Last but not the least (harmful)

Three good pieces on the interim budget (vote-on-account) presented by the Finance Minister of the Government of India. One is by Swaminathan Aiyar who focuses on the assumptions behind the projected deficit numbers. They are simply plugged out of thin air. Neither the expected nominal GDP growth nor the revenue elasticity of that projected nominal growth rate are realistic. Perhaps, tacitly, the Finance Minister has conceded that, under a new dispensation, the economy will revive like a fully wound up coil.

Bibek Debroy’s last sentence says it all about the reign of Mr. Chidambaram as the Finance Minister. On the face of it, the FM had changed for the worse, from a governance standpoint, from the 1990s. Was he less discretionary in the 1990s?

Varun Gandhi’s Op.Ed in ET is well written. But, it has no solutions. Of course, the underlying internal BJP dynamics behind VG writing these ‘sophisticated’ op.-eds is an interesting side story in itself.

BJP should cultivate RBI

Once the investment cycle gets re-established, jobs will be created and you will see the supply side being addressed, which is the correct way to tackle inflation. You cannot address inflation by hoping to choke demand by increasing interest rates and in the process kill the economy and growth.

Modi-ji articulated some thoughts in our National Council meeting about the price stabilisation fund. If you go into his 2011 recommendations when a committee was setup under Modi ji on steps to tackle inflation, he came up with some brilliant ideas and not one of them spoke about increasing interest rates.

I think governor Rajan is only aggravating the problems and making it worse by increasing interest rates. In the last six years they have increased interest rates multiple times but inflation has not come down at all, it is relentlessly increasing. Food inflation certainly has no correlation with interest rates. I have not been able to understand why they are tackling food inflation by increasing interest rates.

Let Indian manufactures flourish in a low interest regime. If you make interest rates so prohibitive, how will our manufacturers compete with the onslaught of foreign goods. This is the reason we have a $ 31 billion trade imbalance with China and that is going to get worse with interest rates being what they are, regulatory environment being vitiated and corruption at such high levels.

These are some of the comments made by Mr. Piyush Goyal, Treasurer of the Bharatiya Janata Party (BJP) in an interview to Economic Times. The full interview is here.

He had made some good observations to make on letting banks raise capital from the public, on sale of shares to the public by government companies, etc. We should welcome his opposition to the re-capitalisation of Scooters India Limited by the Government and the government running airlines and hotels, etc.  However, it is a pity that he ducked the question on privatisation.

The lingering doubt remains if the NDA – in its current form – is as committed to centre-right policies on economics as the government under PM Vajpayee turned out to be from the period 2002-04. There is a lot that the government can and should do and should do better. One is to stop being a petulant litigant. The Vodafone case comes to mind. But, the government cannot govern the country and run businesses too. It has to let go.

More than these, his comments on managing inflation are worthy of reconsideration (on his part, that is). Inflation can be handled if supply constraints are removed. It is hard to deny that. Whenever the Indian economy has grown at more than 8% for more than two years, prices had moved higher. Indian economy’s speed limits have to be raised through better infrastructure and production. No doubt.

But, until that happens, what should the Reserve Bank of India do? Wait for supply improvement to happen, without trying to cool down inflation expectation? If it does not put upward pressure on the government’s borrowing cost (in fact, the RBI rate pressure on the government is not strong enough), how will the government feel the pain of its profligate ways?

Ok, interest rate increases have not reduced the inflation rate, on the face of it. Non-food manufacturing inflation (in the wholesale price index) rate has come down to below 3%. This is due, in part, to declining credit growth. That, in turn, is due to higher interest rates, at least partially. With food inflation being where it is, if non-food inflation too has remained high, where would the inflation rate be now?

In other words, it is one thing to argue that the rate of inflation has not come down fast and enough. But, it is important to ask the counterfactual question: where would inflation rates be, without even these modest interest rate increases? Would India have escaped the turmoil in emerging market stocks and currencies in January had the RBI, under Raghuram Rajan, not raised rates in the last few months? Where would inflation be with a continuously depreciating rupee?

Two things have to be etched in the foreheads of people discussing economic policy: ‘counterfactual’ and ‘productivity’. We will come to the second one later.

