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.

Bubbles: Is it possible for it to be used advantageously?

The first time it heard the word bubble was during the 2000-2001 tech heady days when everything related to computers/software was supposed to be a great money spinner. A bubble is used to describe a situation where the market value of an asset is far higher than its actual intrinsic value. But, the term bubble has another interesting meaning, which i learnt in an economics course. A bubble is nothing but a vehicle for transfer of wealth from one entity to another, it is a vehicle used for such transfers. This is in line with happens practically during a boom phase, there is a transfer of wealth as the buyer of an over inflated asset is primarily paying far more than the asset's actual value to the seller. The actual transfer happens during the act of buying/selling but it manifests only in the bust phase.

Of all the critical issues that a country faces today is the lop sided income distributions and the need to effectuate a redistribution of the same. In effect a transfer of wealth has to take place from one set of people to another set. So can a bubble be used as a method for achieving the same? Now let us look at the various types of bubbles that are generally created,

1. Financial bubble: In this type of bubble, the transfer of wealth takes place primarily through the financial markets like the stock market. The last two bubbles have been financial bubbles.

2. Infrastructure bubble: In this type of bubble, the transfer of wealth takes place primarily through the construction of lot of unwanted physical infrastructure.

3. Inter-generational bubble: This is type of bubble, in which the a transfer of wealth occurs from one generation to another. Generally, these are most prevalent types of bubbles these days, but are very subtle and not as apparent as the Financial bubbles. One type is where there is a transfer is primarily as loans taken by one generation which is repaid by the next. Another example, is the pension system, wherein the second generation pays for the first generation. These type of bubbles take a long time to come into becoming a focus point and once detected the problem becomes quite large to be easily diffused.

4. Information bubble: In this type the primary reason for the transfer is the mismatch in information between one party and another party. This is also know by another name, as corruption

So which of the above, are bubbles through which transfers can take place. Financial and Information bubbles achieve primarily the opposite of what we have set out to achieve. In these bubbles, a small group garners the wealth from the the larger group.

The system that has been used by all till now for achieving the transfer has been through Inter-generational bubbles. Governments have used this either through subsidies, money transfers which have lead to these governments having to borrow money (like Indian government). The costs of which are borne by the future generations. Another system is where the Governments have provided for all expenses of its citizens and have funded the same through high tax rates ( like European countries).

Infrastructure bubble is one system which has lead to increased per ca pita growth across all sectors of the society. This bubble leads to creation of employment opportunities which in tern leads to generation of wealth in the hands of the people. However care has to be taken to ensure that the benefits of this are widespread rather than concentrated on one section of the society, which is easier said than done. Does this mean all the development needs to be undertaken by the government or the entire development should be regulated or it should be a free market without any restrictions. Each of the above options leads to inefficiencies in the system, only government led development would lead to restricted development as the government cannot take up all the works at once. A free market economy without any restrictions would lead to a high level of development however the financing of the same and the ensuing defaults due to the extensive development shall lead to the costs being borne by the populace. This process shall lead to a temporary spurt of development followed by a bust phase.

A combination of the free market and regulated development is ideal combination. Developments in countries like Korea, Japan (pre 1980's) in their earlier phase of development were a kind of this type of development. The entire focus of the country was in developing export industries and developing strong R&D base. This kind of regulated development created a bubble wherein there was a transfer of wealth from the richer countries to population in these countries.

Phoenix has risen

The events over the last few weeks only strengthens by belief that socialism is making a come back in political sphere of many countries. Increasing delusion with the way governments are approaching the problem of solving the various monetary and economic issues plaguing the world currently, is the prime reason for this increasing aversion towards unbridled capitalism. Anything in excess is always bad, and over the last decade we have seen the impact of unregulated free markets. We are still trying to come into grips with the same.

The growth of the last decade has been real and illusionary at the same time. The growth in the income levels of people has been strong but the real fruits of the growth has not been spread equally among the population. One of the strong belief's i always had was that the growth has only increased the inequalities within each country, with the sub section of the population taking the cake. This sub section resides in the top most tier of the society with respect to income. To verify if the above assertion is correct, lets have a look at the Gini coefficients of some of the countries,

1. USA : 45

2. Greece: 33

3. Ireland: 32

4. Singapore: 52.2

5. Portugal: 38

6. Italy: 33

7. Ireland: 32

8. China: 46.9

9. India: 36.9

10. Brazil: 56.7

The above data indicates the above countries already have a lot of inequality as far as income levels are concerned. It would be interesting to see how the Gini coefficients varied between 2004 to 2010, however there is no availability of such data. However the general trend among OECD countries has been that the income levels of the top percentage has grown at a rate higher than the rest of the population since 1980. Thus the lead has only increased. This increasing inequality has lead to resentment among the populace during the current downturn. The policies followed by various governments in overcoming the current downturn are inclined towards reduction of various government programs to reduce the deficits. However this decrease in times of low economic growth would only impact the lower strata of the society more that the upper strata. The government budget cuts coupled with the low job availability in increasing discontentment among the lower strata.

