Will the market force Germany into making a decision?

November 24th, 2011

In yesterday’s post, I explained why it would be difficult for Germany to support any euro rescue effort that transfers risk from the peripheral nations to itself. Eurobonds are one such solution. And while eurobonds allow the peripheral nations to access cheaper funds, they will increase financing cost for Germany and France. Till yesterday, Germany was unwilling to commit itself to a position on Eurobonds. Today, the markets signalled that Germany needs to decide.

Germany was able to sell just over 60% of a scheduled government bond issue of €6 billion at an average yield of 1.98%. Secondary market yields on German sovereign debt rose in the aftermath of this issue to 2.09%. This reduced attraction to German sovereign debt could well be fuelled by the possibility that if Germany were to agree to the eurobond solution, it would borrow at higher rates as explained yesterday. While the credit quality of Eurobonds will be inferior to Germany’s due to contamination by other Euro nations, they would be treated in a similar manner for risk weight and other risk management purposes. In this scenario, buying German Bunds now would deprive market participants of additional yield that may be available in the coming days.

Logically, participants would wait for a German decision either way, resulting in reduced demand for existing and fresh German sovereign debt. Yesterday’s failed sale of German Bunds seems to suggest that this has come to pass. For Germany, this is a grim reminder that even though it believes the decision deserves serious deliberations and time, time is a luxury it may not have.

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The Euro - is there a way forward?

November 23rd, 2011

The Eurozone’s travails have been occupying centre stage for virtually all markets around the world for some time now. Despite the passage of time, involvement of some of the best financial brains in the world and apparent willingness on the part of Germany & France, a solution seems to be not only elusive but increasingly impossible from a realistic standpoint. As data about the finances of countries that comprise the core of the Eurozone emerge, reasons for the impossible problem facing the Eurozone become apparent.

However, the most important factor that one needs to bear in mind when analysing these, is the status of all countries in the currency union. While all these countries seem to have a currency that they can call a ‘domestic currency’, it differs from normal domestic currency in one critical aspect.

None of the participant nations in the currency union can create their currency at will, like other counties with a domestic currency can. The US for example, can create any quantity of the US dollar that it wishes to, based solely on its domestic requirements, without any restrictions from other countries. Japan can do the same, as can India and all other countries that have their own domestic currency. In the Eurozone, countries can create fresh Euros through the ECB, which can either agree or disagree based on its judgement of the requirements of the Eurozone as a whole. Therefore, factors other than the nations own economy influence this decision meaningfully, robbing these countries of the freedom others enjoy. And it is this freedom, the ability to create money at will, that distinguishes sovereign debt from all others. Put simply, while all other borrowers have to earn the money required to repay their debts, a sovereign nation borrowing in its own currency (which is completely in its control) can, in the absence of earnings, simply create the money required to repay its debts. Participants in the Eurozone do not have this ability. As a consequence, their ability to repay debt is completely dependent on their ability to earn the money required.

It is in this context, that the finances of each nation participating in the Euro become critical. Ignoring Greece for the moment, since it is already in technical default and funded by the ECB and the EFSF, it is equally instructive to analyse the others.

Italy, with a Debt/GDP ratio of 120.5%, has a primary surplus of 3.1% of GDP. This implies that if its average cost of borrowing exceeds 2.57% p.a., its primary surplus will be insufficient to cover interest cost. This would force it to borrow to pay interest which would result in a fiscal deficit and in the absence of economic growth, an increased Debt/GDP ratio. With an existing average cost of just over 4.1% and a fiscal deficit of 4.6% of GDP in 2010, it was agreed that Italy would embark on an austerity program that would allow it to achieve fiscal balance by 2014. This was before recent events that sent market yields on Italian government debt soaring to their Euro era highs of 7%.

With 26% of outstanding Italian debt due for maturity in 2012 which will need to be refinanced at an interest rate 3% higher than the existing average, a lot more austerity will be required to achieve fiscal balance and stabilise the Debt/GDP ratio. When seen along with the possibility that such austerity may cause the economy to shrink, it seems increasingly unlikely that Italy would find its way out of the woods in the near future.

