What to do to avoid a rupee ‘crash’?

A friend to whom I had sent this piece of mine on Rupee risks asked me as to what steps might help avoid a ‘crash’ in the Rupee. Such questions make us think if there is anything at all that governments and central banks can do to avoid such an outcome or it might be that the train had left the station? The truth could be a bit of both. The bulk of the conditions that presage a fairly large depreciation might already be in place but policymakers should, nonetheless, do a few things (if they are still possible) to mitigate the effect; to cushion the effects or to even moderate the depreciation. So, here goes:

(1) Very important to project confidence and calmness and avoid looking panicked. I am starting with this because, in these situations, that is arguably the most important aspect.

(2) Also, panic will force the government to take measures that would aggravate the situation. RBI’s decisions to increase the limits on foreign portfolio investors for government and corporate bonds and the relaxation on eligible external debt borrowers from India are examples of measaures that could be considered ‘panicky’.

(3) Avoid measures that would aggravate the fiscal deficit. For example, these would be reducing excise duties on petrol and diesel and not allowing oil companies to pass on prices. Both are wrong. One, the Government of India (GoI) needs the revenues badly. Two, if GoI has to keep the import bill under check, it has to pass on the higher prices and curtail demand growth.

(4) RBI should neither cut rates nor raise rates unless its inflation mandate is materially threatened. It must see through the oil price related inflation impact. Unless second round effects are important, it should ignore first order effects

(5) The Government should refrain from public advice or instruction to RBI on interest rates. It is lose-lose-lose. Loss for the Government – meddling image; loss for RBI – even its independent decision would be labelled ‘capitulation’ if it coincides with Government’s wishes; Loss for the economy because these two would drive rupee down.

(6) If the GoI can come up with some schemes to consolidate or reform PSU banks’ governance – even if they cannot privatise now – it would be a positive

(7) Any forward movement (or, a successful bidder announcement) on AIR INDIA privatisation will be a positive

(8) I do not know the details of the NSE law suit against SGX (Singapore Stock Exchange) but it is bad optics

(9) Similarly, SEBI diktat banning all Foreign Portfolio Investors (FPI) from participating in Indian capital markets if they were managed by people of Indian origin from buying into Indian market seems rather too drastic and excessive. It will curtail inflows when these are the ones who will have more patience, tolerance given their better understanding of India’s ground reality. If their goal is to avoid round-tripping of Indian money, they can impose more KYC requirements (even though they may be already quite comprehensive and tight) but banning FPI that are even remotely connected to Indians or people of Indian origin (even if they are now foreign nationals) for this reason is too drastic. They aggravate the situation with respect to capital inflows and increases pressure on the Rupee.

(10) I do not know the current situation but if they can completely remove or lift all restrictions on agricultural exports, it will be a good signal. But, may be, very few restrictions remain but they should let farmers cash in on export markets or domestic markets – wherever they get better prices. It is farmer-friendly and also rupee-friendly. If domestic urban consumers have to adjust their consumption, that is the price that has to be paid or a cost incurred.

Import(ant) angle to rupee weakness

When I was doing some research for my recent weekly column in MINT on whether a rupee depreciation would help India, I came across some important statistics on India’s imports. Indirectly, they once again reaffirm the limitations of India’s growth numbers ever since the new methodology and the new base year came into effect.

There are five categories of imports:

22. Machine tools
23. Machinery, electrical & non-electrical
24. Transport equipment
25. Project goods
26. Professional instrument, Optical goods, etc.

These are taken from Table 130 of the Handbook of Statistics of the Indian Economy from the website of the Reserve Bank of India.

The sum total of value of imports (USD million) under these five heads in each of the last five years have been

2011-12 2012-13 2013-14 2014-15 2015-16 2016-17
68204.9 66083.9 57606.2 56889.5 56873.4 58877.9

Of course, there has been a big fluctuation in the value of the Rupee versus the US dollar in this period. So, we may be spending more in rupee terms but the dollar price may not have changed much. In other words, the dollar value does reflect the fact that we may be importing less of them either because they are now more expensive in rupee terms or because the economy might not be doing well or both. In some sense, the recovery in economic growth rates since 2012-13 as per CSO figures is not borne out by these numbers.

In fact, the quantity index of imports under the category, ‘Machinery and Transport Equipment’ confirms the above observation:

India_Machinery and Transport Equipment Import

Source: Table 138 of the Handbook of Statisics on the Indian Economy, Reserve Bank of India.