This group is increasing resorting to ways by which there thoughts can be heard. This is similar to what happened in Greece, namely the riots in Athens. As long the governments follow policies which are more inclined towards reducing losses for banks and other investors and less towards trying to find a sustainable policy which would lead to increase in job growth, the restlessness among the populace is only going to increase. The offshoots of this restlessness shall be revival of socialist policies and more countries becoming more inward looking. This would herald a stop to the Globalization phase. The earth shall again revert to becoming round from flat for a short period of time.

Fear....Chaos..Confusion..We have not learnt anything

Frankly I have been trying to make sense of whats going on over the last one week and its impact on the future course of events. I am more confused trying to get an idea of it all. Over one week we have seen a return to fears of economic slowdown, US government rating being revised and the intervention of governments to keep their currencies down. Before trying to anticipate the future lets understand what is the impact of each these.

1. Currency interventions

It was only expected that with the slow fall in value of dollar, people are looking at other assets like Gold, Swiss franc and yen. This is creating issues for people and governments of these countries. At the start of the financial crisis, I had commented that the current problems are due to structural problems created due to artificial currencies. Are we in the same mode now, with few countries struggling to keep their currencies in line ? Or are we seeing that the markets are now forcing the governments to correct the structural problem rather indirectly? Continued fall in dollar, would only increase inflationary pressures in countries which have kept their currencies low in order to keep exports competitive. Eventually these countries will have to let their currencies rise. This would mean they need to stimulate their domestic consumption in order to keep their gdp's growing. This is task easier said than done as it is a very painful exercise. an exception to this is EU. A strong euro would destroy whatever chances southern European countries have of having growth. This would only lead to increased pressures which would lead to the EU region breakup.

2. Derating of US

The impact of the fall in the rating of US by one notch will be driven by the need for these export surplus countries to keep their currencies low. This would only help to keep the yields low.But the greater danger is the reluctance of US to increase government spending to support the little growth. In case in face of increased pressures from the Congress, the US government starts decreasing government, spending, then the US economy is in for a big trouble. We will have a case of government de leveraging and public de leveraging happening at the same time. The only way this can be sustained without increasing pain, is if the country attracts investment or if its exports become competitive. Both of which are currently difficult to achieve. A slowdown in US economy would mean, that all the export oriented Asian countries would also face a slowdown.

3. Global slowdown

In case countries still follow the path of the same few countries exporting and the same few consuming as we followed in last decade, we will only aggravate the situation further. The time has come for governments to realise the export/consumption story has run its course. Now the tide has to reverse for equilibrium to be realised again. Consumption in asian countries has to increase and consumption driven countries of the west have to regain their competitiveness.

All the events of the last week are only indicating that the problems which had to be solved at the end of 2008 have only been postponed, we are again back to the same issues. What does this all leave various asset classes, my view is that Gold would keep rising...the fall has only been postponed. Emerging markets which are not balanced but dependent on consumption or export only would face issues.

One of the countries best placed to face the uncertain times in my view unexpectedly is India. The risks India economy faces are more internal than external. If the government gets its act together, in improving investment climate, then we are readily looking forward to a period of strong growth. The uncertain environment would only help in keeping commodity prices low, aiding Indian economy. The big question mark is the Government..what is it going to do?

Is Gold really a store of value?

What makes an asset a store of value? Is it the lack of supply or is its perceived value in the minds of the people. An ideal store of value is an asset which is limited in supply and it is expected to be so at any given point of time especially during times of crisis or afterwards. Lets write down the key features of such an asset,

1. It is limited in supply and its supply is not distorted by market dynamics

2. It is easily fungible and it is recognized across different markets

3. Storage costs are very low and it is easily transportable (not counting security costs)

4. Quality is easily verifiable and defined standards for its quality

5. Ease in buying and selling and has a liquid market (they both are different even though one does not exist without the other)

Now that we have listed down the qualities, lets see if gold is a suitable candidate in the current scenario,

Point 1 is the toughest one, which we tackle in the later part of the blog. Gold strikes "gold" when it comes to points 2,3 .4 and 5. It is an ideal candidate and it is compact and very easy to hold/transport. With increasing technology and growth of the ETF market, the liquidity of the market has only increased. It is very easy to buy gold these days, especially if it is "electronic gold", you just need a demat account to hold it.

