“For what it’s worth, a key conclusion from the IMF’s new World Economic Outlook is that recessions caused by financial crisis typically end with export booms, with the trade balance improving,on average, by more than 3 percent of GDP. I find this a disturbing result: we’re now suffering from a global financial crisis, which means that the usual driver of recovery will only be available if we can find another planet to export to.”
Paul Krugman

With results still coming in, projections show the United Progressive Alliance is likely to win about 250 seats, making it a shoo-in to form the next government and provide continuity, a stable administration and progress on key economic and corporate reforms.
Wall Street Journal, May 16 2009

Prime Minister Manmohan Singh’s electoral victory, the biggest any Indian politician has scored in two decades, may loosen political shackles that have restrained the country’s economic growth as it struggles to free half a billion people from poverty…..Political stability will make India a more attractive investment destination as Singh, 76, seeks the funds to stimulate Asia’s third largest economy.
Bloomberg, May 18 2009

Many are called, but few are chosen, as the saying goes. But could it just be that this time around, and on a one-off, never to be repeated basis, India might find itself right there in the midst of things, with a 50-50 opportunity to add its name to that select and noble band, the chosen few. After all, someone has to lead the next global charge? The majority of the developed economies are either bogged down in the substantial quantities of debt that they desperately need to pay off, or weighted down by those elderly populations who are weakening consumption growth and leading to export dependence (Germany, Japan…). And as Krugman humorously points out, someone will have to add the extra demand which will allow global trade to start to grow again, so why should India not supply a significant part of this new demand, after all we are more likely to find consumers in India than we are on Mars. (more……. )

What is the biggest lesson from the Great Depression? In my view, it is that monetary policy and the financial sector play a crucial role in economic development. Let me put it more precisely: good monetary policy is unlikely to accelerate the speed of economic growth – after all we have more income year after year because mankind comes up with new ideas, with new products, with more efficient ways of producing output. However, bad monetary policy can easily derail economic development. It is true for rich and poor countries alike.

Why are financial markets and the banking sector so important? Banks fulfill a very important role in the economy by matching borrowers and lenders. When we deposit $100 in a bank, the bank keeps, at most, two to three dollars in its vaults (in fact the money is often in the central bank), the remaining $98 or so is lent to a borrower.

Most businesses require loans for their normal operations. When the banking sector does not work properly, businesses cannot get loans and they have to curtail their production and lay off workers. As they curtail production, they demand fewer products from their suppliers and therefore their suppliers have to reduce their output and fire workers. If manufacturers cannot sell their goods because the firm downstream does not need as many products as before, they cannot generate enough revenue to repay their earlier loans. Businesses go bankrupt and banks experience further problems as their balance sheet deteriorates due to non-performing loans. At this point, banks want to lend even less because of the uncertainty generated from bankruptcies. As they lend less, the vicious circle continues – with producers cutting production and firing workers. On the top of this, depositors start worrying about their deposits because the non-performing loans have made some banks go belly up – your bank has lent out your money to borrowers who cannot return it. Depositors start withdrawing their cash and banks have even fewer possibilities for lending as they have to hoard cash in case there is a run on the bank. If the financial sector does not work, the real economy can go into a deadly spiral and shrink by 30 per cent as during the Great Depression.

And one thought like Ilian that this would be obvious to all the policy makers. However all the lessons from the Great Depression seem to have been lost within three-quarters of a century. It seems, to paraphrase Marc Bard, that politics [especially of the petty and partisan variety] eats policy for lunch seven days a week.

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)

All non-plan expenditure heads excluding interest payment, repayment of debt, defence capital, salaries, pensions and the finance commission grants to states will be subjected to a mandatory 5 per cent cut.[IE]

Does it really matter? After all, the unutilised amounts of defence expenditure for the tenth plan [2002-2007] were 14.46% of the total allocation.

Chicanery, in its purest, unadulterated bureaucratic form…

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.

