Surjit Bhalla on Sonia

TGS has often disagreed with Mr. Bhalla on his optimism on the Indian economy, especially when it is predicated on lower rates. As recently as about ten days ago, we wrote this piece on his estimate of potential GDP growth in India.

His two recent pieces in IE on the role of Ms. Sonia Gandhi are worth reading and deserve to be widely circulated.

He gives a pass to Dr. Manmohan Singh (MMS). I disagree with it entirely. It is puzzling that, in order to train his guns on the ultimately culpable person, he lets off others who are equally guilty. Honourable men must have resigned and left and told the nation the truth.

The devastating summary of sham fiscal consolidation presented in the budget for 2013-14 by the Government is captured too well in just one sentence:

So what does the latest UPA budget for 2013-14 do? It plans for 13 per cent GDP growth, 16 per cent higher expenditure growth, financed by 19 per cent tax revenue growth! This is meant to bring sanity into the fiscal deficit sphere?! Heard a better definition of occultism lately?

His terrific piece on the NREGA corruption, published in February 2012, is here.

I just finished reading the long piece on the National Food Security Bill written by Ashok Gulati, Chairman of the Commission on Agricultural Costs and Prices. I made a two page summary of it: Key paragraphs from Ashok Gulati paper on NFSB

Frankly, if one read that research piece, lent back in the chair and reflected on what this government has wrought over the last eight years or more, it is not just about economics. The damage is pervasive in every aspect of the Indian economy and governance.

Second time it is a choice

I circulated the blog post from ‘Short side of long’ blog to friends in India:

My purpose was to alert them to the risks that lie ahead for Indian stocks and the currency because India runs a current account deficit and hence relies on foreign capital inflow to finance the current deficit. Any adverse turn in international investors’ attitudes to risk will have a bearing on capital inflows into India. Therefore, given that fund managers are already rather overweight equities, underweight cash and negative on bonds, the inference is that there is not much scope for risk appetite to improve further and remain high for any reasonable length of time. If such a scenario came about, then India might be hurt with the Indian rupee weakening. That is a risk scenario that Indian funds, importers and exporters should be aware of and be prepared for.

The response I received from a friend is revealing. He sent a long mail but concluded with this:

“I would not disagree with you that we are living in precarious times, but whether the central banks will permit any serious dislocation to capital flows any time soon remains to be seen.”

This abiding faith in central banks backstopping stock markets is a recent phenomenon (from 1998) and it has not removed the risk from investing in stocks. If anything, it has enhanced the risks of being invested in stocks because investors fail to do their homework and instead rely on central banks bailing them out. Has that – the reliance on Central Banks’ PUT – made them richer in the process? Perhaps, some have enriched themselves. For the vast majority of investors, stock markets have been anything but a joy ride in the last decade and more.

Letting liquidity drive stocks and hypnotizing investors to believe that there is a strong Central Bank PUT option backstopping stock prices, policymakers have reduced the incentive for hard work and risk management on the part of investors, before they choose to invest.

It is amazing that investors too easily forget the message from history. Bernanke promised that there was no housing bubble in the US. Merwyn King promised that Northern Rock in the UK would be a mere footnote in history, if at all. We choose to believe in them despite their fallibility and we make this choice repeatedly.

This touching/in-denial faith in Central Bankers and their expansionary monetary policies reminds me of another friend in Singapore who hears no evil, sees no evil and speaks no evil about policymakers. For him, the Indian government is sincerely trying to grapple with energy and other subsidies; Bernanke is sincerely trying to aid de-leveraging and prevent systemic instability arising again.

A conversation with him makes us wonder whether we are too mean and uncharitable. We come across as though we are finding fault with firefighters bravely fighting fires. Of course, there are two minor details that he is overlooking and hence, his love and benevolence towards policymakers cuts no ice with me. One is that, in this case, the firefighters are the ones who started the fire and two, they are fighting fire with oil and not water.

I must take heart from the fact that some one like Paul Volcker shares similar concerns. That reassures me that I may be a lean thing but not a mean thing. I saw reference to his recent comments in Doug Noland’s weekly Credit Bubble Bulletin dated March 15, 2013. I felt bad that I had not been a regular reader of Doug Noland’s bulletins for quite some time now.