Spain, with a Debt/GDP ratio of 72% of GDP may seem to be in a better position. However, it already has a primary deficit of 3.5% of GDP at a time when it needs a surplus of 2.5% of GDP to stabilise its Debt/GDP ratio (at the existing average cost of borrowing of 3.5%). Also, market yields on Spanish debt have also risen to near 7% levels, which would result in higher refinancing costs for the 16% of its total debt maturing in the next year. To make matters worse, its existing economic condition does not allow any serious consideration of austerity measures; unemployment is at 21.5% with Spanish GDP growing at less than 1% over the last year and widely expected to shrink in the current year. In summary, Spain’s troubles seem unlikely to fade as well, although for entirely different reasons.

Similar conclusions can be drawn for Portugal and Ireland, though the latter seems to be best placed to weather the storm. The common thread in all these cases is the increased possibility that these countries may not be able to finance their needs independently, and if they are, the cost of this financing would do more damage than good. Consequently, the most popular solution among market participants at the moment seems to be the Eurobond solution. In this proposed solution, all national sovereign bonds in the Eurozone may be replaced with generic Eurobonds. Since these Eurobonds will be backed by the combined financial strength of all Eurozone countries, their credit quality will be better than that of the individual countries mentioned above and lenders would be more willing to buy these at yields significantly lower than those existing for these countries.

However, on the flip side, the credit quality of the combined entity would be worse than the individual credit quality of both France and Germany. As a result, both would need to borrow at interest rates higher than they do at the moment. An indication of the rate at which funds would be available to this combined entity is available in the market yields of bonds issued by the European Financial Stability Fund (EFSF) which was established to fund bailouts of these periphery nations and is backed by the financial might by all nations of the Eurozone. EFSF bonds currently trade at 200 bps, or 2% above German Bunds. This is where the solution starts unravelling.

Germany’s current Debt/GDP ratio is just over 81% of GDP and it generates a primary surplus of 1.3%, which covers an average interest cost of 1.6% p.a. Its current cost of borrowing is in the region of 1.8% p.a. which when seen together with GDP growth of 3.6% in 2010 and expected GDP growth of about 2% in 2011, will allow it to progressively reduce its Debt/GDP ratio every year. Any increase in borrowing cost would hamper this reduction and will be extremely tricky to position politically.

After all, in the German mind, they have done everything as it should be done and are being rewarded by the markets with low interest rates on their borrowings. Accepting a cost of funds that is more than double their existing cost along with the possibility of greater debt burden, to assist nations which have been unreasonably profligate in their ways is sure to offend the austerity loving German gravely. This is especially true when there is no sign of the peripheral nations making any serious attempts to address the root causes of these issues. While almost every elected official has paid lip service to this goal, when confronted with the task of implementing decisions that would achieve it, responsibility has been entrusted to non-elected governments in two of the most severely afflicted countries. And while there is hope that these technocrat-heavy governments will be able to implement unpopular decisions, this hope may well be dashed at the altar of populism when the time comes.

This sentiment was reflected in the German Chancellor, Angela Merkel’s statements yesterday. While stopping short of an outright rejection of the Eurobond solution, Ms. Merkel made it clear that in the current environment, it is extremely difficult to imagine German support for it. It seems increasingly clear that Germany would consider it only if fiscal decision making in these countries was moved from local politicians to a central European body, where Germany would have the required influence to ensure fiscal discipline. This is, at best, a long drawn process involving political negotiations and treaty renegotiations.

In the absence of any short term solutions, it seems extremely likely that the Eurozone crisis will continue to haunt markets. Unfortunately, this is not one of those situations that find a cure in the passage of time. In fact, each passing week worsens the finances of the peripheral nations. Each passing week increases the probability that the Euro, in its current form, will soon cease to exist.

The blogger is an independent macro-economic consultant and has been a part of the debt market for over 15 years. He also blogs at www.rajivshastri.com. Views are personal

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Is the CD Deshmukh Memorial Lecture a political event?

August 13th, 2010

Going by Dr Subbarao’s contribution this year, it certainly seems to be. This speech, if one were to take it at face value, exhibited a complete lack of awareness regarding monetary matters which drew a sharp & detailed rebuttal from Ila Patnaik.