In the last five to seven years, India has grown on the basis of its knowledge economy and consumerism. The IT industry, and its related industries, provided jobs for Indians. As Indians earned more, they spent more, and that’s how consumerism drove economic growth as a whole and also led to a huge growth in the retail-credit and consumer-credit business in India. As we peak today, this growth in consumerism is leading to a huge investment cycle in India. Because manufacturing capacities have been fully utilized, and infrastructure needs to be established, people are now investing in manufacturing capacities and infrastructure. I estimate the Indian corporate sector has plans today to invest about $700 billion in manufacturing and infrastructure, which will be spent over the next three years. The next wave of growth for India is going to come out of capital investment.[IK@W]

The Indian government has already accepted a little dent in its prospective growth rate this year. It is widely believed that India’s internally driven growth, has increasingly decoupled its fortunes from the US economy. It is certain that an US slump will impact India to a lesser extent now, than it might have done a few years ago. Indian companies are more resilient than ever to a global downturn these days, with lower borrowing costs and healthier debt-equity ratios. Nevertheless, there are some challenges.

Inflationary pressures loom on the horizon. Inflation triggered by higher food and oil prices could deflate the rapid economic growth curve in India. The tight monetary policy of the RBI is related to inflationary pressures. With large-scale credit contraction in the Western markets, the growth plans and capacity expansion at Indian companies will find it difficult to access overseas credit .

The uneven growth in the middle to short term, with the states of Madhya Pradesh, Orissa, Uttar Pradesh and Bihar having seen lesser growth than others, has led to increased social and political tensions. The increased spending on social sectors and populist largesses in the election year, including recommendations of a new pay commission, can also impinge on the growth story. This spending, however, can be met by the dramatic increase in direct tax collections (by over 40% in each of the last two years).

As a banker, Kochar can probably view certain propitious omens that most other economic commentators in this country cannot. The jury is, however, still out on her hypothesis and previsions of a sustained growth rate for the Indian economy.

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!

The BBC reports that the World Bank is considering the first ever proposal for a loan of $3.5 billion to be disbursed and repaid in rupees and not the US dollar. This is being done to ostensibly counter the fluctuating rupee- dollar rate. However, it needs no saying that a continually strengthening rupee and forecasts of a double-digit Indian economic growth make the proposal extremely lucrative for the World Bank.

The Maharashtra state government is seeking a loan worth some $3.5bn but is concerned about the fluctuations in the value of the dollar.

If approved, it would be the first time the World Bank has agreed to a such a loan in rupees.

The idea is that the loan would be sanctioned in dollars, but would be handed over in rupees.

All repayments would be in rupees too.

This would prevent any changes in the amount to be repaid caused by fluctuating exchange rates. [BBC]

Professor Kaushik Basu of the Cornell University believes that the rise of the rupee against the dollar is inevitable in the mid-term. He also believes that the sudden collapse of the dollar is unlikely but there is not much that India can do to alter the current dynamics of exchange rates.

In recent days the rupee-dollar exchange rate has been, on average, Rs 39.3 per dollar. A year ago it was 44.7. This means that the rupee has appreciated against the dollar by 13.7% in the last year.

A gentle depreciation of the US dollar over the medium term seems to be unavoidable, given America’s over-spending. The big risk for India and the world is a sudden collapse of the dollar. This is unlikely, since a dollar meltdown is against the interest of all major players, but not impossible. It needs to be understood that the source of the rupee appreciation is, largely, outside of India. Over the last year virtually all major currencies have been appreciating vis-à-vis the US dollar. The euro rose by 14.7%, the pound by 10.4%; the Canadian dollar by 23%, Sweden’s kroner by 13.7% – the same as the Indian rupee. Vis-a-vis all major currencies, outside of the US dollar, the rupee has changed very little. The exception is China. Its currency has appreciated but only by 5.7%. China has a different strategy. It wants to keep up a sustained subsidy to its exporters and continue to build up dollar reserves. This is costly but it gives China muscle against the US. [HT]

This is not very good news for Indian IT firms, whose revenues are generated in dollars and costs are denominated in rupees. The fear of a slowdown in growth and profits has led the IT companies to employ complex hedging strategies against a weakening dollar. Prior to taking over as the Dean of Singapore’s Nanyang Business School a few months back, Jitendra V. Singh (then with the Wharton’s management department) had argued that Indian firms should use the rupee’s strength to their advantage by adapting their business models in innovative ways, much as Japan’s automakers did during the 1980s.