This is what Paul Volcker said on the seemingly perfect ability of central bankers to turn the tap off on QE when the time came:

But they have a very large balance sheet – very large amount of excess reserves… It’s OK for the moment. We have no inflationary problem at the moment. They want to support growth in the economy and so forth. The crucial question for a central bank anytime – but it is going to come in spades this time: OK, have easy money when we have a recession or when there’s a lot of unemployment. But at some point when the worm turns and the party is getting under way – to use that old analogy – at what point do you begin retreating and you retreat decisively enough? You can make a mistake and go too quick. But the much more frequent mistake, in my judgment, it’s been that you go too slow. Because it’s never popular to take the so-called ‘punchbowl’ away – or to weaken the liquor. And there’s a lot of liquor out there now. Mechanically, sure it can be done. They can put it in; they can pull it out. Will it be done at the crucial time in a delicate kind of way that can be done without creating expectations in the other direction that will be harmful? It’s going to be a big challenge.” [Link to his full speech and the above remarks can be found in page 15 of the PDF that is linked]

In another conference held on March 13th, he had much to say about this limitless ability of central banks to fine-tune inflation. This speech can be accessed here:

“I do see a risk of what I consider a strange theory that these all-powerful central banks can play a little game. And when you want to expand – let’s have a little inflation that peps it up. But, of course, as soon as it gets a little big we’ll shut it off and then we’ll bring it down again. There is no central bank that I know of that has ever exhibited the capacity for that kind of fine-tuning. And if they lose sight of the basic role of a central bank is to maintain price stability, stability generally – the game will sooner or later be lost. That doesn’t mean you’re going to off in the next few years on some great inflationary boom – an inflationary process. But this hubris that somehow we have the tools that can manage in a very defined way little increases or decreases in the inflation rate to manage the real economy is nonsense. Did I say that strongly enough?

I was at a school graduation ceremony two days ago. The Dean of the School left the following message for students now stepping out into the world of college education:

 Never make a mistake twice because the second time around, it is not a mistake. It is a choice.

A low quality blog post

Emre Deliveli writes an interesting blog on Turkish economics as part of Roubini Global Economics. He has a post where he gets struck by a phrase by the Turkish central bank governor: `short-term capital flows could disrupt price and financial stability by causing excess volatility in lending and exchange rates’. As with a lot of what India’s RBI says, it sounds like plausible mumbo jumbo and passes muster in the conventional low quality economic discourse, but actually betrays a lack of knowledge of monetary economics.

That was a verbatim quote from a blog post of Mr. Ajay Shah. Here is the link to that post dated 22nd February 2013.

There were too many judgemental phrases that piqued my interest. Plausible, mumbo jumbo, conventional, low-quality, lack of knowledge, etc. He also did not waste an opportunity to take a dig at the Reserve Bank of India. Wonder why the Ministry of Finance of the Government of India does not come in for closer scrutiny in the hands of Mr. Shah.

I went and read the original post by Mr. Emre Deliveli. I cannot have anything against him since I did not know him before I read the above comments. But, I must confess that I came back with very little clarity on what Mr. Deliveli was trying to say. I had not read the speech of the Governor of the Central Bank in Turkey. Perhaps ,the speech was in Turkish language and much of it could have been lost in translation. Second, it also seems to me, a tad unfair, to take one part of it out of context and criticise the speech.

In particular, this paragraph from M. Deliveli’s blog post conveyed the impression that either he did not understand the central bank or that he failed to convey to us his understanding of the central bank or may be, I am just a low-quality economist:

During his presentation of the bank’s 2013 Monetary and Exchange Rate Policy on Dec. 25, Gov. Erdem Başçı noted that “short-term capital flows could disrupt price and financial stability by causing excess volatility in lending and exchange rates.” Therefore, the bank would not allow sharp moves in either. In Friday’s column (you can read the whole thing at the HDN website), I argue that this new target does not make sense: The market and academic economists I talked to are not aware of any theoretical link between the volatility in credit growth or exchange rates.

I do not hold any brief for Turkey monetary policy. I have not followed it closely enough to praise it or sink it. But, even if the Turkey Central Bank was wedded to inflation targeting (it would be a pity if it were the case), I am unconvinced as to why it should not be casting a wary glance at short-term capital flows which, by their nature, are destabilising.

They can cause a rapid appreciation of the currency if the central bank did not intervene. If it did, it could cause domestic money supply to raise and credit growth to raise, unless sterilized. If sterilized, sterilization costs can be substantial. These are real issues and could have a bearing on the price gauges too.

It is all fine and dandy in theory to allow the so-called market forces to play out. But, who are the participants in global capital markets today? Central banks and sovereign wealth funds.

Second, market forces may work out all very well in the very long run but real economic players face real costs of adjustment if financial prices move too much in too short a time.