Coming back to Point 1, lets have a look at the demand and supply statistics of Gold. The overview of the sector as stated in the Gold Council report for 1Q 2011 is,

" Gold Demand in the first quarter of 2011 totalled 981.3 tonnes, worth US $ 43.7 tonnes. Much of the 100-tonne increase in demand was due to strong growth in the investment sector. We believe suitable conditions remain in place to ensure that investment demand will maintain its sold growth path in coming quarters"

Demand for gold has been quite steady over the last 2-3 quarters at around 1000 tonnes. Important to note that demand fell after the financial crisis primarily driven by the fall in demand for jewellery. This loss of demand for jewellery is as expected. The total demand of gold for investment purposes has been steadily increasing over the last few quarters. The demand for gold bars had peaked during the financial crisis and has been on an increasing trend since then. Gold holdings of ETF's also has been increasing. It is important to distinguish this demand from demand for jewellery, jewellery demand is more consumption in nature rather than investment nature. The only other usage of gold is in the technology sector, which has seen steady demand over the last few quarters.

Lets have a look at the supply side, the total supply from mines has been constant at around 600 tonnes per quarter. The other main supply source is recycling of gold recovered from old fabricated products. One has to note the increase in supply of recycled gold after the financial crisis. This coincided with the rise of gold prices after the financial crisis. Over the last few quarter the supply has been around 1000 tonnes per quarter. This supply matches with the demand. But with increasing demand for gold as an investment, price rise can only be expected as the short fall has to be met by recycled gold.

Now lets envisage a scenario where we are currently facing a sudden economic/financial crisis, could be brought about by european crisis. Now as it has been stated that gold is a store of value, the demand for gold would shoot up, with many people buying gold to store their wealth. Now considering that the supply is limited, the price would shoot up. Till now the crisis proceeds along expected lines. Now once the initial fears become subdued, the supply of gold would shoot up...the supply would not only be from traditional sources but also from all the sources who have bought gold for investment purposes. People would liquidate their ETF holdings to make profits from the high prices and invest the proceeds in other assets to make use of low prices of other asset prices. This would put pressure on the price of gold. So it is it an asset which can store the value??

My view is that the current rise in demand for gold as an investment vehicle has distorted the supply demand dynamics. The price would be driven by investment rather than any other purposes, thus making its value dependent rather than independent. Point 1 has been distorted.

This is similar story of what happened to land as a store of value. Prior to 2008, land has always been viewed as an asset which never loses it value. But with the sudden increase in demand for land as an investment, distorted the value and demand supply mechanics. With a sudden supply coming up post the crisis, the value plummeted and the market became illiquid.

Debt restructuring: is it inevitable

The last two weeks has saw increasing interest in gold and silver among various investor classes. Even jewelery traders have climbed onto the bandwagon of ever increasing prices of gold and silver, you have advertisements by jewelers who have started promising customers "that if they book early then they can buy gold on akshaya tritiya at a price which is lower of the booking day price or the price on akshaya tritiya".

If this is not a sign of irrational exuberance then nothing is. It was only expected with increasing liquidity worldwide that the price of some asset classes is going to rise. So what is going to bring this party to an end,

1. Is it slowdown in growth in most emerging countries due increasing inflation/interest rates,

2. Rate hikes by central banks in EU and US,

3. Another shake up due to government defaults,

I believe this phase of rise in commodity prices is going to come to a end due to point 3 more that anything else. We are having a mismatch in inflation rates across the world, economies which remained unscathed by the 2008 financial crisis are facing increasing inflation and economies which have faced the brunt of the crisis are either facing low growth coupled with high employment and/or high government debts. We still have not fully recovered from the financial crisis and that is because we haven't allowed the crisis to reach its conclusions. The belief that infusing more and more money into the economic system is the only way of solving economic slowdowns has to be critically examined. Easy money increases demand in the short term but the costs of this easy money include increasing cyclicality.

Lets take an example of a company, the company has many subsidiaries, each one contributing to the topline. Each of the subsidiaries has certain level of debt. Now in case the subsidiaries revenue slows down and in case of high leverage this would impact the ability of the ability of the company to repay debt. Now the subsidiaries plans to raise more debt to cover the deficit on interest/principal payments to creditors. How ever these subsidiaries have a unique characteristic, the subsidiaries revenue is dependent on the revenue of the other subsidiaries and the expenses of one subsidiary is an income for other subsidiary. So in case of a slowdown, with creditors pressing for repayment or other conditions in one of the subsidiary, that starts to charge more from other subs and starts cutting its expenses. Because of the inter connectivity between the subsidiaries, this only reduces the topline of the stricken subsidiary and further increases pressure on the payments to creditors.

In case the creditor is one of the other subsidiary which has strong cash and its dependency on debtor subsidiary is not high, then is can raise additional debt to cover its expenses. However this is dependent on the creditor subsidiary not having strong dependency on debtor subsidiary.

In case the creditor is a third party and dependency of the subsidiaries is high, then in case debtor subsidiary tries to cut back its expenses and increase its revenue, then is only causes its revenue to fall further to due to the inter dependency among subsidiaries. This resurfaces the problem of debt repayment problem. One of the ways the subsidiary can solve the problem is to reduce dependency among themselves and restructure its debt so that there is not immediate repayment pressure in the short term.

