What is holding back India's growth story?

Feels good to be writing again after 18 months. In this blog I would like to identify the key factor which is holding back the Indian growth story. Let's start by looking at the basic blocks of GDP. GDP can be captured in the following basic formula,

GDP= C+G+I +NX

C: Consumption

G:Government Expenditure

I:Investment/capital formation

NX: Net exports

India is a consumption economy and this evident in the following graph,

The above graph clearly shows, that private consumption is the main driver of Indian GDP. And private consumption as a % of the GDP has not changed a lot over the last 10 years. Government expenditure also has been constant at ~10% of the GDP. The main variant of GDP has been the capital formation.And it is this variation that holds the key to problem of static growth that the Indian economy is facing over the last 2-3 years.

Lets look at the % growth (net exports growth being shown on the secondary axis on the right) of each of these elements during the periods of 2004-2007, 2009-2012 and then from 2012-2015.

In each of the three periods, private consumption has been in the range of 5%-9%, hitting a peak of 9% in 2007 and the bottom of 5% in 2012. Government consumption also has been in a narrow range of 5%-8%. The exceptions being the 2008-09 and 2009-10, wherein GFC led to a huge stimulus being implemented by the Government to keep growth intact.

On the other hand, NX and capital formation growth rates have varied a lot. (Note: Considering that India was a net importer during the last 10 years, a smaller positive or negative growth is beneficial to GDP quantitatively). The falling growth rates of capital formation are a key reason for the static growth over the last 3 years. The strong contribution  and stable growth of both government and private expenditure is the reason why Indian economy has a floor when it comes to growth. However, these two key pillars of the Indian economy will not be the main drivers of any growth. A deficit expenditure by the government or a spurt in personal consumption on the back of a credit boom can lead to a strong growth of the Indian economy. However even though this will be positive in the short term, it will be negative in the medium term and can lead to bigger problems. Hence the focus has to be on pushing investments or making the country an export oriented one.

Becoming an export oriented economy is not a good theme in current global environment. The following statement in the WTO's press release on 30th September 2015 only makes it evident that purely focusing on export driven model will not work for India.

"If current projections are realised, 2015 will mark the fourth consecutive year in which annual trade growth has fallen below 3 per cent and the fourth year where trade has grown at roughly the same rate as world GDP, rather than twice as fast, as was the case in the 1990s and early 2000s"

Hence, a combination of investment which focuses on replacement of imports through domestic manufacturing and infrastructure development is required for GDP growth to pick up again. The Government initiatives of focussing on "Make in India" and attracting investments is a step in the right direction. "Make in India" has to be utilised as a platform for replacement of imports and the Government has to continuously focus on increasing investments and making the required changes so that investment can pick up. This is the only way the Indian economy can grow at a faster pace in the current global enviroment.

Data source: Reserve Bank of India

Are we on monetary treadmill?

Money supply plays an important role in every economy. It is the lubricant which oils the internal system, lack of its stops the machinery and too much of it makes the operation sub-optimal with lot of wastage. As the topic suggests the agenda for this blog is check on this money supply. Since i remember central banks have been responding to each crisis by simply increasing the money supply and hoping that the increased liquidity will solve the problem.

Graph 1 shows the money supply currency wise. This chart clearly shows that money supply in the global economy has been growing year on year. To a certain extent the graphs look like an exponential curve.

Graph 1: Global Currency in circulation

Lets look at the money supply growth rates in US. Graph 2 shows the money supply CAGR rates. Each of the periods tells us the story of the effect of increased money supply. From 1960 to 1970 the CAGR was a high of 8% per annum, which eventually led to the gold standard being abolished. The period from 1970 to 1980 which had a 10% CAGR led to a high inflation environment in US. The period from 2010 to 2013 in recent years also has been a period of high growth rates in US money supply. This is evident from the easy monetary policy of the Fed. The only period wherein the money supply growth rates have come down is during the period from 1990-95, it was a period wherein even there was no global financial crisis and the ones that occurred were localised (Mexican currency crisis). Post that period, we have seen a sustained increase in monetary supply with atleast a 6% growth rates and we have witnessed one global financial crisis every 5 years. 