I decided to go and check out the website of the Central Bank of Turkey and I found the speech of the Governor that Mr. Deliveli has blogged about. I shall resist the temptation to take a page out of the book of vocabulary of Mr. Shah and will not call Mr. Deliveli’s blog post all low-quality mumbo jumbo. But, clearly, he has made a mountain out of a molehill or Much Ado about Nothing.

This is the link to the Bank’s Monetary and Exchange Rate Policy for 2013. The relevant paragraphs are paragraph no. 5 and 21. In fact, at the outset ,the bank says that it has had to overlay considerations of financial stability on top of price stability, esp. after 2008. For my money, I cannot understand why central bankers should be focused on price stability. Well functioning markets for goods and services will take care of themselves. Central banks ought to have focused (only) on systemic stability. If you have not yet read George Cooper’s ‘Origins of Financial Crises’, it is about time you did so.

What is macro-prudential regulation? Jargon-free definition: watch every damn thing.

This is what the Central Bank in Turkey said in paragraph 5 of its 2013 Monetary Policy and Exchange rate policy statement:

5. In Turkey, movements in capital flows and global liquidity cycles manifest themselves mainly as fluctuations in credit and foreign exchange rate. In emerging economies like Turkey, a rapid appreciation of the local currency may favorably affect the balance sheets of firms, leading to excessive lending appetite by banks and thus rapid credit growth. Therefore, the new policy framework attaches special importance to variables like credit and the exchange rate. Both the rapid credit growth and excessive appreciation of the exchange rate distort the resource allocation within the economy and negatively affect macroeconomic stability by causing the domestic demand to grow faster than aggregate income. In the economic literature, rapid credit growth also stands out as one of the significant variables that precede financial crises. Meanwhile, excessive appreciation in the foreign exchange rate may create distortions regarding the macroeconomic and financial stability in an open economy by increasing systemic risk through multiple channels, in particular the balance sheet channel. On the other hand, an abrupt contraction in credit or an excessive depreciation in the local currency is also undesirable from a macroeconomic and financial stability perspective. Therefore, in order to smooth out the effects of the volatility in capital flows, credits should grow at plausible rates and developments in the foreign exchange rate should be consistent with economic fundamentals. The policy framework developed by the CBRT in the last couple of years should be considered from this viewpoint.

21. While aiming at keeping inflation at close levels to the target, the CBRT continues to safeguard financial stability from a macro perspective. In this context, the CBRT will maintain its strategy to contain the volatility led by capital flows on domestic economy. Therefore, the CBRT will not disregard excessively rapid changes in credit or significant exchange rate misalignments. In sum, without prejudice to the price stability, risks to excessive borrowing and macroeconomic imbalances will be taken into consideration in the conduct of monetary policy.

Nowhere has the Central bank said that it is targeting either credit or exchange rate. Nor is it advocating a tax on short-term capital flows or capital controls. I must admit that the paragraph 21 is clumsily worded in English, especially the second sentence.

In simple words, Central Bank of Turkey will be concerned by large and abrupt swings in short-term capital flows for they impact the domestic economy via domestic credit channels and corresponding large swings in the exchange rate. So, it will have to watch excessive credit growth and other macro-economic imbalances without prejudice to its primary goal of price stability.

No decent quality economist – whether monetary or non-monetary – should have objection to a Central bank wanting to keep a close eye on excessive credit growth.

So, I cannot see anything that is low quality, mumbo jumbo nor basic ignorance of monetary economics in the policy statement of the Central Bank of Turkey or that of the Reserve Bank of India.

If Mr. Deliveli (or, for that matter, Ajay Shah) is looking for a central bank that is engaging in mumbo jumbo, low quality monetary economics, he can do no better than look here.

Cyprus Resolution

The one good thing of the Cyprus bailout/bail-in was that it gave some fodder for many arm-chair economists and journalists like Yours Truly to write about, for a week or two. Now, it has given fodder for academics to write some papers on the pecking order of bail-ins, in the winding up of banks.

Apparently (I do not know where I saw this), the Reserve Bank of New Zealand has spelt it out correctly and the bank deposit insurance issued in the wake of the collapse of Lehman Brothers is being withdrawn. Well, it is not new. It was articulated in September 2011 itself. RBNZ has simply clarified that the situation in their country is not the same as the resolution that Cyprus has finally embraced.

I recommend these three articles on the Cyprus resolution. Some of them could be behind subscription firewalls.