Let us turn our attention back to inflation and interest rate hikes by RBI. Let us run a thought experiment. W all know that the Indian corporate sector borrowed close to USD50 billion dollars or more in 4+ years starting in 2009 in overseas markets. We know that the Government of India does not borrow in foreign currency. Small, medium and unincorporated enterprises do not or cannot. So, obviously, it has to be only the large incorporated sector. USD50 billion is not a small sum. At an average exchange rate of around INR55=1USD, that amounts to INR275,000 crores or INR2.75trillion! That is a lot of money.

With corporations having thus overcome the interest rate disadvantage, allegedly imposed by the RBI on them, what did they do with it? If they had invested it wisely and productively, would India have suffered from high current account deficit in the last few years? Domestic production would have been higher. The private sector could have blunted the ill-effects of the fiscal policy of the Government of India. Either it did not invest wisely or borrowed through their Indian operations to invest elsewhere – outside India. Clearly, there are reasons other than interest rates. The Chief Minister of Goa Manohar Parrikar knows them too well.

This train of thought automatically and correctly leads one to exclude RBI and its rate hikes from the list of factors that held India’s economic growth and supply side response back.

I was going through the papers written by Dani Rodrik and his co-authors in 2008 on the economic restructuring of South Africa. The links were made available by one of the commentators on his latest piece, ‘Death by Finance’ (a must-read, btw).

One of the ways a country can boost its domestic production is to ensure that investment took place in tradable goods sector. The second most important thing for supply to be augmented is to use the existing capacity and resources productively. According to Professor Robert Solow, productivity is the only thing that matters for economies. The interview did not mention ‘productivity’ even once.

The restructuring proposals made for South Africa are must reads for BJP think-tanks and advisors and ‘would be’ policymakers in the party. South Africa’s problems with boosting its manufacturing and the suggested solutions are highly relevant for India too.

In the meantime, it would make sense for aspiring BJP policymakers not to burn their bridges with the current management in RBI. They are doing a good job. They have shown themselves to be pragmatic, flexible and open-minded. It is undeniable (though hard to prove conventionally) that the presence of Raghuram Rajan has lent credibility and a floor to the Indian rupee. It is not easy for Western policy and academic types to trifle with him.

When he sends out a ‘threat’ to the West on adjustments in emerging markets and how they won’t like them, the threat hits its target. It is widely noticed.

If the BJP comes to power under Modi’s leadership – as it appears likely and as this blogger wishes – they would have to work closely with the Reserve Bank of India in many ways, from fiscal management to non-interference in commercial decisions of banks to designing and implementing capital management measures, in the face of continued and more unconventional policies from the West. Such policies are not only likely to get bolder but also remain as indifferent to emerging market concerns as they are now.

Emerging economies have to pull together – both within and without – if they are to mount a credible challenge to the discredited Western policy orthodoxy which is hurting them considerably now. Emerging economies like India should not only get their internal economic house in order but they should also articulate their case internationally for global monetary regime change with substance, knowledge and sophistication.

The BJP, in due course, might come to acquire all these but right now, RBI has it. It makes sense to cultivate RBI and build bridges with it rather than striking a solo note.


Conciliation talks with Vodafone have failed. The Income-Tax department of the Government of India is now free to proceed to try and recover the amount it considers as due from Vodafone (INR200 billion = USD3.2billion). The Supreme Court of India had ruled in favour of Vodafone two years ago. The current President of India, then as FM, retrospectively amended the tax law to nullify the Supreme Court’s judgement. He was wrongly advised. This won’t help.  It is no one’s case that foreign companies do not try to take advantage of the weak institutional structure in developing economies and the arm-twisting abilities of their parent countries vs. their host countries. But, retrospective amendments to laws are not done.

The country needs investment. With investment will come growth and with economic growth, will come tax revenues. May be, more than INR200 billion can be collected in taxes through better economic growth. Some holistic thinking is needed. Perhaps, this government is afraid of withdrawing the case lest it be accused of corruption. This is what corruption does and how it vitiates the decision-making process and decisions of the Government.

‘Another feather’ in UPA cap

Thanks to the UPA Fiscal Policy and its inevitable monetisation, the proportion of government securities that the central bank (RBI) is holding, exceeds the securities that the Federal Reserve is holding, in the USA as a % of GDP. That is so despite the latter’s QE programme and the absence of a formal QE programme in India!