In addition to the fact that we are increasingly dependent on an increasing money supply, the frequency of financial crisis is also decreasing. In effect it is like a drug whose effect is decreasing with every injection. The tapering could create certain problems in such scenario wherein economies are addicted to such sustained increases in money supply over 20 years

Source of data: tradingeconomics.com

Bitcoin: Private Money

Bitcoins have been in news of late due to variety of reasons, for their legality/illegality, opening of an ATM, increasing value in US$ terms etc. This blog only to has a limited discussion on this movement ignoring the legality aspects and the mode of issuance. To understand the Bitcoin saga we need to understand the concept of 'MONEY'. What is Money?

It is nothing but a negotiable instrument, a note from the issuer who promises to pay the person who presents the note to the issuer the amount of a certain product (for want of better term) as stated in the note. During the gold standard days, the US Government used to guarantee that it shall pay the bearer of the US$ a certain amount of gold. Along with the promise, the free transfer-ability without any questions being raised on the trail of ownership of the note are the key features which led to the strong growth of the money being a preferred mode for exchanging goods and services. 

As long as a currency issued by a person has the key features of its ability to be exchanged for goods/services and promise by the issuer to repay the bearer the agreed amount, any person can issue a currency. For example, royal families of Florence used to issue coins called 'florins' which were a form of currency. In the current post gold standard era, the concept of the issuer repaying the bearer a certain quantity of amount has lost its significance. However the need to be able to exchange it for goods and services is necessary. Hence their is a great need for an 'Exchange' for any currency to survive. In case of normal currency, people do the exchanges on a daily basis without any need for a third party to moderate between them. To a certain extent, foreign exchange bureaus play the role of the 'Exchange' converting local currency to foreign currency.

For Bitcoins to succeed till the time they become mainstream, the 'Exchange' needs to play an important and critical role as the success of Bitcoin is dependent on these. Hence maybe investment in the 'Exchange' may be a better bet as investment opportunity to an investor rather than holding onto Bitcoins. Revenue from the 'Bitcoin Exchange' would increase as the volumes increase however the price would fall as the transaction volumes increases. The reason for the high price of Bitcoins and recent run up could be the low volumes and high demand. 

The total number of Bitcoins issued currently stand at 11,940,700. The daily volume for the top 5 exchanges on 30th Oct was 58,000 BTC i.e only ~0.5% of the total Bitcoins issued are being transacted across exchanges. As more and more transactions are recorded on the exchanges, the value of the Bitcoins will stabilize. Another key factor that will kick in as the Bitcoins transactions increase is the multiplier effect. The same Bitcoin could be transacted multiple times. This would also ensure that the availability of Bitcoins increases. 

Is the Trilema still valid for emerging markets?

The famous trilema is economics is the ability of a country to be able to control the interest rates, to control exchange rate and to allow free movement of capital. A country can control only two of the three points mentioned above. For example, US controls interest rates, allows free movement of capital and does not have the ability to control exchange rate. China controls interest rates, controls exchange rate and does not allow free movement of capital. India on the other hand, controls interest rates but keeps switching one of the two 'on' at a given time, which predominantly has been to allow free movement of capital. As the topic states the question is do emerging economies really have the ability to choose their two out of three choices provided.

Graph 1 shows the movement of the US central bank rate and the Indian central bank rate and Graph 2 shows the US 10 yr Treasury yields and the Indian central bank rates.

As illustrated in Graph 1, the Indian central bank rate movements have been in sync with the movement of the US central bank rates for the period from 2000 to 2008. This has been an era of increased movement of capital from developed economies to the emerging economies and an era of very high liquidity in the global markets. Since 2008, US central bank has kept the rates constant whereas Indian central bank has changed the rate on numerous occasions. As shown in Graph 2 since the talk of tapering of the purchases by US central bank, the yields of US 10 yr Treasury rates have spiked up. This also has led to many steps being taken by the Indian central bank to increase the short term interest rates and eventually the Indian central bank also increased the base rate. This shows a certain degree of limitation to the freedom enjoyed by the Indian central bank in deciding the interest rates in the India. Graph 3 shows the movement of rates of various emerging economies in Asia. The trend of movement is similar across all the countries.

