RR on R

I am referring to comments by Raghuram Rajan on the Indian rupee. I am not sure why the government should ask the CEA to reassure markets on the currency. The job is ideally done by the Finance Minister of the country, the central bank governor of the country or by both jointly. The government is clearly trying to draw upon the international credibility of Raghuram Rajan. But, such overexposure on his part, on behalf of a government that is lacking in policy options and credibility, will create a ‘drawdown’ situation for him.

Earlier, I had written on the Indian rupee, arguing that the Indian rupee was not being singled out. It is still true. Other EM currencies like the Brazilian real, the Turkish lira are faring badly too. However, a good friend pointed out that India’s current account funding [or the combined current-capital import, depending on how one wishes to classify gold imports in his/her head] requirement is the second largest in the world.

On fundamental grounds, the rupee is undervalued. But, India is in the position of having to pay a risk premium to attract funding. Since interest rates cannot be raised to pay that extra premium, the rupee has to weaken by enough to induce investors and others to buy the rupee against their currencies. In that sense, the rupee’s fundamentals are vulnerable. This pretty much sums up my article in MINT that appeared on Tuesday.

A note of thanks

I read the piece in MINT written by Mr. Aakar Patel that good friend Smita has commented upon in her brilliant blog post. Read her post here.

It was a shockingly abominable piece because it is devoid of meaningful content. It is written by an individual who has fled the ‘Non-drinking and vegetarian utopia’. Considering the quality of writing, it is clear that it was written in a state of inebriation – inebriated with inestimable hubris.

I divide my response to Mr. Patel’s response into three parts:

1. Reactions from a member of a ‘non-drinking and vegetarian’ utopia

We do not want to know about the utopia in which he sought asylum but I can say that many, many people in the ‘drinking and non-vegetarian utopia’ also support Modi.

Regardless of Modi’s ‘non-drinking and vegetarian’ habits, has Modi tried to implement an austere code as even vacuous governments in Maharashtra have done?

There are millions of others who have no idea what they want and who are led into a certain lifestyle and clutch of habits by sheer herd mentality. It is appropriately consistent with a liberal outlook that they be presented with the choice of a ‘non-drinking and vegetarian utopia’ not under a State diktat but by the personal example of a leader.

Indeed, the so-called personal choice and personal freedom that many liberals are fond of extolling really exist only in their imagination since their own minds do not allow them those very choices and freedoms. Since they claim to know and speak English, they are better off reading ‘Thinking Fast and Slow’ by Daniel Kahneman to realise how little or no choice that their own minds allow them, in their decisions. They are simply unaware of how much they are led by many unnoticed stimuli.

2. That condescending remark on non-drinking and vegetarians having been dealt with, let us turn to his remarks on matters of public interest.

I could not believe these words in Mr. Patel’s piece,

The Greeks had Cleon (mercilessly panned by the great playwright Aristophanes) and the Romans had Gracchus and Caesar.

Like Modi, none of these strongmen appealed to the most populous segment of their society, the servants, the real landless. Their constituency was the neo-literate middle class.

For those able to look beyond his superb oratory and humour, the vapidity of Modi’s message is striking. It has not been noticed or remarked upon, but Modi has never been to college (his degree is from a correspondence course). His simple views spring from this lack of knowledge.

His writing is all in Gujarati and—I can claim to know something about this—it is mediocre. He’s not well-read, has little idea about the world or its history. It will be embarrassing, if he becomes prime minister, to have him in the same meeting as US President Barack Obama.

India would like to elect a leader who can communicate with millions of Indians. It does not matter if U.S. Presidents have to hire some interpreters. They will do it gladly if India became a nation that was not a laughing stock with nation-wide power grid collapses,with trillion rupees swindled from the exchequer, with flooded airports, with low growth, high cost of living, high borrowing from foreigners and a weak currency all under a doctorate Prime Minister who wants another term in office.

3. Finally, a vote of thanks to Mr. Aakar Patel and UPA

There is one thing that I would disagree with the scores of comments that Mr. Patel’s article had attracted in the pages of MINT: I do not think that MINT should have refrained from carrying this piece. Mr. Patel had written many interesting pieces before and he is usually politically incorrect. But, this one manages to be contemptuous and too patronising towards the neo-literate middle class, at the same time. One wonders why he had refrained from calling them the ‘unwashed masses’.

