabilization scheme (MSS) bonds and an increase in the cash reserve ratio (CRR). Over the last 12 months, the RBI has sterilized about 58% of the foreign inflows. The sterilized liquidity (excess liquidity) stock including reverse repo less repo balances, MSS bonds, government balances with the RBI and the increase in the cash reserve ratio has shot up to US$77 billion as of end-October 2007 from US$19 as of end-October 2006.

Now while the issue of whether or not India is now overheating once more raises its ugly head here, the context is now quite different, and it is clear that the Reserve Bank of India is having to struggle with a very different problem set from the one we were looking at back in the winter of 2007/8. The problems that may arise in the wake of such a massive influx of funds, and especially if the flow continues (or even increases further as it may well do if the problems the developed economies experience in 2008 turn out to be greater than appear to be the case at present), and doubly so the if India’s attraction only rises further on the back of a discovery that not all the emerging economies are as structurally sound as they appear to be.

The 9 August 2007 date is a significant (and even historic) one, since that is the day that French banking giant BNP Paribas announced it was suspending three of its funds — Parvest Dynamic ABS, BNP Paribas ABS Euribor and BNP Paribas ABS Eonia — since they were considered to be unduly exposed to US high-risk property loans. BNP Paribas Investment Partners, a unit of the French bank, chose that day to announce that the funds would forthwith accept no redemptions or subscriptions, and in making this announcement the so called “US Sub-prime Financial Turmoil” problem was born, and with its arrival the history of the entire global economy was given, it seems, a gentle turn of the page.

One outcome of the Paribas decision that no-one perhaps envisaged when it was announced was that half a century of severe distortion and imbalance in global economic dynamics (you know, that old-hat “rich economy”/”poor economy” thing) might be given a hefty push in the direction of unwinding itself across a five to ten year window. Acceleration and recoupling is now the name of the game. (Since explaining all this involves getting involved a little bit in what the Bretton Woods II architecture is all about, as well as in the significance of what is happening in Japan, about which I have previously posted something here, and about what Bretton Woods III might look like, and how quickly it might now have to arrive, I will not enter more into this intriguing topic, but will save it for a separate post next week).

Now I don’t think it really needs saying that India is hardly to blame for the sub-prime blowout, or for the fact that the whole Bretton Woods financial architecture is looking extremely shaky at this point in time. One thing is sure though, and that is that given that money is leaving one place (some of the G7 type developed economies), rather than intentionally heading somewhere else, India now finds itself reeling under the weight of a quite sudden and unexpected inflow, which she may seriously be asking herself what it is precisely she has done to deserve, since what seems to be involved is some form of reversal the directional arrows normally though to be associated with the expression “capital flight”.

What is obvious to me at least at this moment in time is that, amongst all the growing risk you can see steadily accumulating itself out there (and here I would part company slightly from the Morgan Stanley China team, since I think the dial registering inflation risk in China is now starting to turn dangerously red) India looks to be as good a substitute for a safe haven as you can find these days. And so in the money comes.

The question is that while India’s new found growth potential and relatively tame inflationary environment is in part a by-product of the fact that the rupee has been allowed to steadily rise, the ensuing process is not, to use our Economist India correspondent’s own euphemism, a comfortable one. And in the same way that the representatives of the European Central Bank express concern about “violent changes in currency values” – meaning by this the unduly rapid rise in the value of the euro – the gentlemen over at the Reserve Bank of India and the representatives of the Singh administration have every right to speak out plainly to the effect that countries like India and Brazil (for all their tremendous potential) simply cannot shoulder the whole weight of the massive global correction which is now in course.