Monetary policy is, as such, somewhat a blunt instrument in India given the relative lack of penetration of banking and the large food component in the inflation basket. That has been further compounded by UPA Fiscal Policy.

The cost of India’s reckless fiscal spending of the last five years(if not ten years) is that that it has not only been largely unproductive and has garnered national savings for such unproductive spending but has also reduced monetary policy effectiveness so thoroughly that it has led to a persistently high rate of inflation.

Large and wasteful fiscal spending have latent inflation written all over them. Rendering monetary policy impotent too has been the compounding crime of India’s fiscal policy of the UPA government over the last half to full decade.

[Those who are wondering as to why RBI should have gone ahead and bought all those GoI securities should read this blog post]

Wealth effect

I read this mostly thoughtful op.ed (blog post/column) by Barry Ritholtz. I did not realise that his popular blog has now become a mirror of his Bloomberg columns. Several points worth making and made well:

The vast majority of employees and consumers have only modest investments in equities. When we look at 401(k)s, IRAs and other investment accounts, we see these are primarily held by the well-off. Ownership of equities is heavily concentrated in the hands of the wealthiest Americans. Start with the top 1 percent: They own about 40 percent of stocks (by value) in the U.S. The next 19 percent owns about 50 percent. That leaves the remaining four-fifths of American families holding less than a 10 percent stake in the stock market.

Which leads to a Fed policy that has become overly concerned with the markets reaction to well, everything. Fed policy, FOMC member speeches, even FOMC minutes are obsessively considered in light of how markets will react to them. This is a terrible and unique Fed error. It makes for bad policy and worse governance in a democracy. [Link]

Just as he concludes that the wealth effect and the focus on stock market reactions are two sides of the same coin, the Fed policy actions driven by the wealth effect (and with an eye on stock market reactions) and the stock market performance itself are two sides of the same coin.

It is Barry’s strength (or, weakness) that he does not think of the inconsistency between this and his mostly positive outlook on stocks. In other words, would American stocks have done as well in the past and do well in the future but for the wealth effect obsession of the Fed?

American stocks did well from late-1994 to early-2000 despite a Fed policy that had a high real policy rate of interest, and fiscal surplus. It was because of productivity and some technology advancements. Can the same thing be said of the stock market advance from 2003 to 2007 and from 2009 until now?

A stock market advance driven largely by a Fed policy obsessed (wrongly) with the wealth effect and partly by stock buybacks and labour squeeze is not a sustainable bull market.

Yet, that is quite what Barry Ritholtz suggested in his previous column. I am not sure if his logic is inconsistent or if I am reading him wrongly.

Confused narrative

Good friend Harsh Gupta pointed me to the article penned by Dani Rodrik and Arvind Subramanian on the recent market turmoil faced by emerging economies (Turkey, South Africa, Brazil, etc.). They do not name names but they are referring to the comments made by the Turkish Prime Minister and that of Raghuram Rajan, the governor of the Reserve Bank of India. For a great point conveyed with telling deliberation and to great effect by Raghuram Rajan, see this short video.

There is always merit in making people see what they could have done correctly themselves but the points have to be cogent and coherent. Look at this paragraph and the next one:

The Fed has received scant word of thanks for propping up the U.S. and, hence, the world economy at a time when policy elsewhere (especially in Europe) was so counterproductive.

The next one:

The Fed may not be internalizing the objectives and constraints of other countries today, but neither did emerging markets act on the behalf of the Fed then. It isn’t convincing to cloak self-interest as unselfish cooperation.

So, in the first paragraph, the Federal Reserve saved the world and in the second paragraph, the Fed may not have internalised the objecives of other countries.

If the second statement is true, then the ‘Fed saving the world economy’ was incidental. The Federal Reserve was clearly acting in the interest of the US economy in 2008-09, 2011 and 2012 when it reduced interest rates to zero (0 to 0.25%) and then repeated QE2, QE3, not to mention ‘Operation Twist’.