The chart is as important as it is dramatic. Quantum of capital goods imports has dropped substantially even as their unit value has gone up substantially, presumably because of the rupee weakness.

So, the more rupee weakens, the less we import of these goods and, consequently, India adds less and less to its productive capacity and potential. So, paradoxically, we will be importing more of the goods that would be produced locally with these machinery, otherwise. So, rupee weakness will make us import less of what we need and more of what we would otherwise be producing internally!

That is why I wrote that we should be sure of what we want, lest we get it!

Some thoughts on EURUSD

In the past, when we look at the two episodes of strong U.S. dollar, it happened when the U.S. real interest rates were higher than elsewhere: 1982-85 and in 1995-2001.

Between 2003 and 2008, the dollar was weak when U.S. real rates were broadly lower than in the Eurozone.

Between 2009 and 2010, USD weakness resumed as U.S. reduced nominal rates to zero and real rates were negative, more negative than in the Eurozone.

Between 2010 and 2013, the EURUSD stayed broadly stable but the negative relationship with the USA-Euro real rates was maintained.

Between 2013 and 2016, US dollar was strong not so much because U.S. real rates went up but real rates in the Eurozone were much lower. In other words, the differential moved in favour of the U.S. and hence EURUSD weakened. Again, the negative correlation was maintained. But, the anomaly started in Dec. 2016. The two lines – red and blue are correlated positively!

See the two charts below. One is the long-term chart and the second chart is for the more recent period.

EURUSD - Chart 1

EURUSD - Chart 2

Even though Ms. Yellen has softened her interest rate increase talk, as he writes, the U.S. real rates have trended higher compared to the Eurozone. The Eurozone is nowhere near beginning to think about the matter.

Further, even Fed balance sheet reduction in the U.S. should see a tightening of rates.

So, to sum up, why is EURUSD moving higher even as the real rate differential is moving in favour of US dollar?

(1) Perception of competence, leadership and decisiveness strongly favours Eurozone political leadership than the American leadership, including the Congress.

(2) In political and policy leaderships in both the regions – America and the Eurozone  – there is no constituency that objects to the current trend in EURUSD.  Germany does not mind a stronger EURO. It has a current account surplus of 8.5% of GDP. It does not want to stimulate the economy by spending more. The economy does not need stimulus. It is growing nicely.  Germany hates to become fiscally profligate because of long-term fiscal sustainability. Any faster growth would stoke inflation concerns. Better to let the currency appreciate and it would also make the American President less critical of the exchange rate.

(3) Should the stock market crash in the U.S., and globally, there is a recession or slowdown combined with rising risk aversion, it usually makes the dollar stronger. But, we never know about the future. This time, clearly Yellen would turn around and go back to easing.  But, for the Eurozone, there will be no change in policy. So, therefore, at the margin, the policy would turn easier in the U.S. with no change in the Eurozone. That too is negative for the U.S. dollar.

[Important: this is not an investment recommendation. Just some loud thinking on the EURUSD exchange rate. Nothing more. ]

The Euro over the Gold Standard

I just chanced upon this piece two days ago. It is meant to be a provocative piece and not a defence of Gold Standard. If one could tolerate Euro and its institutional setting, why not tolerate a Gold Standard? That is the question he poses and answers and the question does not answer why Euro could be tolerated or should be tolerated. That argument is not made, looking at costs and benefits.

Telling someone to tolerate random shocks arising out of fluctuations in gold supply and production because they are tolerating random shocks or are forced to tolerate random shocks from member country situations in the Eurozone and the consequent monetary policy responses is not particularly helpful.

In the days of trillions of dollars of capital flows dwarfing trade flows, it makes no sense to motivate an argument based on trade considerations alone. Yes, floating exchange rates do not offer any protection against spillovers and sudden starts and stops of capital flows. But, that does not prove that fixed exchange rates are better. The logic is flawed.

Floating exchange rates may not help. But, fixed exchange rates most certainly don’t. See the difference? Gold Standard is most certainly an extreme version of fixing. To actualise it and make it work for the real economy, one needs to confront the demon of financial flows and, more generally, financialisation.

An example would help clarify things. A this very mature stage of the economic cycle and an even more advanced stage of the market cycle, the SEC has approved a passive ETF on NASDAQ leveraged four times for public distribution. Under these circumstances, no regime would work – fixed or floating or the Gold Standard.