These are developing economies, and the whole path of their development process can be distorted or skewed by an excessively hot-house fashion injection of funds. In this sense I fully endorse the preoccupations being expressed by Chetan Ahya about the rate at which the inflows are pouring in. An annualized run rate of US$250 billion is simply enormous in an Indian context, and historically (in proportional terms) unprecedented anywhere I think. So regardless of the validity or otherwise of Ahya’s suggestion that India currently can only absorb somewhere in the region of US$40-50billion of capital inflows annually without producing overheating risks (here we go again, my guess is that this number could be higher, but this is just that, a guess, since I certainly have not done the requisite studies, but who, in all honesty, really has, or is in a position to realistically estimate what is involved here. A brave man, I would say).

This is not the moment to take all this off into those still very much uncharted waters. My friend and colleague Claus Vistesen recently had a stab at identifying some of the issues involved in this Compass and Charts Needed post. Clearly a coordinated and concerted response from the entire central banking community as well as from a rapidly enlarged G7 type forum is badly needed (was the case for enlargement of the G7 ever so clear as it is now, what the hell is Italy doing in there while India and China are out, our institutions simply are not keeping pace with events). I, for my part,only want to register here that something profound and important is taking place, and that there are no easy answers to hand. This is not simply a tepid repeat of events we have all seen far too often in the past, and recipes (which is what I fear we are being offered in the pages of the Economist) will not suffice (even if they are of the softer Chicken Tikka Masala variety rather than the undiluted Vindaloo one). Starting from this recognition, let the debate as to where we go next, and what to do about it, commence!

Obviously institutions matter, but so does demography. This is not a one horse race, or if you prefer, this particular horse doesn’t only run on one leg.

The topic in question here is India’s potential growth rate. Recent GDP performance at just under 9% must have been astounding many of India’s critics, especially given the way inflation, despite all that growth, has been kept pretty much under control.

So to go to the start of our story, back in September 2006, I posted a piece here on this blog entitled “Uncharted Water” where I argued precisely the following:

What is clear is that the Indian economy is currently gathering steam, and this at a time when there is a general consensus that the political will for reform isn’t what it used to be. Strange isn’t it?

My meaning here isn’t that reforms aren’t necessary, but that there are other factors at work, and in particular demographic ones. The importance of these demographic factors generally can be seen from the fact that it is now the newly developing countries (China, India, Brazil, Chile, Thailand, Turkey) who are pulling the global economy (and in the process pushing up energy and commodity prices). The developed world – which makes up say 50% of global GDP is growing much more slowly than the developing world – and some of this for ageing related demographic reasons. Global GDP is forecast to grow at a 5% annual rate this year, yet the US is growing at around 3.5%, Japan 2.5% and the eurozone around 2%. So you tell me, who is pulling who here?

And this is why I say we are moving into uncharted territory. Economists used to have a little model which worked on the assumption of each economy having a certain growth capacity in any given moment. But could any one tell me, what *is* the growth capacity of China or India? I certainly have no idea, and I haven’t seen anyone else make a convincing case on this topic. The magnitude of the growth we are now seeing in the developing world is beyond all historical precedent.

Doesn’t look to bad at all, does it, in the light of what has been happening during the second half of this year. And remember this was written in the Autumn of 2006, not Autumn 2007 when just about everyone and their auntie is saying something like this. Of course this whole debate is ongoing. Nandan Desai had an excellent piece here earlier in the year which put things pretty much in perspective and in October 2006 I had another piece in the IEB, basically in response to the Sizzling India article in the Economist, where I said:

I am even brazen enough to believe that trend growth may well have moved up beyond 8.5% going forward, and that indeed within 5 years we may well see India overtaking China in terms of average quarterly growth rates (of course this may well vary from one quarter to another, a phenomenon known as volatility, and of course 5 years from now the Chinese economy may not still be sustaining the very high growth rates we see today).

Again, I am really comfortable standing by this, and even the point about China, since the inflation problem really does seem now to be getting a grip there, in a way which it isn’t doing in India (and remember they have had nearly 30 years now of the one child per family policy, and at some point soon their labour market is going to tighten and tighten, and for a glimpse of what may well happen next in China see my recent analysis of the growing problem we now see in Russia: “Russian Inflation, Too Much Money Chasing Too Few People” (not too much danger of this getting to be a problem in India in the near future, now is there?).