I believe there is a strong parallel here from which Indian companies – especially, though not solely, the IT firms – can learn some important lessons. If Indian companies compete mainly on cost arbitrage, they will find that as their costs rise because of the stronger rupee, they will increasingly become less profitable. Of course, it is also the case that, as the rupee appreciates, net margins at some companies erode more than at other firms. Specifically, if Indian IT companies compete as low-cost providers of IT services, their competitive advantage will erode in a regime of rupee strengthening.

Instead, Indian firms should take advantage of this opportunity to adapt their business models. How can they do that? While the details of the two industries are quite different, the Japanese automobile industry can suggest some answers. Consider what leading Japanese firms like Toyota did as the yen strengthened against the dollar. For product lines where they made the highest margins, such as the Lexus, they continued production in Japan. However, for lower-priced models — where their profit margins were lower and would have been eroded further by the rising yen — they moved production to the U.S. They protected their margins on non-premium products by moving production — and therefore shifting costs — into dollar-denominated areas. They also reduced their vulnerability to further appreciation of the yen.

You may remember that during the 1980s, Japanese auto makers were facing a protectionist backlash in the U.S., and they were subjected to import quotas. Their strategy of moving production of lower-priced/lower-profit cars into the U.S. paid off in a couple of different ways. First, they were able to shift yen-denominated costs into dollars. Second, this was a quite savvy political move, because although these companies continued to gain market share in the U.S., there was little pressure to shut down their plants. Doing so would have meant a loss of American jobs.

I believe Indian companies should take a similar approach in response to this recent rising rupee regime. They need to consider how to adapt their business models. To the extent that they compete primarily on cost arbitrage, the rising rupee will work against them. One key question to ask is how to develop other sources of competitive advantage, such as building high-level capabilities which cannot easily be replicated by competitors, or how to change the mix of activities carried out in India versus other countries. Of course, in order to do this, they will have to change their mindset: They will have to stop thinking of themselves as Indian companies and think more like global companies of Indian origin. They will need to analyze their portfolio of costs and move production to where it makes the most economic sense. Notably, Indian IT firms are trying to address rising wage costs by moving production within India to lower cost regions — Eastern India (Kolkata, Bhubaneshwar) and to Tier II and Tier III towns. However, this will only offset a rising rupee to a limited extent, since the costs will still be in rupees. [IK@W]

This prescription may hold good for Indian IT companies and these companies would surely be considering taking the suggested route. However if the IT companies follow this advise blindly, it will have grave implications for the overall health of the Indian economic landscape. It helps to recount the happenings in Japan during that period -

But, by the late 1980s, the exporters found it harder to bear the burden. They were caught in a squeeze between high costs at home and a rising yen, which made it harder to pass on those costs in export markets. As a result, more and more of the efficient exporters were being driven overseas. They were investing in offshore markets rather than in Japan itself. Step by step, Japan’s efficient export sectors were being “hollowed out.” As this happened, the productivity of the entire economy started being dragged down to the level of the stagnant sectors.

…At the end of 1989, when Japan’s “bubble economy” was at its height, the country felt on top of the world. The crippling heart attack was but a few months away, but Japan felt stronger than ever. [BW]

India growth model has to focus on generating suitable employment for its large population. If the efficient sectors of the economy move out and only the inefficient sectors remain in the country, the employment inclusive growth plummets. It has serious social and political implications in a democratic society. In a sense, individual companies would progress but that growth would be at the cost of country’s economic well-being. It is nobody’s case that this movement of firms should be legislated against; such policy prescriptions are unviable, if not unthinkable, in today’s ‘flat world’ and damaging in the long run.

For other Indian exporters, such as from the manufacturing sector, of leather products and clothes, or of commercial produce like tea and coffee, who are in direct competition with other Asian countries (mainly China), this is not even an option. They will continue to seek RBI intervention to keep the rupee competitive against the dollar, and peg the rupee vis-a-vis the yuan. Notwithstanding the difficulties involved in managing the rupee-dollar rate, there is no option for the government but to manage the rates in the short to medium term. This will indirectly benefit the Indian IT companies as well; some of them may even defer the implementation of their long-term plans to their own detriment.