That Matthew Klein is not serious about the Gold Standard is evident from his recourse to the ‘snake oil economics’ of Martin Sandbu. I stopped wasting time on reading that gentleman’s writings more than a year ago. One cannot resort to debt write-downs, as one would do a morning walk every day to stay fit and healthy. Nor is wage flexibility a solution these days, except in blogs. It never probably was a solution except for Britain in the Gold Standard era. That was a different period and the difference was not just about the Gold Standard.

Second, he disappoints with his standard, run-of-the-mill baseless assertion that Draghi saved the Euro and that Trichet almost buried it. Economists who know about policy lags, the impossibility of counterfactuals and the unintended consequences of policy decisions would not make such glib assertions. First, had Trichet used up all the monetary policy bullets, Draghi may not have had many bullets left to fire. Two, we do not know how history would play out and whether Draghi would be reviled or revered. It is still very early days. The lagged effects of ‘whatever it takes’ have not yet played out.

Further, Mr. Klein is surprisingly sloppy with facts. The monetary policy response to German reunification happened in the 1990s before the Euro and ECB were reality. That was the German Bundesbank. They were tight and that led to the two European Exchange Rate Mechanism (ERM) crises including the famous ejection of the pound sterling from the ERM. Indeed, only then, did the Euro project come alive from 1993 onwards.

But for the Bundesbank’s tight monetary policy battling German money supply increase and the temporarily higher inflation, the ERM fissures wold not have been exposed, speculators would not have targeted it, the European currencies would not have come out of their sub-optimal policy straitjacket and economic growth in continental Europe and the UK would not have resumed from around 1994 or 1995.

ECB in fact loosened monetary policy in 2001-02, notwithstanding that the Euro had just plumbed new lows in October 2000. European real short rates were below normal and below average up to 2004 or so. In fact, those were engineered for Germany that was hurting from the collapse of the technology bubble. Therefore, monetary conditions were too loose for Spain, Italy and Greece. Their real estate booms ensued and turned into bubbles later.

With those facts and chronology addressed, let us revert to his arguments on the Gold Standard.

My blog is named, ‘The Gold Standard’. One can appreciate my predilections here. But, even then, I would concede that the enabling conditions simply do not exist for considering the Gold Standard. What the world needs is something far less radical than that but still a very radical departure from the current central bank orthodoxy.

The world abandoned fixed exchange rates (Bretton Woods/Official Global Dollar Standard) in 1973. I has experimented with floating exchange rates and discretionary central banking. The data point in favour of ‘discretionary central banking’ (alternatively, against rule-based central banking) was one – the Great Depression. Now, forty-four years later, the costs have begun to exceed benefits vastly – in many ways – economic, political and social.

Discretionary central banking with unrestrained ability to create reserves providing the basis for unfettered money creation by commercial banks does not make for a stable system at all. Nor is it social welfare enhancing. The blind and empirically unverified faith in the transmission from asset prices to the real economy and the indifference to the distributional consequences of such a faith/belief need to be abandoned.

The onus lies with the Federal Reserve, the intellectual leader in global central banking and the Wall Street alumni who govern other central banks.

The world has walked too far down the path of discretionary monetary and financial recklessness to return to the Gold Standard. Some simple changes, as suggested above, would do for now.

(p.s: Matthew Klein has put up a brilliant post rebutting the arguments of Steve Rattner on U.S. tax cuts. Very well worth a read)

What to do about spillovers?

Our results provide new insights. We find economically and statistically significant spillovers from the United States to EMEs and smaller advanced economies. These spillovers are present not only in short- and long-term interest rates but also in policy rates. In other words, we find that interest rates in the United States affect interest rates elsewhere beyond what similarities in business cycles or global risk factors would justify.

We also find that monetary spillovers take place under both fixed and floating exchange rate regimes, which lends some support to the conjecture in Rey (2013, 2014) that the global financial cycle constrains monetary policy irrespective of the exchange rate regime.

From a policy perspective, our findings suggest that neither are interest rates fully independent nor is monetary policy fully unconstrained when economies and financial markets are closely integrated. Even under flexible exchange rates, central banks – though technically able – seem to find it difficult to conduct a monetary policy that is based purely on domestic factors and which ignores monetary developments in core advanced economies. Furthermore, our findings also shed some light on the causes of the persistently low interest rates that have prevailed globally over the past seven years. Back-of-the-envelope calculations based on our results suggest that easy monetary conditions in the United States have exerted considerable downward pressure on interest rates elsewhere. [Link]

These are from the paper, ‘International Monetary Spillovers’ published in the 3Q2015 Quarterly Review of the Bank for International Settlements.