Case 1 is an example of Japan, where the economy has a strong export economy and the government obtains funding internally due to high savings of the population.

Case 2 is an example of Greece, being a part of Euro, they have reduced chances of being an export competitive economy, this makes it even more difficult for it to reduced inter dependency. This makes it even more necessary for debt restructuring to happen. The earlier it happens the better as it reduces the pain.

However a voluntary debt reduction is not going to happen easily and this eventually would lead to a blow up later on.

Inflationary policies

Pic 2: CPI (source: labour department, RBI)

Pic 1: CPI (Source RBI)

When i was young, still in school, i was always troubled by one question. If government controlled printing of money then why do we have some poor people. The government could just print some more money and distribute it. Then everyone will have money and there shall be no poor people.

My father tried to explain to me the concept of inflation and money supply. Giving money to all does not solve the problem as we are only increasing the availability of money but the number of items available to buy are still the same. This only increases the prices and makes the poor people poor again. I could not understand at that time but now can really relate to the same.

The recent move of the government to increase the wage rates under NREGA and link them to consumer price index reminded me of the dilemma illustrated earlier. There does not seem to be any study done by anyone to understand the impact of NREGA on the purchasing power of rural sector. A search on google for such studies did not yield any result.

In order to understand the impact on NREGA on purchasing power of rural sector, one way could be to understand the rise in inflation in agricultural labour sector vis-a-vis city non labour force. There are two different CPI indices for rural sector, one is for a set of people who derive their income from agriculture and another is a for a set of people who derive their income from rural labour.

During the period from 1998-2005, there has not been much of a difference in these indices (Refer Pic 1). Pic 2 gives an idea about the CPI of agricultural labours, rural labours and urban non labour. Inflation in rural economy has been increasing faster than in urban economy, especially over the last 2 years. This should give a fair idea that the social programs being administered by the government are leading to a rise in purchasing power. The impact of which is being felt in the prices of goods being bought by the rural sector. In this scenario linking wages to CPI would only increase the inflationary pressures in rural economy.

Focus of the government should be in raising purchasing power through productivity, through infrastructure development rather than increasing it through wage rises.

However the observations made in this blog only indirect, a detailed study has to be undertaken to understand the impact of NREGA on rural economy.

Are Government Auctions optimal?

The topic for this blog is very relevant today with most of the sectors where Government has resources to be given to private sector being done through auctions. Auctions have a peculiar character of giving the seller a good and easier way of attaining maximising the value of the asset being sold. Considering this shouldn't auctions been the right way for Government to auction public resources.But at the same does not hold true for the buyer, auctions have been known to loss making to many buyers, thus the word "winner's curse". Government's auctions are unique in the sense the seller is the populace and the ultimate end user is the populace.

Lets consider a simple example to illustrate the above point.

Case A: Take a person who owns a house. Note that the ownership of the house is held by a single person and he wishes to sell the house. The buyer of the house will have to rent out the house to recover his cost. There are many people who are willing to take the house on rent and the seller is not one among them.

Case B: There is a family which owns a house and the ownership of the house is divided among these people. The buyer as in Case A has to rent out the house to recover his cost. But in this case few of the members of the house have to stay in the house and are willing to rent it from the buyer.

In Case A, the seller is justified to go for an auction as he gets the maximum price and as he is not going to rent of the house, he is bothered with the fact that higher sale price translates to higher rental value. Whereas in Case B, the seller may not be justified to go for the auction. Here few of the sellers will have to bear a higher renting cost as the sale price is very high. Thus as long as the marginal gain in higher sale price is able to reduce the marginal costs in higher renting, the auction system works fine. But in case the transfer of high sale price does not happen to individual sellers properly then he is worse off than earlier.

Case B is what happens when Governments auction public resources. The Government achieves a higher sale price, but due to leakages in the systems the transfer of the higher sale price is not effective and the consumer ends up paying a higher price for using the resources. For instance, the recent 3G auctions, may have given the Government high price but most of the gains are going towards reducing the deficits run by the Government rather than any transfer of wealth to the people through increased infrastructure or better facilities. The high prices are only going to increase the eventual usage price of the 3G services. Thus the consumer may be better off by not having an auction itself.

The high price also raises the question of viability of the service itself. High price of usage may deter eventual consumers and the company which has one the auction may be forced to reduce prices thus incurring losses. This is also disadvantageous for the customer as eventually the company might stop providing the service.

In case of the public resources, I think one way to be followed by the Government is have an auction on both the highest price for the resource and lowest end user price for the eventual consumer. This would be able to generate higher price as well as restrict the consumer getting better services.