In the G-20 meetings, the rest of the world – emerging economies in particular – was urged to increase their domestic spending so that the developed world could export their way out of trouble. Their domestic economies were broken. What have the leading emerging markets got for boosting current account deficits and spending? A run on their currencies mainly and in some cases, accompanied by run on their bonds and stocks.

Clearly, emerging economies were doing their part in running up current account deficits. The problem is the manner in which the current account deficits came about. That is a legitimate target of criticism but that is not what the authors criticise.

Instead, the authors criticise them for their financial globalisation. It is not unfair (deliberate use of double-negative) but it misses the point too. Yes, for instance, countries like India ran up fiscal deficits and in order to help corporations get their funding, the government liberalised external commercial borrowings. Corporations too, on their part, borrowed overseas heavily unmindful of possible risks – lack of foreign currency earnings, interest rate risk, Indian rupee weakness especially in the light of the inflation-laden fiscal policy that the government has been pursuing, etc.

These criticisms are fair but up to a point. If the argument is that these countries liberalised their capital accounts too much too soon, then that point should have been made more directly. ‘Financial globalisation’ is too vague and fails to carry the impact.

Were the authors afraid of the backlash they would get in their host country if they spoke up for capital controls?

Further, are emerging nations always free to choose to reject wholly or in part and also choose their timing of ‘financial globalisation’? Is the power balance between the United States and developing economies or emerging economies equal?

The US dollar is a global reserve currency but only the US can issue this fiat currency. The United States enjoys a lot of advantages of being the most dominant global reserve currency. That privilege comes with obligations whether M/S Rodrik and Subramanian agree or not.

Never in its history has the United States displayed any mindfulness of those obligations. It is not an ‘obligation to charity’. It is a quid pro quo for the enormous interest rate advantage that accrues to the US for the rest of the world accepting its fiat currency as their reserve currency.

Prof. Ron McKinnon has written extensively about the ‘Rules of the Game’ that were supposed to undergird this post-Bretton Wood dollar standard. The United States was expected to run a balanced fiscal policy and not be overly mindful of current account imbalances. The United States has failed in both.

When the current account deficit rises, it starts looking for scapegoats in the international community to blame. It deploys protectionist trade policies. It deploys rhetoric  against the so-called restrictive trade practices of other nations, both via friendly journalists, think-tanks and other outlets. The US knows but others pretend not to know that the charge of ‘restrictive trade practice’ cuts both ways and they happily play the blame-game on behalf of the United States.

Dr. Y.V. Reddy, the former Governor of the Reserve Bank of India brilliantly observed in his book that global financial markets (or, should we call them out more directly as ‘international financial institutions’?) do not treat emerging economies the same way they treat developed economies. Therefore, he said that it is symmetrical and rational for emerging economies not to treat financial markets the same way as developed economies treat them.

In a sense, that is what Raghuram Rajan said in his measured remarks delivered with great deliberation and to good effect. See link above.

In fact, given the ‘regulatory capture’ by financial institutions of policymakers in the developed world, sometimes the rest of us are hardpressed to distinguish genuine policy moves by developed nations from those aimed at benefiting their financial institutions.

So, what is the conclusion?

Developing countries did get their policies wrong to an extent. But, running up current account deficits is not one of them. The developed world wanted them to, but markets are now punishing them for it. They could have run up the current account deficit for the right reasons – domestic capital and infrastructure spending. But, that is an internal matter and does not alter the fact that they contributed to global demand which they were asked to do.

US acted in its self-interest as did developing economies. But, what the latter did was in line with the obligations enjoined upon them in G-20 meetings. What the US did was entirely for its own economy and it has not lived up to the commitments it made in those G-20 meetings in 2008-09.

There is an international power imbalance between Western and developing nations and hence, pacing or even avoiding ‘financial globalisation’ is not entirely in the hands of developing nations.

As the issuer of the global reserve currency, the United States has obligations to conduct monetary policy in a manner that is sensitive to global concerns. It is not an obligation to charity.

If it does not, other countries can choose to respond appropriately and that is exactly what Raghuram Rajan has said. That was not ‘playing the victim’ but a remarkable display of his grasp of realpolitik by warning them of the aces he has up his sleeve without showing them.

That was very well needed. M/S. Rodrik and Subramanian are off target by a wide margin.