In his Per Jacobsson Memorial Lecture in 2012, Dr. Y.V. Reddy recognises the difficulty of managing spillovers but does not offer solutions:

Public policy is conducted at the national level, but at the same time, globalisation of economies, often driven by technology, is a reality, and the global macroeconomic environment is an outcome of national policies in a framework of nebulous global governance arrangements. The challenge for national central banks is to find space for the conduct of their own policies in an increasingly inter-dependent global economy.

Too much global policy coordination might lead to the universalisation of risks of policy mistakes. The main contention is that good finance is essentially a function of good economic policies, and such good policies are primarily national, though significantly impacted by the global macroeconomic environment – which, as already mentioned, is not a product of design. [Link]

This is interesting, however:

It is true that successful arrangements for global coordination while retaining space for national public policies are working well in certain sectors, such as aviation, telecoms and the internet. But they seem to get into difficulties in regard to macroeconomic policies and finance. Clearly, there is a need to explore why global agreements work reasonably well in some sectors, leading to acceptable and assured outcomes, while when it comes to macro policies and finance such agreements appear difficult to arrive at – and what we can learn from them.

The spillover issue suggests a few solutions in no particular order of importance or categorisation into financial, macro, domestic and global.

(1) Selective and time-bound application of capital controls and quantitative restrictions including the use of higher risk weights for bank exposure to sectors receiving too much credit and equity – from domestic and foreign sources

(2) Regular, gradual and moderate foreign exchange reserve accumulation

(3) Bailing-in of creditors during banking crises. Living wills and insurance funds from premiums paid by banks can be part of the solution

(4) Encouraging domestic consumption and gradually lower reliance on U.S. consumer

(5) United States to de-emphasise the importance of asset prices for macro-economic growth and stability. The Federal Reserve assigns too much weight to the wealth effect transmission to macro aggregates, especially from the stock market. That has resulted in many other problems too, including the leaking of insider information on a systematic basis to financial institutions, investors and the media.

In other words, the United States needs a new monetary policy framework that incorporates financial cycles and financial stability and not just employment, price stability and stability of long-term interest rates.

(6) United States to conduct more symmetric monetary policy than now

(7) Federal Reserve to obsess far less about managing and minimising market volatility

(8) Less emphasis on forward guidance and transparency in the monetary policy framework of advanced countries. This will moderate risk taking in financial markets which are globally integrated and hence the risk-taking goes global. To the extent they are restrained in the United States, the restraint will also spill over to capital markets around the world. This is a virtuous spillover. Indeed, this is the logic behind suggestions (5) to (7) too.

(9) Higher capital requirement for banks. This will restrain endogenous money creation by banks. That will, in turn, moderate credit and capital flows to emerging economies.

(10) Re-introduction of separation of retail-commercial from investment banking. Same outcome as in (9) as it will moderate risk taking by financial institutions.

(11) This last one is admittedly a hypothesis. For many reasons – benign and not-so-benign – policymaking in the United States is captured by China. One of the benign explanations is that, for U.S. policymakers, China has become another ‘Too big to fail’ institution. Hence, their nervousness about conducting normal monetary policy. One more reason for asymmetric monetary policy. This results in a sub-optimal monetary policy in the United States which is then transmitted to the rest of the world with integrated and pro-cyclical capital markets.

Postscript: the possibility of a multi-polar world of currencies must be deemed remote now. China’s yuan might be part of the SDR basket. But, it is unlikely to be an international currency. China does not have the stomach for it. Its actions in recent years have demonstated that its penchant for control overrides the objective of internationalisation. The Euro is unlikely to become an alternative, ever.

Hence, the reform of the American monetary policy framework is the only hope. Will the Chinese ‘capture’ of American policy in benign or not-so-benign ways end?

Will the Trump administration rise to the challenge on both? My answer, five months ago, would have been more optimistic than it is now.

(For completeness, you can find Raghuram Rajan’s suggested solutions for the spillover problem in his speech delivered in New York in May 2015).

Demonetisation update 20 – the Great Gatsby era

It is almost five weeks since the Indian Prime Minister announced his great monetary policy experiment. He already has a follower. Venezuela announced one recently. Not that the country (Venezuela) is a disciple that PM Modi can proudly show off! Many commentators are unwilling to wait. They want a judgement here and now – positive or negative. Reality is seldom that neat, if ever.