His arrogance prevents him from seeing the fact that many Muslim dominated constituencies and towns that were Congress bastions in Gujarat since independence have shifted their allegiance to Modi-led BJP in Gujarat. 31% of Muslims voted for him in the Assembly elections in December 2012.

So, do Muslims love him because they agree with his dislike of Muslims and because he has shown Muslims their place in Gujarat? Somethings do not add up and his arrogance prevents him from being open-minded.

Now, I had not explained why we should not fault MINT for publishing this piece or, for that matter, condemn Mr. Patel for writing what he has written.

Without the UPA and without people like Aakar Patel, where would Modi be today in the national consciousness in India? How could he rally the fence-sitters? We need more of such pieces to nudge the fence-sitters off their fence and into the Modi camp.

So, Modi has to be thankful to Dr. Manmohan Singh, Ms. Sonia Gandhi, Mr. Rahul Gandhi, Mr. Aakar Patel and other such fellow MINT columnists and journalists who speak/write with vitriol on him but with little content.

Boom built on quicksand

Throughout the first three years of UPA I, I had remained sceptical about their contribution to economic growth in India. They just happened to be there when growth was beginning to happen, due to global factors and the lagged effect of the reforms that took place up to 2004, from 2002. My friend Nitin Pai urged me to do a blog post on a paper that appeared recently in ‘Economic and Political Weekly’ recently that had attempted to provide concrete evidence of the nature of the economic growth boom that India experienced between 2004 and 2007 or, more precisely, between 2003 and 2008. The paper is here.

Although the paper appears to be ascribing the growth story entirely to unhealthy construction boom and the availability of credit for the construction of shopping malls, multi-storeyed office complexes, etc., the good thing about the paper is that it presents evidence that allows the readers to draw their own conclusions. Actually, bank credit was more evenly spread and manufacturing did revive. Not all manufacturing that picked up was in consumer durables (or, consumption goods). There was growth in infrastructure industries. Growth in electricity generation picked up at least for a couple of years out of those five years. But, the broad point (see below) is well made and well accepted here at TGS. It was an unhealthy and unsustainable boom. 

Despite a sharp rise in the domestic savings rate, it was a debt-led growth, financed by burgeoning bank credit to the private corporate sector, and boosted by a surge in foreign private capital in three principal streams, namely, FDI, FPI and FCCBs. FDI rose from 0.6% of GDP in 2003-04 to 2.8% of GDP in 2007-8; and, the total capital inflow (sum of FDI, FPI and ECCBs) reached 10% of GDP just before the financial crisis struck in 2008.

The author recommends a ‘crowding in’ strategy of unleashing a public investment in infrastructure. That should crowd in private investment consequently. I am not sure I agree 100% with the thesis. I had argued elsewhere (in Pragati) that political change is the ‘crowding in’ or stimulus that India and the Indian economy needs.

Nonetheless, what I liked about the author’s recommendation is that he does provide an answer to how he sees ‘crowding in’ occurring. After all, if more public investment had to happen, money has to be found from somewhere else. He recommends the total elimination of energy subsidies and also allowing companies providing infrastructure goods to be able to pass on their cost increases to public utilities:

The high world energy prices need to be passed on to domestic consumers to avoid external debt and its adverse effect on petroleum refiners. To avoid domestic infrastructure suppliers getting financially crippled and seeking fiscal help, they should be allowed to raise prices of public utilities to recover costs, and earn surplus for reinvestment.

His closing comments on the importance of facilitating and attracting the right type of capital from overseas are well made. India has liberalised ECB norms excessively in the last two to three years. That is a knee-jerk and short-sighted reaction to the drying up of domestic liquidity. The servicing of these debts now adds nearly a percentage point to the current account deficit, according to the RBI.

Overall, it is a balanced and a reasonably rigorous paper, contributing usefully to the policy debate in India which, for the most part, happens in a fact-free and data-free atmosphere.