Urban Serfdom

Serfdom the once widely prevalent practice in rural populace, wherein the landless farmers would be enslaved to work in the fields of the landowners for perpetuity. With increasing economic growth the urban populace is also increasing the disposable incomes available with the populace. But is this increase in disposable income creating increasing wealth in the hands of the urban populace. Rather than wealth creation, consumption is taking a higher chunk of the disposable incomes in India. India has been a consumption driven economy over the last decade and the private consumption is a growth story. Easy access to credit is fuelling this growth of consumption. Credit purchases have increased and cover a wide variety of products starting from clothes. This every increasing dependence on consumption goods is only going to increase the dependence of the urban populace on credit and reduce financial independence which is very critical for wealth creation. We are looking at a situation wherein wealth is increasingly being concentrated in the hands of few and transfer of wealth taking place from a majority to the minority.
Let’s take an example of home ownership to understand this transfer of wealth. In a city like Mumbai, the cost of an average sized apartment is near to the seven figure mark. With easy access to credit, majority of the people would invariably take huge loan amount to acquire the apartment. The tenor would be for 10 to 15 year period. This leads to creation of a long term liability which the buyer has to service and this puts him dependent on his income to service the loan. The monthly payment would comprise a major chunk of the monthly earnings. Any negative impact on the buyer’s income earning capacity negatively impacts his ability to service the liability. Thus the person is highly dependent on his job. The situation of the buyer is similar to that of the landless farmer who has been caught in serfdom; the ownership of the apartment makes him more dependent on the vagaries of the economy and less financial independent. The entire consideration is being paid by the buyer to a developer who enjoys a high margin due to the faulty market and regulatory practices which have enabled them to form artificial monopolies.
Financial independence seems to be eluding the urban populace and in absence of a strong social security system in our country, the urban populace is very much dependent on continuing economic growth to be able to reduce the risks of high financial dependence. Innovations and entrepreneurship would flourish only when financial independence is achieved. Also on growth stalling, the risks of social unrest increase quite significantly. The twin risks of high consumption and high liabilities need to be resolved in order to overcome the scenario of urban serfdom.

Residential Bubble

(Source : Nomura Research)

(Source : www.livemint.com and RBI)

Over the last 1.5 years, Indian Real estate sector has seen a tumultuous journey. Starting with the fall in Q3 2008, real estate sector has seen recovery in some sectors while the other sectors have yet to see recovery. Commercial real estate (Office space) has seen increasing absorption across India. Q1 2010 absorption across India has been very positive compared to Q1 2009. However the vacancy levels are still quite high, and with additional space expected to come into the market, vacancy levels would remain high.Rentals have been stable over the last one year, BKC and Gurgaon are the two markets which have seen a slight increase in rentals. However, increase supply of space in these two markets would keep the rentals under check in these two markets. Retail space has also not seen any recovery yet.

Residential space has seen a strong recovery over the last one year. However this recovery has not been spread across India.Hyderabad, Chennai, Bangalore have not seen the high jumps that Mumbai and Gurgaon markets have seen. Prices in Mumbai have surged 31% Y-o-Y basis and prices have increased more than the 2008 levels. Affordability (EMI/monthly income) has increased to nearly 85% and is near 2007 levels.

The RBI report has also provided some interesting data on the transaction volumes and price movements. Over the last few quarters the transaction volumes have shot up in an unprecedented manner. The volumes which ranged over 15,000 to 25,000 units per quarter. The volumes have shot up to 45,000 units in a short time. This is far more intriguing than the price increase data. This volume upsurge is not sustainable and with increasing new product launches, there is going to be a definite oversupply situation in the residential space.

My personal belief is that these two markets are in a bubble zone. The main reasons for this belief area,

1.This increase in prices has been quite sharp and very localised. This localisation indicates that the broad based economic recovery has not been the only reason for this increase.

2. Increased liquidity and low barriers to availability of money.

3. Increasing stress towards high spec residential space.

4. Strong co-relation to the stock market movements.

5. Strong surge in transaction volumes in a short period.

Inflexion Point

(Source: RBI Q2 review)
The main risk factor which i had pointed out in my last blog is going to play a key role in the coming few days. Global economies are currently facing a key decision factor with regard to economies recovery. key countries which had implemented fiscal and other incetives to boost their economies during the period of 2008-09 are now being forced to think and act on removing these incentive schemes due to rising inflation. China has started the process, India is expected to raise interest rates in the coming quarterly policy review. The declines in global markets and strong performace of the dollar over the last one week are a reflection of the fears that market participants have, on the adverse impact due removal of these incentives. The declines indicate that the market feels that the recovery was due to these incentives rather than due to any demand recovery. So what does all this hold for India? The impact of the increasing risk aversion to emerging markets due to fears of a bubble or lower growth due to increasing monetary tightening is being felt and would continue for the next few weeks.

