Thursday, September 9, 2010

Ekonomikrisis - 9th September, 2010

Keeping a promise made long back to myself, I shall try and post my views on economics, financial markets and the rest regularly. Please feel free to contribute, debate, challenge and criticize.

I am fairly puzzled by the recent rally in financial asset markets, Indian equities in particular. Given the current state of things, one can always work out the reasons backwards, but to have predicted that this would have happened was, as always, difficult. I used to laugh on seeing the views touted by the retail gurus on CNBC, but so far they have been right and I have been wrong. Therefore I am forced to accept that somewhere the linkages of cause and effect as imagined by me have been incorrect.

While I am quietly confident about the prospects of economic growth in India, I am not overtly bullish the way other market participants seem to be. We have a long way to go, in many aspects, before we can really claim the coveted tag of an economic superpower. And to my mind there are obstacles right now which make unbridled growth in India seem like a pipe dream.

First, there is inflation. One can refer to innumerable examples in economic history which show that inflationary growth is unsustainable. Despite inflation hitting lows in the developed economies (the reasons for which are totally different) and remaining reasonably stable in India's "peer group" i.e. other emerging countries, India continues to suffer from high inflation. A recent article by the Peterson Institute blames this on asset price inflation (land in particular) and I am inclined to agree with them. Flats in Powai are selling for 15000 rupees a square feet. I heard of a recent sale of a flat in Bandra for 11 crores at a rate of close to 65000 per square feet! Of course it is too chauvinistic to extrapolate from Mumbai anecdotes and generalize them for the whole of India, but it does put things in perspective. Indian equities enjoy a premium of as much as 40% over bottom up valuations, as per some equity analysts. But the market continues to clear because everyone wants a slice of the pie - every financial asset manager has some portion of his money in India. Apart from asset prices, another culprit has been food price inflation. Some people are willing to take a call that with the monsoons doing well, food price inflation is likely to subside. However, I am not as sanguine because the world's supply of food continues to teeter on the edge with respect to the demand. With disturbing weather patterns and increasing protectionism, things may not be as simple.

And the RBI is not able to help as much as it would like to. They view the problem of inflation in India as partly structural due to intrinsic capacity constraints. Additionally, a lot of the country's financing needs are met outside the regulated financial system. Variations in the benchmark policy rates doesn't help them because they are dependent on an inelastic, exorbitant system of financing through local moneylenders and the like.

Compounding the RBIs problems is the fact that we have witnessed the worst recession since the Great Depression and a reasonably sharp recovery in less than 2 years. The strong action taken by policymakers post the Great Recession of 2008 has stopped the pain temporarily at least, but also confused everyone as to where in the economic cycle we stand currently. Thus, the RBI is forced to lag the monetary tightening cycle, taking baby steps as it tries to evaluate where the world and India stand. Short term real interest rates are negative, with inflation at 10% and one year deposit rates around 6%.

Coming to the second point - the fiscal deficit. One of the lessons from the Great Recession has been that governments should learn to run a proactive countercyclical fiscal policy. Essentially they should act like the proverbial ants in the ants and the grasshopper story. When the country is growing well, the government should minimize spending and borrow less, thereby keeping some cushion for it to act with force in times of crisis. In times of a recession, the government can borrow more and spend more, keeping the economy going.

The current government had an excellent opportunity to do that. With the money coming in from the 3G auctions and PSU disinvestments, plus overall robust tax collections, they could have cut down on the huge debt to GDP ratio (which is actually amongst the worst in the world) and built up a war chest to help the nation in times of strife. During the recession, they increased the fiscal deficit to support the economy, which was necessary. Unfortunately they are not reducing the fiscal deficit now. They continue to succumb to populist measures and increase spending and subsidies. I remember Mr Willem Buiter, Citigroup's Chief Economist, mentioning in a talk: The Indian government subsidizes its borrowings by various means such as the SLR (Statutory Liquidity Ratio) requirement on banks, which ensures that there is a forced market ready to buy government bonds.

If one looks at the implications of the inflationary scenario and the tepid fiscal outlook, there is a case for saying that India's interest rates currently are much lower than what they should be. Things are unlikely to continue as they are for an extended period. Something's going to give.

The third point is India's current account deficit. India has historically had a current account deficit post Independence (somewhat paradoxical for a nation that in the past few thousand years was one of the lynchpins of global trade). The Indian economy was highly insular. As mentioned by Paul Krugman, India had a philosophy of trying to meet all its requirements internally, even if it was at a tremendous cost disadvantage, where free trade would have made sense. It is only in the past 10 years or so that software exports and capital flows have provided some semblance to the deficit. India is still forced to import much of its oil requirements and capital goods. Currently, India is able to just about finance the current account deficit (i.e. meet its foreign exchange requirements) through the capital account. Woe betide us if the world economy goes into a crisis mode again, for all the capital that we are enjoying right now will fly away in no time. The only positive, in a perverted manner of speaking, will be that our own growth will also suffer, bringing down the oil and capital goods imports and easing pressure on the balance of payments.

So yes, I am positive on the Indian economy. But I can't put blinkers over my eyes and declare that there is nothing rotten in the state of Denmark. Its probably the time to be calfish, not bullish.


  1. Great analysis! Unfortunately, I do not have nearly enough knowledge to critique your essay. I would just make a couple of observations. The three issues that you have mentioned have been existed (pretty much, except the high levels of inflation maybe) in our economy for a long time, and still we have managed to make good progress.

    The countercyclical measures that you mentioned are the ideal policies that any central bank should adopt; but since economics is embroiled with politics, there is enough pressure to resist the change. That said, RBI has done a commendable job in the past few years.

    Of all the points you mentioned, I feel the inflationary growth may be the most harmful. The main drivers as said is the rise in property prices of food items. While the property prices should take care of themselves (there should be no government intervention), it is imperative that PDS should be overhauled so as to let the effects of a good harvest percolate through the country.

  2. @Ameya: Thanks a lot. What you are saying is correct. The only problem is that the global environment has deteriorated much more than in recent years. Hence, the risk is that going forward India may find it much more difficult to sustain these issues. RBI I agree has done a commendable job. The problem is with the fiscal policy and food distribution (as you have pointed out).