RBI has announced that the Specified Bank Notes of Rupees 500 and 1000 denomination  (SBN) returned to its chest amounted to INR12.44trn. SBN as of March 2016 was INR14.18trn constituting 86.4% of total currency in circulation. I do not know if anyone has information on the amount of SBN in circulation as of November 7 or 8, before the announcement. If not, then 87.8% of the SBN in circulation has already been returned to RBI. That is staggering.

As someone wrote, perhaps, the government has underestimated the Indians’ ability to launder money. It is not a joke. It is a severe indictment of  the country actually raising profound questions on its future prospects.

Few days ago, I stumbled upon posts on India’s currency swap by Raghav Bahl who started TV 18 and has now set up Quint media. I also read other pieces of him, unrelated to demonetisation. Overall, one should be careful not to be swayed too much by the colourful graphics and dramatisation. Substance is on the shallower side. In fact, in some cases, they are wrong. You can see his pieces here, here and here.

There are some unnecessary and culturally loaded references to people ‘eating greasy vegetarian meals’ and sitting down to listen to the Prime Minister’s speech on Nov. 8. He does not seem to understand (or, deliberately conflates) that not all deposits into the banking system would leave. It depends on how much of ‘transactional’ cash and ‘store of wealth’ cash were deposited.

Yes, I understand the argument. The public deposits cash because they have been told to do so. Only then, can they get new notes. So, as soon as new notes are available, they would withdraw. Some deposits are stuck there now because new currency notes are not available. As soon as they are available, these deposits would be withdrawn. But, most of these conceptual issues have to have orders of magnitude attached to them to be taken to the next level of discussion. Otherwise, in business-school lingo, it is ‘class participation’.

On a side note, it was amusing to note several prominent media personalities tweeting his articles as their contribution to the rigorous analysis of the government’s action.

He had a piece on Raghuram Rajan’s departure. In that piece, he betrayed his lack of understanding of the concepts of inflation targeting and nominal GDP targeting. There is no difference. The latter is a more egregious form of the former. It is cumulative inflation targeting!

Good friend TCA Srinivasa Raghavan sent this article. Very interesting. Did not know that the British government ordered a ‘note bandi’ in 1946. It did not go down well nor does it appear to have succeeded.

The article by Srinath Raghavan in Hindustan Times on the Gold Control decision of Shri. Morarji Desai, Finance Minister in Jawaharlal Nehru’s cabinet is equally instructive. People find ways to get around seemingly draconian orders. Is that a good thing or bad thing? We do not know. Both, perhaps. [If one wanted to read the history of various episodes of demonetisation, one can and should bookmark a widely followed blog, ‘Mostly Economics’. Amol Agrawal is a prolific blogger – more prolific than Yours truly. Mine is episodic]. Back to Srinath Raghavan.

His article in MINT equating the government’s ‘currency swap’ with central planning is a shocker. What the government has done is not central planning at all. One can call the government’s decision by any other (worst) name, if one did not like it. But, ‘central planning’, it is not. It makes one feel sad to see people one holds in high regard succumb to passion and sacrifice perspective, in the process.

Praveen Chakravarty is somewhat angrier too here but less so than Srinath Raghavan. He suggests that shifting the goalposts of the ‘currency swap’ exercise from corruption, black money and terrorism to ‘less cash’ or ‘cashless’ is not only wrong but casual and careless. He contrasts the persuasive ‘Swachh Bharat’ exercise with the coercive strike on black money. In his view, the latter goals do not warrant imposing such enormous (in his view) hardship on the people. He calls it primordial. Interesting arguments and not entirely unreasonable.

But, political rhetoric can shift. That is par for the course for politicians. Corruption, black money and terrorism remain the principal goals. That was the policy announcement. Going ‘less cash’ or ‘digital’ are also instruments against future generation of corruption, black money and persistent informalisation. To harp on it over and over again might scare the public. Therefore, taking it as one’s point of analysis is a bit harsh.

That brings me to another point. There is a lot of confusion and misunderstanding about what constitutes informal sector. But, the confusion is widely shared and even international. There is a political correctness in not equating it with black economy. But, regardless of how one views the sector on humanitarian grounds, it is black economy, unreported, untaxed, unregulated and underground. It is a subset of the black economy.

Professor Freidrich Schneider’s taxonomy of the informal sector is useful:


Professor Freidrich Schneider at the Johannes Kepler University of Linz has been one of the foremost researchers on the ‘Shadow’ or Informal Economy. His paper, ‘Shadow Economies and Corruption All Over the World: What Do We Really Know?’ published in September 2006 is a very useful and comprehensive reference. It provides international comparisons. In this paper, he puts the estimate of the shadow economy in India at 25.6% as of 2002-03.