The NY Times article discussed the political economy of bailing in Russian depositors. The article mentions – according to some of the Russians interviewed – that Germany had spread the canard that the Russian depositors in Cyprus banks were money laundrers and hence deserved to be bailed in. Some Russian born legitimate businessmen (operating restaurants and bars in Cyprus) are rather aggrieved that they have been asked to bear losses since they are not oligarchs who had enriched themselves at the expense of the society – Russian or others.

In this context, this post (ht: Dr. Vidyasagar) by Yves Smith in ‘Naked Capitalism’ provides more details on how the canard of Russian money laundering through Cyprus has been spread to justify imposing the hair-cut. This is standard war-time tactic – one characterises the enemy as less than human so that harm could be inflicted on them without having conscience tugging at your heart.

A small extract from her blog post:

And the oligarchs with meaningful involvement in Cyprus? The New York Times did find one, but he seems to be the exception rather than the rule. From Cyprus Mail:

“You must be out of your mind!” snapped tycoon Igor Zyuzin, main owner of New York-listed coal-to-steel group Mechel , as he dismissed a suggestion this week that the financial meltdown in Cyprus posed a risk to his interests.

His response is typical across the oligarch class of major corporations and super-rich individuals, reflecting the assessment of officials and bankers on the Mediterranean island who say the bulk of the billions of euros of Russian money in Cyprus comes from smaller firms and middle-class savers…

Sources in the wealth management, advisory and banking industry in Nicosia say Russia depositors are typically smaller savers and entrepreneurs. Fiona Mullen, a British economist in Cyprus, said Russians she encounters tend to be buying 300,000-euro homes, not the palaces favoured by oligarchs in London.

Incidentally, that blog post is well worth a read for its discussion on American oligarchs. [Full post here]

The article in Wall Street Journal (could be firewalled) goes behind the scenes as to how the European Union, Germany and the IMF were in no mood to yield to Cyprus, given that the problems were caused by its outsized off-shore financial centre model. That is a fair point. The article says that Cyprus bluffed with its initial refusal to accept the terms of the bailout (that imposed a mild loss on insured depositors too) but eventually had to blink because now the haircut it is imposing on uninsured depositors is a rather big one (20% to 30%).

It is reasonable to conclude that the offshore financial centre model in Cyprus would go into a prolonged suspended animation if not permanently dead.

Of course, there are no easy answers in this situation. But, in hindsight, given the country’s offshore financial centre model,  it appears that the pain could have been spread over a large deposit (depositor) base than hit one segment rather harshly. Insured depositors could have been given equity and other natural gas linked warrants, etc. Cyprus’ economic contraction could be rather deep and prolonged, threatening social stability. It might interest Turkey more than it should.

This lengthy Bloomberg article discusses the fallout of the new deal between the ‘Troika’ (IMF, EU and the ECB) and Cyprus. Some interesting observations found in the article:

It also marks the first time that senior bondholders in a euro-region bank have taken losses. In the case of Cyprus Popular Bank (CPB), also known as Laiki Bank, those bond holders will get wiped out.

The first use of capital controls by a euro-area member may also pose a challenge to countries such as Malta, Luxembourg and Estonia whose banks also boast large foreign deposits, saidJacques Cailloux and Dimitris Drakopoulos, economists at Nomura International Plc.

At Berenberg Bank in London, Chief Economist Holger Schmieding said the lesson is that “countries will take a lot of pain to stay in the euro zone. The glue that holds the euro zone together remains strong.”

The Cypriot saga may also give more ammunition to populist leaders across southern Europe, who say the political elites running crisis management don’t care about ordinary savers. Italy’s political system is gridlocked and Greek voters are signalling mounting support for the opposition Syriza party, which wants to renegotiate Greece’s bailout program.

“Cyprus was led to a painful compromise in the eurogroup meeting late yesterday under the weight of blackmail and threats,” the party, led by Alexis Tsipras, said in an e-mailed statement yesterday.

I had read elsewhere that Spain’s exports were turning around. I do not see it in the data. At Haver Analytics, non-seasonally adjusted export data are available only up to December 2012 and the gains made from September to October have all been given back in November and December. Non-seasonally adjusted export data fell back-to-back in November and in December.

Retail sales volumes are down and the number of the registered unemployed has gone up from under 2 million in 2007 to slightly over 5 million now.

It seems somewhat silly to conclude that tail risks have disappeared in the world – the subject of my MINT column today.

Potential GDP on a napkin

‘Business Standard’ lunch with a celebrity was with Surjit Bhalla. There is no gainsaying that he is both a brilliant analyst and a maverick commentator. When he applies his mind and when he has no pre-conceived conclusions, then he can brilliant to read and his analysis near-total flawless.