Rupee has company

Indian newspapers are screaming with headlines about the fall of the Indian rupee. To put it more precisely, the Indian rupee price of U.S. dollar has gone up. The U.S. dollar has become dearer in Indian rupees. Since the beginning of May, the dollar has gained 9% (and some change) against the Indian rupee. The good news for India is that India is not alone. The US dollar has gained more against the South African rand and even against the Australian dollar, a so-called G-10 currency. Dollar’s gains against the New Zealand dollar and the Brazilian real are equally high. So, the Indian currency has not been singled out.

As far as I can recall, the UPA has not been, at the margin, responsible for the recent bout of rupee weakness. They did not give us another corruption scandal in recent weeks, on top of what we already know.

It is often said – and I have said that too – that markets have no memories. But, that does not seem to be true. Investors are reacting the same way they did when the Federal Reserve in the U.S. had tightened monetary policy or threatened to. If we check the historical data for USDINR exchange rate in 1999-2000 (when the Federal funds rate in the U.S. was going up), in early-2004 and in 2006, we will find that the U.S. dollar had gained. This is knee-jerk reaction.

The Federal Reserve is not about to tighten its policy any time soon. The Federal Funds rate will remain at zero to 0.25% for quite some time to come. All that it is doing is to think aloud about reducing the amount of US Treasury debt and mortgage securities that it is currently buying. We do not know if and when it would actually reduce the amount, when and if it did, whether it would reverse the decision later. All these questions are alive.

Hence, the market reaction is a bit silly. America is not the safe-haven that it being made out to be. What is even sillier is that the British pound and the Euro have gained against the U.S. dollar since the beginning of May! So, they are safer havens than America?! The sclerotic Europe and the (housing) bubble-blowing Britain offer better growth and return prospects than Brazil, India and others? It is again a case of West vs. the Rest. The over-indebted and corrupt West vs. the corrupt and rioting Rest.

So, investors are not displaying much intelligence in reflexively holding back funds from current account deficit countries whenever they sense that the Federal Reserve would temporarily cease to target the S&P 500 stock index. Investors need to be more averse to risks embedded in the current prices of assets in developed nations. They are doing the opposite.

India has a lot of issues. This blog has never hesitated to wade into the Indian policy paralysis and governance failures. India could have been the better exception compared to other developing nations. This government has destroyed India’s economy so much that it would take a few years to bring it back on track, let alone see it expand energetically. But, bad fundamentals are one thing and market action is another thing. There has been no incremental bad news and all the bad news there is, is all known and discounted.  More importantly, the vaunted repair and recovery in the West are vastly exaggerated.

In short, investors have forgotten that the Sun set in the West at the turn of the millennium. 2008 was merely a confirmation. Evidently, they have not learnt their lessons. So, they would live to regret it. I sincerely hope so.

From trading to trust

“We have a kind of casino activity, which is associated in large part from what these companies actually do, and that’s OK so long as people understand the facts,” he says. “It’s rather like betting on horseracing. It doesn’t actually affect the performances of horses, or it shouldn’t.”

That is a verbatim copy of a statement [link] made by Professor John Kay on the eve of a speech he delivered last Wednesday. I think he has nailed the hollowness of the claim that public equity markets serve a useful function. I strongly suspect that he would have meant ‘dissociated’ rather than ‘associated’ in the first line above. May be, there is an error in transcription.

In a subsequent FT article he said the following:

“If we are talking primarily about equity investment, the ideal asset management structure is one in which there is a simple chain of intermediation with one person between the saver and the company. This would reduce trading and encourage more cautious investments, as the saver or person whose money is being invested is likely to be more discerning over what stocks they buy.”

He smiles, then adds ominously. “I’m not sure if this is likely to happen, though. I’m not sure if we can get to a simple system like that. So I suppose the best we can hope for is that people start to understand that investing in shares is like any other form of gambling: it often makes money for the house and nobody else.” [Link]

I downloaded the report on UK equity markets that he had completed last July. It is available here. I went through the 112-page report selectively. Here are some observations that I found rather interesting and salient:

The restructuring of the financial services industry that followed deregulation and internationalisation, the development of financing techniques which made possible the takeover of even the largest companies and the erosion of the traditional resistance of UK institutional investors to hostile takeover, all led major companies to pay far more attention to equity markets and their share price. (1.18)