Let us analyse the performance of the Indian economy through the basic GDP formula, Y= C+I+G+NX.The growth of the Indian economy over the last few quarters has been helped to a great extent by the fiscal push by the government (G). The last quarter has seen the impact of the fiscal push through increased growth in the social and community services expenditure, which is funded by the government.With the government looking at reining in the fiscal deficit, the key growth factors for the Indian economy would be the recovery of the private consumption(C) and Investment(I). With the world economy still weak, growth in the exports would be lower, hence the need for C and I to grow. Growth in Private consumption fell to 1.6% in the first quarter of 2010 and but increased by 5.6 % in the Q2 2009-2010. The impact of the bad monsoon is expected to be felt in Q 3 2009-10 and this is expected to adversely impact the consumption in rural india. Investment growth has still not picked up. The Q 3 2009-10 could see a lower growth as compared to Q 2 2009-10 which had seen the main impact of increased government expenditure and private consumption.So is the government going to start the process of removal of incentives or has the Indian Economy recoverd and is ready to move forward with Government support? The policy review of RBI may give us some hint on these questions.

December Effect

It has been more than 3 months since my post on the dollar/gold movement post in 2009. It is a good time to recap and see if my bets had proven correct or went into a tailspin. Lets start with looking at gold prices (Source: www.goldprices.org), gold prices surged during the period from October 2009 till December 2009 and then the slide set in. December has seen a quite sharp fall in gold prices as compared in any other month in the previous 6 - 7 months. Lets now move onto the performance of the dollar (Source: http://www.marketwatch.com/). The dollar index also shows a reversal in fortunes with strong movement in December 2009. The dollar has shown its strongest performance in 2009 in December. What could be the reason behind this strong movements, did risk aversion started falling or did people think that a bubble had been formed?. Remember that in the last 6 months, dollar carry trade had increased a lot and with fed taking a posture of low interest rates for a long time it was only expected to increase. None of the conditions which resulted in the dollar carry trade and liquidity led rise in asset prices has changed. Interest rates in US are still low, governments have not started retracting stimulus packages, inflation concerns are still be sounded out. No major policy decisions were taken in December by any major economy.

One hypothesis which i have heard but did not have great belief is the "December Effect". With December being the last calender month and most of the traders having achieved there year end targets or not having the time to realise these targets for this year, would have shut shop and limit there risky positions. Also the holiday season of last 10 days of December when limited activity takes place, many people would be happy to reverse there risky trades and limit their exposure. Whether this a reason for the movements seen in December is very difficult to prove. Lets have a look at the equity market performance if there has been any December effect in these markets. The MSCI emerging markets ETF has not seen any major movement in December 2009 (Source: www.marketwatch.com).

Going forward, if December effect was the primary reason for the movements in December, then the reversal should be taking place. The projections I had made in October 2009 still hold good. One major concern on which i would touch upon next week in my next blog would be the performance of the China Property market.

Currency Imbalance: Redux

At the current juncture most of the SE Asian, East Asian and Latin American (Brazil primarily) are facing an acute problem of balancing inflation and currency appreciation effects on their economies. This problem is being further aggravated by the reluctance of China in appreciating its Yuan. Most of the countries in these regions were primarily exporters to the US or China (commodities) in the pre crisis era taking into advantage the lopsided currency imbalances during that period. Economies of these countries are well on the path to recovery on the back of economic stimulus packages implemented by the respective governments. South Korea had the fastest quarter on quarter growth in the 3rd quarter 2009 (due to strong domestic growth), Australia had a exports growth in the third quarter 2009 on the back of rising exports of raw materials, Singapore has also shown a pick up in GDP growth after contracting in the first half of 2009.

With the pickup in economic activity, most of the countries are now looking forward to tackling the twin issues of inflation and currency appreciation. With most of the growth seen due to the domestic growth which was facilitated due to the stimulus packages. As the economic activity rises, the increasing liquidity in these economies will lead to strong inflationary pressures. The governments may look at tackling these pressures by slowly removing the stimulus packages or raising interest rates. Few of the countries have already started increasing interest rates or are having more hawkish stance with regard to interest rates. Australia has increased the interest rates twice in last two months.

Increasing interest rates brings another major issue in front of the countries. The carry trade that is being seen currently. With the US forecasting a low interest rate regime for a long time period, most of the countries which are contemplating a rate increase have to contend with foreign money flows. Most of these countries are increasingly undertaking market operations to ensure that the currency appreciation relative to their competing export countries is not very high. Leading to a situation of accumulation of currency reserves. Appreciation of currencies in these economies is very important to reverse the trade imbalances seen in the 2003-08 period. But with the fear that increased currency appreciation, would only reduce their export competitiveness vis-a-vis other exporting countries thus limiting export growth, is leading to many countries artificially keeping their currencies low. The situation is being aggravated with the dollar peg of China, the biggest of the lot. Lack of interest from China on the appreciation of the Yuan will only precipitate the matter further.