When he has made up his mind, he is difficult to read without twitching your nose and raising your eyebrows. Logic goes out of the calculus.

His ‘Lunch with BS’ is an example. (BS stands for ‘Business Standard’ and not Bull Shit).

Here is his remark:

Our stock of capital is growing at eight per cent. Our elasticity of output with respect to capital is 0.6 – multiply those two, it gives us 4.8. Similarly, labour growth gives you another 0.8; add another couple of percentage points from productivity growth. You get to eight per cent plus without any assumptions at all. So what is this nonsense?”

We won’t even go into his assumption of productivity growth of 2.0%. We shall accept it. Let us look at whether the stock of capital is growing at 8% in real terms. Between 2008 and 2012 (5 years), India’s annual growth rates in capital formation are 3.5%, 7.67%, 13.99%, 4.39% and 2.48%. Over the five years (end-2007 to end-2012), the Compounded Annual Growth rate has been 6.3%. It is incredible that he should put the elasticity of output to capital in India at 0.6. If anything, the ICOR hsa gone up to 5 – in other words, the elasticity has dropped to 0.2 in this 5-year period. It looks set to stay there.

Let us give him some benefit of doubt:

Capital growth = 8%; Elasticity of Output = 0.4; that is 3.2%; labour force growth of 0.8% and productivity growth of 2% gives us 6% and this is still the optimistic scenario.

If capital growth is 6%, elasticity of output is 0.2, productivity is 2% and labour force growth is even 1%, potential growth is 4.2%.

Second, I do not see any problem in a central bank taking into consideration a high current account deficit. Nowhere in the world has a country run a current deficit of nearly 5% with real GDP growth at 5%. That itself shows how abysmally low has potential growth become in the last five years. Potential GDP growth is not cast in stone or frozen in ice – unchanged for ever.

When one makes a realistic estimate of potential GDP growth, then RBI is perhaps not behind the curve but ahead of it with its rate cuts! Recently, I came across a report from JP Morgan that showed how excessively loose policy settings were in 2009 and in 2010. Both fiscal and monetary policies were working over time in India and hence the massively big growth spurt in those two years and payback is now occurring.

We should not forget that even now the Reserve Bank of India is undermining its policy goals with its support to sovereign debt in India. It is engaging in its own brand of quantitative easing. I have talked about it in my last MINT  column.

TGS has no quarrels with his views on the Indian budget.

Shift in FOMC thinking?

David Rosenberg spots a distinction in the Federal Reserve Open Market Committee Communication post-January and post-March meetings.

January 2013:

If the outlook for the labor market does not improve substantially, the Committee will continue its purchases of Treasury and agency mortgage-backed securities, and employ its other policy tools as appropriate, until such improvement is achieved in a context of price stability. [Link]

March 2013:

The Committee will continue its purchases of Treasury and agency mortgage-backed securities, and employ its other policy tools as appropriate, until the outlook for the labor market has improved substantially in a context of price stability. [Link]

I do not think so. There is hardly any material difference between the two. In other words, the post-March meeting press release does not indicate any subtle hint of an earlier end to QE. What do you think?

More on Cyprus

Upon seeing my earlier post, one of my friends sent me the following information:

In 2010-11, Cyprus was the 7th largest FDI investor into India accounting for about 4% of the total FDI inflows…thanks to another “friendly” double tax treaty that has encouraged form over substance investment structures and supported the services industry (accountants lawyers and auditors) that is “necessary” for these structures

On the issue of the bail-out, John Hussman wrote in his Weekly Market Comment on Monday the following:

Notable item over the weekend – a European bailout deal for banks in Cyprus now includes a haircut provision. But not for bank bondholders. Of course not for bank bondholders. No – it provides for a haircut on depositors that is being called a “stability levy” amounting to 9.9% on deposits over 100,000 euros, and 6.75% below that level, exchanging their deposits for shares of stock in those teetering banks. So insuredbank deposits are now effectively subordinate to uninsured European bank debt. It will be interesting to see how that works out.

Yes, insured depositors are subordinate to the uninsured European bank debt. The troika would respond that it was only for Cyprus (because it was too small to matter?) and that too because one-fifth of its depositors were foreigners (off-shore undeclared money?). The other 80% have revolted and that is why Cyprus Parliament has rejected the deal. We have not heard the last on this matter.

It has the potential to develop a momentum of its own – in more ways than one and within Cyprus, Europe and even further.