However, there is an updated paper (July 2010) in which he is a co-author and in that paper, the estimate is 20.7% as of 2007. Even the figure of 25.6% for 2002-03 has been revised down to little over 22%.

With Knoema.com, you can chart it. Apparently, the site combines the word, ‘Knowledge’ and the Greek word, ‘noema’, which stands for “what makes sense”. For what it is worth, find below the chart for the size of the shadow economy in BRICS countries with data from Knoema.com.


With the International Labour Organisation putting India’s informal employment at 83.6%, my guess is that both estimates (25.6% and 20.7%) are somewhat on the lower side.

Interesting that this World Bank Viewpoint Note on the informal sector in Brazil makes the point that informal enterprises do not join the formal sector on their own:

Informality impedes private sector development by undermining investment and productivity growth. Contrary to what many people have argued, informal firms do not always “grow up” and join the formal sector. Instead, they can remain stuck in an informality trap, excluded from markets for finance and forced to evade taxes and other regulations to compete with their more productive rivals. The solution lies in a mix of stronger incentives for compliance and stiffer penalties for noncompliance. [Link]

I examine the issues related to the informal sector in my recent MINT column. I cite the articles written by Niranjan Rajadhyaksha and Manas Chakravarty both of whom deal with the informal sector in different ways. Alex Tabarrok’s points that Niranjan helpfully cites in his piece are rather critical:

India’s dilemma is that its high productivity sectors are taxed while its low-productivity sectors aren’t, so valuable resources are trapped in low productivity sectors. Modi knows this and if he is serious then his surprise demonetization will be followed by more efforts to bring India’s informal sector into the formal sector, leveling the playing field, and increasing total wealth. [Link]

The question is what does the government have in store – the bag of tricks of incentives and disincentives. There, we do not have much to go by. Yes, there are concessions for digital transactions and hints of tax cuts. But, what we need is a thought process and a draft action paper on the informal sector. That is missing. Please correct me if I am wrong.

What we have is a series of T.V. interviews by Mr. Gurumurthy – who does not have any formal role in the government. However, interestingly, Gurumurthy had flagged his own role and the government’s intentions way back in June when he wrote after Raghuram Rajan announced his decision in June to leave the Reserve Bank of India in September:

With the credit offtake falling in a rising economy, the RBI ought to be clearly seeing where the vitamin of money comes from to finance the higher growth. The new finance is sourced in an unprecedented rise in cash holdings which have risen to Rs 15 lakh crore in 2015-16 with the share of high denomination notes in the total currency in circulation rising from 33 per cent to 85 per cent in 2015-16. These distortions were occurring under the very nose of Rajan. But he overlooked them, because he had never handled economies where banks do not control the entire monetary system. [Link]

In one of those interviews, he talks of the ‘Manmohan Singh model’ (yes!) of providing financing to small and medium enterprises (SME).

Apparently, back in 1993, the then Finance Minister Manmohan Singh allowed refinancing of non-banking financial corporations that made loans for purchase of second hand and third hand commercial vehicles. Mr. Gurumurthy argues that it created a boom in that sector and he wants it replicated for the entire SME sector, through the ‘bounty’ that the government and the banking sector would collect, once the exercise of ‘currency swap’ ends officially on December 30.

He attributes the rise of the proportion of the cash economy to GDP and the rise of proportion of High Denomination Notes (HDN in the overall cash) to asset inflation (bubbles) led growth in the UPA years and financialisation of the Indian economy.

I found the following information on the proportion of HDN in the overall currency in circulation in the economy from RBI Annual Reports: It stood at 26.7% in March 2001. It rose sharply to 47.0% by March 2004, had jumped to 73.5% in 2009 and to 84.0% in 2014.

For evidence (of the role of asset prices in propelling economic growth), he cites the lack of overall jobs growth in the Indian economy in the UPA (I and II) years. Data for the UPA II is only partially available. It is two years since UPA was voted out of office! That is Indian statistics for us.

As per Labour Department Statistics, during the NDA 1 years (1998-2004), there was overall employment growth (around 60 million) but not in the organised sector. In the UPA years, it was the other way around. In fact, excluding the construction sector, there was net job loss during UPA years up to 2010. But, there was jobs growth in the organised sector. Indeed, Mr. Gurumurthy would argue that it proves his point. That the fruits of asset prices-led economic growth during that period was only available to select few in the country.