Since this time of course, the whole recoupling/decoupling issue has really taken off as a live debate. My latest thoughts on this can be found here, and Claus Vistesen’s post – The Global Economy, Compass and Charts Needed – follows up on and continues the “uncharted waters” theme.

Well, now for the Economist. What I said in my response to them was the following:

To The Economist

At the risk of having to assume some kind of modern “j’accuse” mantle (for which of course there are ample precedents in the early origins of your own magazine) I am going to put up yet another comment. Maybe this is because I would like to participate in that “severe contest between intelligence, which presses forward, and an unworthy, timid ignorance obstructing our progress” which your contents page so boldly announces.

Maybe it is also because I want to pin down quite clearly for future reference just what the issues are, and just why it isn’t “absurd” to suggest that the Economist currently systematically fails to factor-in the demographic components in economic growth (or the lack of it). Well, saving the best (or should that be the worst) to the last, I would like now to come to the case of your India correspondent. This gentleman (and I sincerely hope that despite his evident predilection for strong Vindaloo curry he is one of these) has been systematically re-adjusting upwards India’s potential trend growth rate in recent months. In fact his estimate seems to have shot up from 6.5% in November 2006 to 7% in February 2007, to 8% in June 2007. Now that’s an upward adjustment of around 25% in trend growth in roughly 8 months. Quite an achievement, especially since he offers absolutely no explanation whatever for these adjustments, but what he does not fail to tell us – oh, he never lets a moment rest without beating this drum – is that: “India’s economy, like Delhi this week (or Vindaloo curry perhaps, EH), remains far too hot.”

Now just in case what I am suggesting here is questioned I would like to quote chapter and verse, since the issue is an important one.

In November 2006 the Economist’s India correspondent estimated capacited growth for India at around 6.5%.

23 November 2006 Too Hot To Handle

INDIA’S curries can be even hotter than the fieriest of Chinese hotpots; likewise the temperature of the two economies. Despite widespread claims that China’s economy is overheating, actually India’s shows more signs of boiling over.

In the year to the second quarter, India’s GDP grew by an impressive 8.9%, while China’s more up-to-date figures show even more breathtaking growth of 10.4% in the year to the third quarter. But to judge whether an economy is too hot, one needs to compare this expansion in actual demand with potential supply, ie, the sustainable rate of growth. Despite India’s growth spurt in recent years, its sustainable pace is still much lower than China’s, which puts its economy more at risk of overheating and rising inflation.

India’s trend growth rate has almost certainly increased but it is still nowhere near as high as China’s. Mr Prior-Wandesforde estimates that it is now around 6.5%, up from 5% in the late 1980s. But India’s recent acceleration largely reflects a cyclical boom, thanks to loose monetary and fiscal policy. The Reserve Bank of India has raised one of its key interest rates by one and a half percentage points to 6% over the past two years, but inflation has risen by more, so real interest rates have fallen and are historically low. This makes the economy more vulnerable to a hard landing.

By February 2007 the estimate had risen to “not much above” 7%.

1st February 2007 India overheats

“But the problem is that this new speed limit is almost certainly lower than the government’s one. Historic data would suggest a figure not much above 7% – well below China’s 9-10%……If something is not done, then a hard landing will become inevitable.”

and by June 2007 it had been revised up nearer to 8%.

June 7th 2007 Waiting For The Monsoon

“This is not to deny that India’s economic speed limit has increased, to perhaps 7-8%, thanks to stronger investment and economic reforms. But growth has exceeded that limit. The economy still shows alarming symptoms of overheating”

And depispite all this, we are now in December 2007, the Indian economy has been growing at around 9% for the last three quarters, and inflation has been kept, as I say, remarkably under control.