Central banks of emerging economies to a certain extent do not have the ability to control the interest rates in their economies. This is governed to a certain extent by the interest rate movements of key economies globally. One of the choice of the trilema is no longer available with the emerging economies.

Coming to the other two choices, do emerging economy countries have the ability to control exchange rates and ability to allow free movement of capital. Graph 4 shows the movement of the various emerging economies against the US dollar in 2013. Most of the Emerging economies have adopted a floating exchange rate and have given up following a fixed exchange rate policy. As the graph shows, countries do not control the exchange rate however the movement has been highly coordinated with most of them showing a fall vis-a-vis the dollar during the recent times. Countries have given voluntarily given up the ability to control exchange rates. And even if they would like to control the exchange rates, they will not be able to defend the exchange rate in wake of a concentrated global assault against the exchange rate as has been seen historically on numerous occasions. Thus even the second choice of having the ability to control exchange rates is not with emerging economies.

The third choice of allowing free movement of capital, is the only choice that the emerging countries have at the current instance. Emerging economies may not allow full convertibility however to a great extent they allow free capital movement subject to certain limited restrictions. However is this a voluntary choice or is this an involuntary choice. In the current global economy, any emerging economy which would like to impose capital controls would face an instant economic turmoil and would be forced to revoke those restrictions. Hence there is limited freedom for countries to stop free movement of capital.

In essence emerging economies do not have the abilty to control interest rates, do not have the ability to control exchange rate and do not have the ability to control free movement of capital. All these choices are dependent on the actions of other actors globally. Does this mean the trilema is not valid anymore or is this one of the fault line which has emerged?

Graph 2

Graph 3

Graph 4

Graph 1

Source of graphs is trading economics web site and Google search

The Exchange Rate connundrum

Over the last one month the fall in the rupee value vis-a-vis the dollar has led to a lot of discussions and debates on the reason for the same. Most of them have been on the FII outflows from the Indian bond market or increasing CAD. But is that the only reason? When two items are valued relative to each other, the fall in their value in relation to a constant has to be considered as this determines the relative movement vis-a-vis each other. Similarly while considering the fall in value of a currency relative to other currency the fall/rise in value of the currency with respect to a constant has to be considered.  The constant factor for currencies is the relative inflation rates in each of the countries. Hence the formula, Exchange rate (year 1) = Exchange rate (year 2) X (1+Inflation in country 1)/(1+ Inflation in country 2)

The above formula is a long term equilibrium, there will be short term variations due to demand supply restrictions. However the inflation rates in each of the countries will determine the relative values in long term. Let us have a look at the actual exchange rate (US$/INR) versus the formula derived value (US$/INR),

The above graph shows two distinct periods, period 1 (1995 to 2006) and period 2 (2009 to 2013). Period 1 has been a period where the formula and the actual rates were very close to each other. In the second period, the relation has been unraveled, the gap between actual and formula based rates shows a very large difference. It is fault line which has been created due to the money movements arising due to continued easy money supply by Central Banks of western economies.

This fault line could lead to greater problems for the Indian economy going forward as at some point the exchange rate will have to revert to the formula rate. This could mean a greater depreciation of rupee going forward, unless inflation rates in US start going up. 

One of the scenario's which could remove this fault line could be the following,

1. Phase 1: Fall in rupee value due to outflow of money from India, due to improvements in the economy of US. 

2. Phase 2: Increase in inflation rates in US due as a consequence of the improved economic conditions

3. Phase 3: Fall in rupee value could lead to an increased export competitiveness (assumption being the competitiveness is not wasted into salary increases but for making investments) which could lead to investments being made by industries and a fall in inflation

4. Phase 4: Fall in inflation rates in India and increasing inflation rates could lead to the relationship being again followed

If the Phase 3 outlined above does not happen then we could see a painful adjustment within the economy leading a crisis.

The 100 year Journey

The main discussion point of this blog is to just illustrate the journey taken by policy makers over the last 100 years moving from one economic theory to another. A disclaimer to start with, the illustration is at a very high level description and does not take into account the micro level differences in the various approaches. 