As for how the cash found its way into asset markets, he calls it a quadrangular relationship between cash, gold, real estate and stock markets that reinforced each other. He is making plausible arguments and these are interesting hypotheses. Not without merit, either.

Many of us had written in 2006-08 period that India’s economic growth in that period was unsustainable and of low quality. I can immediately think of myself and my friend Niranjan Rajadhyaksha in MINT. Even this hyped-up economic growth paled in comparison to how well Indian stocks did. As a representative evidence, one can point to the fact that the Mumbai Sensex index shot up from 2600 points late in 2002 to around 21,000 points early in 2008.

Some would argue that this was fuelled by the inflow of capital from foreign institutional investors. Those come through banking channels. True, at first glance. But, there is a rider. The role of Participatory Notes has to be taken into account. These are instruments supposedly meant to allow non-resident individual investors to hold on to the coat tails of Foreign Portfolio Investors to invest in Indian stocks. In reality, many argue that Indian residents used it to launder money overseas and participate in Indian stocks with the benefit of repatriation into a foreign currency and without paying taxes either, since these monies were routed through jurisdictions that had tax treaties with India. Very neat. It was the ‘Great Gatsby’ era for many economies around the world and India was very much in the thick of it.

The orders of magnitude were substantial:

As things stand, P-Notes make up around 15-20% of the total FII investment in India since 2009. While it used to be much higher, 25-40% in 2008, the reading was as high as over 50% at the peak of stock market bull run in 2007. [Link]

Dr. Y.V. Reddy, former Governor of the Reserve Bank of India was categorical in his assertion of the pernicious role of participatory notes in fuelling black money. Listen to his speech in Bhopal delivered on October 5, 2016 (my date of birth!).

[Interestingly, a website named gfintegrity.org (Global Financial Integrity) puts the annual average illicit financial outflow from India in the decade from 2004 to 2013 at USD51bn. It is USD140bn for China, USD105bn for Russia, USD23.0bn for Brazil and USD21.0bn for South Africa.]

So, his solution is to bring this cash that was merely fuelling asset prices and creating a facade of economic growth without creating jobs into the formal economy through this sudden, one-shot, secretive currency swap move. He thinks that there was no other way it could have been done and waiting for a few more years would have made the situation irretrievable.

Of course, some disagree. Madhav Dhar, a fund manager lists the following prerequisites before undertaking the surgical strike on cash:

The objective is very noble, so was Gareebi hatao. Who can argue against that? Who can argue against elimination of black money? But how you go about it, what pre-conditions you out in place, what behavioural changes you seek so it doesn’t happen, those are the planks you have to put in place before the fact, and that that certainly hasn’t happened. So before you really put India in a different path altogether, both sociologically and economically, you would have said everybody has to get an Aadhaar card. When they get an Aadhaar card, they get an automatic bank account, then they get a debit card whether they like it or not. So that has to be the sequence. Then you say how political parties are going to get funded has to become transparent. Then you make it clear that tax laws are such that are three or four slabs with minimum changes and minimum deductions. And then you say, after all, that we will give you six months to get out of cash otherwise we are going to come down very hard on you. That’s the way to do it. [Link]

It sounds nice and logical. But, well, does ‘stuff’ happen in India without crises? If  you asked Shankkar Aiyar whose ‘Accidental India’ was one of my most favourite reads of 2016, the answer would be an emphatic NO. So, has the government engineered a crisis to leapfrog the Indian economy and crash through (or, rush through) some of the things that needed to be done but would have otherwise taken eons to happen? An interesting thought but difficult to establish one way or the other. In any case, the evidence won’t be in for a few years. That has been my refrain in any case in the last one month. This policy decision cannot be objectively evaluated in real time. That does not mean evaluation won’t happen, however.

Back to Gurumurthy. His proposal is to use the cash collected through the surgical strike – well prepared move or not – to distribute it to the poor through cash transfers and by offering credit to the SME through the banking system. Hence, his reference to the ‘Manmohan Singh’ model of 1993.

These are, prima facie, good and interesting proposals. But, they need to be subject to a much wider debate. That is crucial. Individually, many of these arguments make sense but whether they do so collectively remains to be established. Further, distribution of cash and provision of credit may constitute only a partial set of necessary conditions and certainly not sufficient conditions for formalisation of the economy and further sustained and sustainable economic growth. Will have more to say on it in the weeks ahead.