So actually what we are all really waiting for here is not the arrival of the monsoon, but some explanation from the Economist’s India correspondent about how he is calibrating all these estimates. There is nothing particularly to be embarassed about in getting this one wrong, since it is pretty difficult to put a number on where Indian growth is going, but it does seem hard to maintain the credibility of your calls if you conveniently keep ignoring what you were saying only yesterday, and more importantly fail to diagnose exactly why it is that India has been able to grow so much faster than you expected. And of course one day India may overheat, and stopped clocks do give the right time twice a day, but this doesn’t make them especially useful measuring instruments.

Back in the autumn of 2006 I argued that we were now entering “uncharted waters” and that no-one really had any accurate idea of what India’s true mid-term trend growth rate actually was. I also asserted that it was in all probability way above the more conservative and conventional estimates. I was guessing really, but behind my guesswork was a long hard look at India’s underlying demography, and it is just this kind of approach that the Economist India correspondent discounts. Again, chapter and verse:

1st February 2007 India On Fire

Many Indian economic commentators say that further structural reforms, though desirable, are not essential to keep the economy growing at 8% or more because of the “demographic dividend”. A fast-growing working population and a falling dependency rate (thanks to a lower birth rate) will ensure more workers, more saving and hence more investment.” “India’s demographic structure is indeed starting to look more like that in East Asia when its growth took off. But this mechanistic view of growth assumes that demography is destiny and that economic policies do not matter. In fact, open markets, education and investment, especially in infrastructure, were the three chief ingredients of East Asia’s success. Population growth by itself does not add to prosperity, unless young people are educated and new jobs are created. India needs to reform its absurdly restrictive labour laws which hold back the expansion of manufacturing particularly.”

Basically I find myself in agreement with the Indian economists he doesn’t like. It isn’t that these reforms aren’t desireable, as he admits, we all agree on this. But the point is, even ex-reforms (and of course there have been reforms and global opening) demographic momentum would indicate that substantial growth is now going to occur. How substantial? Hard to say, but I think it is quite probable that 5 years from now India will be growing faster than China, and may even peak out at the highest annual growth rates yet seen for a significant economy over the 5 to 10 year window. I can justify why I think this with some sort of coherent argument, but I think the big danger for the sort of view they are advancing at the Economist is that they imagine virtually nothing is possible without institutional reform, and this is just as big a mistake as saying demography is everything. You need to systematically take the two components into account. If you don’t do this you risk getting into the ridiculous position the World Bank found itself in earlier in the year, when countries like Argentina and Thailand complained that since their countries were registered as going backwards on the global governance index, while both countries were growing quite nicely, then logically the methodology used to construct the index must be wrong. IMHO the World Bank has been totally mechanistic about institutions and thoroughly deserves all the problems it creates for itself on this count. OK, so that’s it. I finally rest my case. The dialogue will continue.

And it is, undaunted by the failure of all that vindaloo curry to overheat more than his own digestive tracts our dear correspondent is now worrying about, guess what, the rise of the rupee. More on this, and the real current state of the “overheating” situation in my next post tomorrow.

That’s one of the proposals Sushant Singh puts forward in his article on moving towards an endgame in Jammu & Kashmir:

…unemployment among the youth of the valley remains to be adequately addressed. Handing out of doles and packages to the state government and public sector institutions is not the solution. An alternative would be to incent the private sector, perhaps even outside the state, with an offset to employ a certain percentage of people from Jammu & Kashmir.

The idea of converting the entire state into a virtual special economic zone (SEZ) has been mooted. The state has a special status under the Indian Constitution. So do SEZs. What is required is the repositioning the state to one that leverages its special status to achieve socio-economic development.

It would also require a rebalancing the distribution of fiscal transfers from the central government between the public and private sectors.

This will undermine the separatists’ main economic grouse—step-motherly treatment by the Centre and no attempts at development in the state. [Pragati - The Indian National Interest Review]