This issue is one which can derail the little economic growth that is being seen. If the countries do not raise interest rates in the fear of increased inflows, then they might face a situation of asset bubbles returning back and causing more pain going forward on there bursting. In case they allow currency to appreciate, then the economic recovery might be short lived as their main engine of growth (exports) may not recover and domestic consumption may be able to sustain itself.Many countries have started thinking of using different means by which they are able to contain the inflow of money into their economy. Brazil has started a sort of Tobin tax on the inflows. Other countries may raise barriers to investment. Limiting the investment flow is an option which many end being counterproductive. It is pertinent to remember that the impact of the currency appreciation has not been felt as strongly by the commodity exporting countries on their exports yet.

Gold, Dollar and et al

An analysis of dollar and gold price movements over the last one year,Sep 08 to Sep 09 provides us with very interesting information. The gold price has moved from $850 per ounce (Sep 08) to above $1000 as on date (Oct 09) and dollar index has moved from 73.48 (Sep 08) to 78.22 (Sep 09). The overall movement of the dollar and the gold is show in figure 1. We can clearly see three main segments of this movement. Each period provides us with good indication about the prevailing sentiments in the global economy. The periods are Sep 08 till Dec 08, Jan 09 till April 09 and May 09 till Sep 09.

1. Sep 08 till Dec 08

Let us step back and see what was the prevailing sentiment during this period. Lehman had collapsed, credit ratings plunged and risk premiums sky rocketed. There was a perception of the global economy moving towards dooms day. Investors started moving towards safe assets. Equities worldwide faced a meltdown with most of the equity assets being sold off and money moved into safe assets like Gold.In the immediate aftermath, Gold price increased from $740 per ounce(11 Sep 08) to % 902 per ounce(26 Sep 08). Yields rose during this period (Figure 3). Once the fear of imminent economy and currencies got reduced, the money started moving into US treasuries. Figure 3 shows the impact of this movement. Yields plummeted across all the tenures. $ strengthened on the back of this buying of US treasuries. Gold prices fell in face of this sustained dollar rise. The correlation between US $ index and gold during this period was -0.689. The movement of Dollar index and Gold price is shown in Figure 2.

2. Jan 09 till April 09

With the collapse of the economies worldwide, brought about by the financial crisis, governments rolled out stimulus packages aimed at provided support to their respective economies. Banks and Financial institutions were provided support and money was pushed into the economies. This resulted in a slow built up of liquidity in the global economy. Once the fear of the Sep 08 till Dec 08 period was diminished, this increased liquidity resulted in a rise in equities and commodity prices. Asset prices across the spectrum started rising. A brief about his liquidity movement has been discussed in a previous post on Indian Equity markets price rise. Both dollar and gold rose simultaneously during this period (Figure 4), indicating that the fears of debasement of the US $ were very remote. With the recovery of the US economy still far away, dollar debasement due to the high fiscal deficits of the US government were not a concern.

3. May 09 till Sep 09

Global economy was expected to recover quickly and most of the fears seen in the period1 were removed. Emerging markets were expected to lead the recovery phase. Emerging market assets were being bought and money started moving into these economies. Risk appetite increased and this resulted in the fall in the US $. Also with the increasing confidence on the recovery, risks of higher inflation caused by the fiscal deficits were playing on the minds of the investors.The high fiscal deficits and inflation fears also led to the dollar losing value. Gold prices started increasing with the fall in the US dollar (as shown in Figure 5). The correlation between Gold price and Dollar index was back to -0.68.

Looking back we can see the movements and the reasons for these movements which can aid us in providing a glimpse of what may happen in the future. Going forward the main themes are,

a) The increase in the prices of assets caused by the liquidity push could lead to creation of a new bubble. This would only lead to increasing gold prices and dollar being sold off both on concerns of inflation and dollar becoming the new "yen" in carry trade

b) Recovery gets prolonged and the impact of high inflation is not felt. This would lead to the dollar regaining some of its strength.

My bet is more on (a) happening rather than (b).

Deficits and Interest rates

With the projected fiscal deficit of nearly 6.7% of the GDP, the focus has now shifted to the means of financing this deficit and the impact it would have on the interest rates. The government has decided to push growth through government spending. This is one of the appropriate steps that had to be taken considering the fallout of the financial crisis. The fiscal deficit would have many impacts. lets concentrate on one of them arising out of the probable financing of the deficit.

Following are the few ways traditionally used to financethe deficit,

1) Market borrowing:

Government's issue bonds and raise money from the market.

2) Monetisation:

The central bank may resort to money printing to fund the deficit.

3) Asset sale:

Proceeds from sale of assets like disinvestment program could also be used to fund the deficit.

Each of the above has a different impact on the Indian economy,

1) Market Borrowings

Over the last few years, the financing of the fiscal deficit has been primarily through market borrowings. This has been through issue of dated securities and 364 day treasury bills. Nearly 65%-75% of the financing has been through market borrowings. If going by the past history the government plans to raise money by issuing securities, the pressure on interest rates is going to increase. The borrowing program of the government may lead to lack of availability of credit to the private sector thus increasing the cost of money. We are currently facing a falling interest rate regime, due to subdued investment activity. With the economy expected to improve by early next year, the pressure on credit availability is expected to increase. This is might lead to a scenario of increasing interst rates by 2009 end of early 2010. The increase in interest rates is dependent on the return of economic growth.