Rajrishi Singhal makes a thoughtful point that the law of unintended consequence could operate with respect confidence in the banking sector. If the public deposits money into banks and is unable to withdraw it or if the bank denies it (even if only for a short period), then, it can lead to the public losing confidence in banks. I agree. That risk exists and it is not trivial, if the notes shortage in banks persists.

An unusually angry Andy Mukherjee echoes him on the unintended consequences on the banking sector here:

Amid the chaos, discussions about improving the governance of India’s dominant state-run banks, and selling or shuttering the weakest of them, have come to a standstill. The more urgent task of cleaning up their compromised balance sheets has also lost the steam it had gathered under previous RBI Governor Raghuram Rajan. If a month ago there was fond but foolish hope that banks would get a big one-time recapitalization boost, now there’s despair about how long they can go on fighting fires without any chance of a revival in credit demand.

It’s hard to believe Prime Minister Narendra Modi didn’t think through these unintended consequences. [Link]

Read this one too where he argues that RBI should have cut rates. But, nothing prevents the banks from cutting their lending rates, if they have cut their deposit rates.

The government’s lack of preparation could have been and should have been discussed by making it prepare well at least to answer questions on its lack of preparation. The Opposition has failed to do that. It was an opportunity lost for them and for the government to share its thinking more transparently with the Opposition and with the public. Shankkar Aiyar, as thoughtful as ever, makes these points here.

Prof. Ken Rogoff also thinks that the government has bitten off more than what it could chew. He is still positive about the move despite its ‘drastic’ nature.

In an economy profoundly crippled by tax evasion and corruption, India’s radical demonetisation may yet have positive long-run effects. In a sense, Mr Modi’s broader goal is to change the mindset of India.

The FT header sounds a little bit too critical than his piece itself.

It has been a long post in the making. Time to wind up. I shall do so with a link to a recent column by R. Gopalan (former Secretary of the Department of Economic Affairs, Ministry of Finance, Government of India) and his co-author on the economic growth impact of the currency swap. They argue, echoing the notes I had seen from Neelkanth Mishra (and his team) at Credit Suisse, that GDP growth statistics for the fiscal third quarter (October – December 2016) and fourth quarter (January – March 2017), counting as they do the visible sector, could understate the true negative impact on the real economy since much of it is borne by the cash-based informal sector. Gopalan and his co-author argue that it could last 3 to 4 quarters.

I noticed that I had called comments by three respectable and thoughtful commentators as angry. That is something for the Prime Minister and his office to think about. If the law of unintended consequences combined with bad planning makes collateral damage the central (and persistent) story of currency swap, (heavy and likely adverse) political consequences would follow. Oh, well. There will be other occasions to dwell on the consequent unpleasant prospect for the Indian economy.

Trump, Taiwan and China – 2

I was looking for some articles by Philip Bowring, veteran journalist, on China when, coincidentally, an email from FT landed in my mail box.China is going to help Malaysia’s Sovereign Wealth Fund – 1MdB – to pay its loans. It has adverse implications for regional stability. In that context, Trump’s phone conversation with Taiwan President assumes more salience and legitimacy.

Philip Bowring has been in Asia for nearly four decades. He currently writes for the South China Morning Post. He has written some very good pieces on China’s claims in the South China Sea. In fact, his piece questioning the very name provides a great deal of historical context. South China Sea’ is of  very recent vintage.

This piece makes a strong case for rebutting China’s claims to ‘South China Sea’.

His article for ‘Yale Global Online’ on Malaysia leaning on China was hard hitting. The header says it all: ‘Desperate to Survive, Malaysia’s PM Sells His Country to China’.

But, came this piece and I found it hard to understand. Even if one were not happy with Trump, how can China be expected to step into his place and do the right thing, in the light of all that he had written above? His judgement on the voter choice in the U.S. fell into the stale and disappointing pattern of the mainstream analysts. Oh, well.

In other news, China tightening and imposing more stringent exchange controls hardly befits that of a country that has foreign exchange reserves of over USD3.0trn and a country that aspires for international reserve currency status for its currency. It is hurting European companies operating in China, says this story in FT.

FT has a longish discussion on the pros and cons of a Renminbi devaluation, on the back of a supposedly ‘rogue’ currency move that saw a Renminbi fix that was 8% lower than the previous day. It was dismissed as an error. May be, something is cooking.

Just about two hours ago, FT informed us that China’s foreign exchange reserves had declined by around USD70.0bn in November. USD3.0trn is within a whisker of being breached on the downside.

In this context, the Reserve Bank of India’s decision today not to withdraw interest rate support to its currency seems all the more appropriate.