The unhappy shareholder exits only by finding someone else to take his or her place. This substitution does not eliminate the impact of exit, but it greatly reduces it. At the same time, the structure and regulation of equity markets today overwhelmingly emphasise exit over voice and this has often led to shareholder engagement of superficial character and low quality. We believe equity markets will function more effectively if there are more trust relationships which are based on voice and fewer trading relationships emphasising exit. (1.32)

It has long been recognised that there is a logical contradiction embedded in the efficient market hypothesis20. If all relevant information were fully incorporated in market prices, there would be no incentive to obtain the information in the first place. The more efficient is the process described as ‘price discovery’ – the more rapid the incorporation of the views of market participants into market prices – the less the reward from engaging in the socially more important function of ‘value discovery’ – understanding the fundamental value of the company attributable to its potential earnings and cash flow. (4.11)

The belief that the best approach to information asymmetry is the provision of additional data may have led to a proliferation of data ill adapted to the needs of users, and to a belief that activities whose attractions are derived from the exploitation of information asymmetry are acceptable if accompanied by full, even if largely incomprehensible, disclosure. (4.16)

Regulatory philosophy has increasingly been based on a model of markets which emphasises trading over trust relationships. Regulation has been framed to excessive degree with the concerns of market intermediaries rather than market users in mind. It is a measure of priorities that regulation admits, even encourages, market participants to gain an advantage over others by reacting more quickly to data, but prohibit market participants from gaining an advantage over others by obtaining better information. Equity markets should be seen as a means of contributing to the performance of business, not as a game in which all competitors race for relative advantage when the starting gun is fired. (13.11)

John Kay has done a great job in highlighting ‘voice’ over ‘exit’, trust over trading and in reminding everyone that the purpose of capital markets (implied by the very definition) is to intermediate users of capital with providers of capital. The structure as it exists today in financial markets is that various intermediaries (including managers of the companies) make the most money – not the savers, not the shareholders and workers in the companies.

The insight that financial markets are characterised by increased transactions, trading and activity that are totally unrelated to the companies and their businesses should form the bedrock of regulatory architecture, design and specific provisions.

Instead, most regulatory regimes seem to be reconciled or resigned to (or happy to go along with) the fact that financial markets are a casino and that they exist only to facilitate secondary trading between different kinds of market participants. If that is the case, such a market does not benefit those who need capital and those who save. Such regimes are designed for, by and exist to serve financial intermediaries.

I suspect that India’s Financial Services Legislative Reforms Commission did not read ‘The Kay Review of UK Equity Markets and long-term decision making’ published in July 2012.

Likely messy

Two weeks since I blogged here. One of those spells. Interesting that the last blog post was on the day after Ben Bernanke (BB) testified to the Joint Economic Committee of the U.S. Congress. Financial markets have not been the same since then. This coming Friday is a big day for financial markets. We do not know if a strong report from the US on job creation would be welcomed or regretted. Odds favour market resentment of a strong number. All that they want is liquidity and not fundamentals. Chances of liquidity continuing to flow are higher when economy operates somewhat below its potential.

One of my good friends is convinced that Bernanke is serious about tapering or even totally withdrawing the additional stimulus (asset purchase) of 40 billion dollars per month put in place since last December. In fact, if I recall our conversation correctly, he said that the entire QE (asset purchases) might be stopped. I am not so confident of the U.S. economic recovery or the resilience of the recovery. Nor am I sure that BB and his team are that confident. As they have been at pains to stress, it could be just a one-month show or two-month tapering, followed by a pause and may be, even a restoration after that. Who knows?

On the contrary, they might be overconfident of U.S. resilience and that is why they are talking of ‘tapering’ so soon after launching QE3 in December. It is all very fuzzy.

Let us look at the case for tapering – a case that my friend articulated rather well. In the six months to March, job creation in the U.S. totalled 200K per month. But, that was also seen in 2011-12. Jobs growth tapered off after that. Then, he said that European peripherals are going to surprise markets with data improvement simply because they cannot fall any further. He added that unemployment rates going higher in peripheral Europe was not important since it had always been a lagging indicator. May be, he is right. But, I remain far from convinced. Not just the unemployment rate but many other indicators are still in bad shape in those countries.