2) Monetisation

Monetisation might be away of not pressuring the credit pool. Monetisation leads to an increase in money supply. This leads to potential inflationary pressures in the economy. This should be one of the last resorts of financing of the fiscal deficit.

3) Asset sales

Disinvesment in government companies woudl lead to reduction in the government borrowing program. Thus by not crowding out the private sector, the interst rates might be under control.

Currently the government has not indicated a dedicated program for disinvestment. But, this would definetly be one of the ways in which the government would finance its deficit.

Another way in which the government might be able to reduce the impact of the deficit on interest rates would be to attract foreign investment into India. The availability of external funding for private sector would reduce their dependence on domestic funds. Thus keeping the interest rates low.

Ideally the government should look at using a mixture of the above means of financing.

Run up in Equities

The run up in equities over the last 30-40 days has been quite disconcerting to me. The prime reason being the pace and the lack of any change in the ground situation. Many reasons have been floated over the last 2 weeks on the reasons for the run up. One of the reasons have been indications that the Indian Economy is recovering. Three prime indicators that i have read mostly are car sales rising, industrial indexes rising, and rural economy kicking in. Most of the indicators only point to a temporary relief and not true recovery. The pay commission beneficiaries expenses will only lead to temporary spurt in consumption. Rural economy will grow at its own pace and this is definitely not going to be scorching one. Most of these indicators are only pointing to the fact that Indian economy has a minimum growth level below which it can't go. Also one needs to consider the fact that investment by companies is not rising.

My premise is that the run up is primarily global one and the money propping it is a suspect. Lets have a look at the FII investment and mutual data over the last 4 months. The first two months in the year, the net investments made by both the groups were negative,predictably the effect of the lehman crash was yet to wear off. Since March, with the lowering of risk aversion worldwide, the investments started rising. This also heralded the start of the current run up in equities. The stark contrast in the net investments being made by FII and mutual funds stands out in April.The net investment made by FII's in this month was INR 6508 Cr and by mutual funds was INR 38.6 Cr. The difference is too huge to ignore. This data points to the fact that the run up was primarily a FII driven one. Indian markets are just following the worldwide trend and there is no unique factor for attributing the rise to India alone. The month on month growth of MSCI EM index and the NSE both peaked in April.
Unless the source of money which is propping this run up is clear, the sustenance of this run up is a suspect.

Lending rates India Addendum

After publishing the last post,  I have read some articles on stickiness of PLR rates in India. One major issue for stickiness of the PLR is the linking of PLR to the various loans given to agriculture sector. But, this does not reduce the validity of point no1. in the previous post. Banks are worried about the ability to get back the capital lended and this is manifesting to a certain extent on the stickeness of the PLR.

Lending rates : India

Over the last one year, interest rate regime has changed from increasing to falling rate regime. Over the last one year, the Central Bank has used the two rate instruments it has to reduce interest rates and stimulate lending. The repo and the reverse repo rates have been decreased by 325 bps and 275 bps respectively oer the last 6 months. But the banks have not reduced the lending rates greatly, the spread between the deposits and the lending rates has only increased in the last quarter of FY 2008-09. The reasons for banks not being reduce the rates could be,

1. Reluctance to lend: 

The Banks, worried at increasing NPA's, are looking at reducing lending to sectors which they feel are really vulnerable to the economic slowdown. The are more willing to take hit on interst income rather than capital. With the current risk perception, Banks may be feeling that the interest rates should be high to cover the default costs. In the current scenario they seem to be comfortable parking funds with RBI. Nearly INR 100,000 Cr has been parked with the RBI under reverse repo window. The total investments in SLR was at 9.84 Lakh Crores as on Sep 26 2008 and 11.87 Lakh Crores as on Feb 27 2009. Another indication of the reluctance of bank lending has been the fall in the Credit Deposit ratio during the period from Sep 2008 till Feb 2009. The ratio has fallen by nearly 4%.

 RBI by reducing the reverse repo rates is specifically targeting this trend. With the current reduction the negative spread has increased to nearly 4.5% ( with respect to greater than 3 year deposit rate). 

2. High costs of funds:

Post the market fall in Jan 2008, the banking system has seen an increase in the deposits.The total Aggregate deposits with the banks in Feb 2009 was 38.51 Lakh Crores as against 31.85 Lakh Crores in Feb 2008. An increase of nearly  17%. Also an important fact to be noted is that during this period the deposit rates were very high. The high cost of funds is proving to be a major deterrent to the banks in lowering there lending rates.

Resolving these two issues is primary to increasing the credit flow at viable rates to the commercial sectors.