Free Market Era (1900 to 1930)

Lets start with the 1910 -1920 in the US. This was the period of the ultimate free markets and this was a period wherein the US administrators started taking the first steps towards having regulators in various industries. The monopolies erected by the Robber Barons were the target and these were broken down with the break up of the Standard Oil being the pinnacle of these efforts. However the lack of regulation of the markets ultimately led to a skewed allocation of resources leading to a boom and bust phase. This era of free and unbridled market economy came to an end with the 1929 depression  People lost faith in the markets and viewed markets as perverse to economic development.

Era of Government (1945 to 1980)

The golden period of Keynesian economists was during this era. With the opinion of the public being firmly to regulate the market with Government taking the main role. This was in done in various formats in different countries. In US, it took the form of multiple regulators regulating the economy.In UK, the Government owned companies lead the efforts for regulating the market. The role of the Government expanded quite rapidly and in some countries, the Government was present in most of the industries in some form or the other. As Government role started increasing, inefficiencies started creeping in.This strong Government role lead to an economic crisis brought about by high fiscal deficits and high government debts. This laid the base for the return of the market.

Return of the Market (1980 to 2008)

With the economic crisis brought about by the large Government role, the opinion again started moving back to have a limited Government role and free markets. The Thatcher and Reagan government firmly moved towards having a less regulated markets, this lead the groundwork for the next period of economic growth. The Chicago School of Economics lead the charge towards the free market. Milton Friedman and Hayek both firmly were against the large role of the Government. Markets were expected to do a much better job than the Government in allocating resources and ensuring growth. Free markets were back and that again brought with the lose regulation. The results of this growth were a boom and bust growth which ended in 2008.

?? (2008 to ??)

So now that we have again realized that a loosely regulated free markets are not a solution, do we go back to the Government? We have seen Government using fiscal and monetary tools to revive the economy with the private sector/market not putting in its resources in the revival. The role of the Government is increasing slowly.Have we not learnt anything over the last 100 years? we have moved from one extreme to another and are back again to the same state. It will always be very difficult to pin point the exact mixture of free market and Government led regulation. Till we are able to do so, the pendulum shall always be moving from one end to another.

Any differences in the growth of the 90's to the growth of the 2000's

As the heading states, the subject for the current post is to see if there are any major differences in the reasons for growth that took place in in the 90's and the growth that has taken place in the first decade of 21st century. Currently I am reading a book titled, " Why Nations Fail", the main thrust of the book is that only growth that is backed by inclusive political and economic institutions leads to sustainable growth. In case either of the two are not present, we could see spurts of growth which would not be sustainable in the long run. These days we are seeing many news articles about the growth of private companies over the last decade is not due to any productivity or innovation led growth but due to their ability to obtain natural resources at a low cost. So does it mean the growth has been due to extractive economic institutions?

The main drivers of growth of the 90's was, as expected, the growth of services space especially the trade/hotel/communications space( CAGR of 7%) and the financial services/real estate/business services (CAGR of 7%) in the '90-'99 period. For the next period of 10 years, the main factors of the growth were the above two in addition to the strong performance of the construction sector (CAGR of ~10%). The strong growth of the construction sector is evident in the period from 2004-2009, wherein the growth was in double digits. This was the period wherein the CAGR of the gross capital formation of the private corporate sector and the public sector was ~14% whereas the household capital formation CAGR fell to 9% from 14% for the '90's.

The above data points shows the strong performance of the infrastructure sector. Thus the growth of the 2004-2010 period has been in both non-construction services sector growth plus the construction side growth. 

It is this construction side that is facing issues post 2010, the growth rates for the last 3 years has been 7% in 2010, 8% in 2011 and 5% in 2012. The growth of the mining sector which also was growing at nearly 5% p.a. since 1990 has slowed down to NIL growth over the last two years.The dismal performance of these sectors has been one of the major causes for the slowdown of the Indian economy over the last 2-3 years. The growth of the infrastructure space is the main difference between the growth of the 90's and the growth of the first decade of the 2000.

Does this slowdown have to do with the fact that most of the construction and mining related activities were undertaken or given to companies on a preferential basis and thus leading to an situation of existence of extractive economic institutions? The current fight regarding the coal mines allocation is an instance of the existence of these extractive economic institutions and the instability these institutions are facing due to stronger oversight of the other institutions in the country. Due this the growth from these extractive economic institutions has gone and as evident in the slowdown in the infrastructure growth.