Further, riots in Sweden and Turkey convince us that not all is well with the world in general. Not sure if it won’t spread to other smaller (but more prosperous) and peripheral European nations. However, I must add here that this Bloomberg  story on Spain exports (first trade surplus in 1Q2013 since 1971!) bolsters my friend’s case considerably.

All told, I remain sceptical that Bernanke is really serious about tapering off. May be, all he wanted to do was to introduce a bit of caution with his verbal ‘tapering’. In fact, I am still expecting the ECB to join the printing party after September.

My friend believes that the FRB or at least BB is convinced that if they did not act now, bond yields would keep rising.  He has a point. The 10-year U.S. bond yield rose 27 basis points even before BB’s testimony. May be, the bond market has begun to anticipate better economic activity or higher inflation or both or stagflation! So, the FRB may be getting into the mindset of the beginning of 1994 and mid-1999, when they began tightening.

David Rosenberg has a point when he points to the reduction in the unemployment rate from 8.1% to 7.5% even as the U.S. economy grew at only around 2% or below. He wonders if the potential growth rate is only around 1%. If the FRB shared his view, then they would be inclined to taper and taper more.

On the flip side, the biggest unknown for the Fed is the reaction in financial markets. The big question is whether financial markets would crater big time. On both those previous tightening episodes (1994, 1999-2000) they did. Not to mention the tightening in 2005-06. In fact, given the asymmetric nature of the FRB policy approach (ease more easily than tighten), the slide in prices of financial assets has been intensifying in each of these tightening episodes. Response to 1999-2000 tightening was worse than the response to 1994-95 and the response to 2005-06 tightening was worse than it was in 1999-2000. For that, the FRB has no one to blame but itself.

Like in 2002-04, the Fed had eased too much this time around too (QE3 on top of QE2) and remained easy for too long. It has spoiled the market by keeping rates too low for long and weakened its immunity against higher rates more and more. Now, the immunity must be at its lowest point. They, the markets, the U.S. economy and the rest of the world will have to pay the price for it.

[Parenthetically, it is very interesting that the Federal Advisory Council – a body of commercial bankers that advises the FRB – warned of the dangers of cutting interest rates to solve the student loan problem. Lower rates would encourage more borrowing and raise the potential burden on the taxpayer! Wonder if they had such clarity of thought on the Fed’s rate cuts and QE programmes. Is it easier to see the downside of reckless policies and prescriptions when one is not the beneficiary?]

This uncertainty over how would the market take it must be weighing on the Fed’s mind too. So, how they go about this very finely poised exercise will be interesting to watch. In 2006, after his speech at a conference when he spoke of ‘unwelcome’ developments on the inflation front, BB raised the Federal funds rate only once and left it there at 5.25% until 2007 when he had to start cutting it again. Even that rather timid tightening could not prevent a market collapse because much of the risk had been accumulated already when monetary conditions were too loose for too long. The situation post-2008 has followed the same trajectory. Hence, chances are that both their approach and the market reaction would be messy or messier, this time around too. That was my conclusion in my MINT column on Tuesday.

In mitigation, the Fed can point to the fact that they are only withdrawing the quantitative easing and not raising rates. That should shield the economy even if asset prices fall.

Two counter-arguments to that: the Fed has always stressed the linkage from from asset prices to wealth effect to consumption. So, shouldn’t they worry that the transmission from falling asset prices could take the economy down with it? Second and this is admittedly cynical, has the Federal Reserve really been bothered about the economy as much as it has been bothered by the health of the financial markets? Many would call this an unfair criticism but if they cared for the economy more, they would have allowed natural economic cycles to play out (Recall the FAC observation on the behavioural impact of lowering interest rates on student loans) providing a minimum of hand-holding to the really distressed segments of the public.

It is all very fuzzy because, in the end, we do not know if the Fed and its chairman know what they want and how to go about it.

[p.s: It makes sense to revisit these testimony/speeches of Bernanke made in March, May and June 2007.  He made light of emerging troubles in the sub-prime mortgage market and stressed inflation risks. He remained poised to tighten monetary policy up to June-July 2007. In hindsight, it is clear that he had misread the economy’s resilience then. Is he about to make the same mistake, again? Not that if he did not taper off QE, the economy would become more resilient. That is an altogether a different story. QE was always going to be problematic and that is the only clear statement we can make.]