However, I believe that the speech was made with a very specific intention. While a large chunk of the speech was dedicated to it directly, with the RBI Governor detailing the reasons why he believes that the RBI should be the coordinating regulator, the rest of the speech dealt with the proposed environment in which this should happen, albeit indirectly.

Discussions concerning the RBI’s role in the economy came to a head recently with the government replacing the ULIP Ordinance with The Securities and Insurance Laws (Amendment and Validation) Bill, 2010 [PDF]. This Act provides for the establishment of a joint body to reconcile and rationalise jurisdiction disputes between the four regulators (RBI, Sebi, Irda and PFRDA) by a joint committee which apart from representation from these regulators, will have the Union Finance Minister, The Finance Secretary and The Secretary (Financial Services) in the Ministry of Finance as members with the Union Finance Minister chairing it. In a concession to the RBI, The RBI Governor will not just be an “ex-officio member”, as stated in the ordinance, but the “ex-officio Vice-Chairperson” of the Joint Committee. The Committee will then follow any procedure it considers suitable and inform the Central Government of its decision within three months. The decision will be binding on all regulators.

The RBI has always believed that it is far more important than any of the other financial regulators, and with good reason. After all, RBI decisions touch far more lives, and exert greater influence over the economy, than those of other regulators. However, in expressing the underlying reason for this “seniority” the RBI often, intentionally, mixes its up. This was evident in Dr. Subbarao’s speech as well.

He takes the RBI’s current responsibilities and builds a case for such seniority being formalized by law at a time when the scope of the RBI’s responsibilities is being intensely contested. To say that the monetary authority should also be the prudential regulator for banks as they are the primary channel for transmission of monetary policy is denying current reality. Financial system risk is no longer restricted to banks and non-banks, including Mutual Funds, play an important role as well. The monetary authority, therefore, needs to have authority over all forms of financial risk in the system. The RBI tries to achieve this by making a case for increased power. I think it is better achieved by reducing it. Let me explain.

RBI’s role as a monetary authority would be enhanced if it were to delegate all prudential regulation, including that of banks, to other regulators, specializing in various types of financial risk. As a monetary authority, its role can then be strengthened by giving it the power to supervise the functioning of all regulators without undue favoritism. Currently, with bank & NBFC prudential regulation entrusted to the RBI, it has a tendency to favor these over other financial intermediaries, which in reality, works against efficient transmission of monetary policy as was evident in the events of late 2008. In this case, the RBI was very willing to look at the problems faced by banks, but agreed to assist the mutual fund industry only after intense discussion and convincing. The result was financial mayhem. The suspicion RBI harbors about the intentions & regulatory framework surrounding other financial intermediaries is an outcome of its regulatory ownership of banks & NBFCs. It believes other regulators to be deficient not because it knows them to be so, but because it believes that it does a far better job than them. If we take this competitive ego out of the picture, the monetary authority will be far better placed to manage systemic financial risk.

But for such a monetary authority to be empowered to this extent would need it to be accountable for its actions. After all, we cannot have an unaccountable body overseeing all prudential financial regulations and this is where the rest of the speech fits in. Dr Subbarao, using archaic arguments, goes to great lengths to avoid any form of accountability for the RBI. He maligns the concept of inflation targeting as detrimental to the RBI’s other aims, namely development and financial stability, without defining a target for either. If the RBI wishes to support growth and control inflation in a financially stable environment, it can specify the target and relative priority for each and justify every action on this basis. If it believes that inflation in India comprises mostly of factors exogenous to monetary policy, as Dr Subbarao states in the speech, let it define the inflation it is willing to target. Many central banks do the same by ignoring food & energy prices (both exogenous factors) and focusing on managing core inflation But it needs to come forth and say what it wants to manage, define a target and justify all actions on that basis. This would also lend greater discipline to RBI’s decision making and reduce the scope of personality driven monetary policy which is common under the present system.

By avoiding any form of quantification, the RBI wants to gain control over all financial regulations without any form of accountability. Without the increased power it strives for as well, it is evident that the RBI needs to be more accountable in its role of monetary authority. With increased power, it would be critical. As mentioned earlier, its a two step process. We need to create a Monetary Policy & Financial Stability Board in which the current RBI Governor and two relevant Deputy Governors assume the role of Chairperson and Members of the Board respectively. Chairpersons of other regulatory bodies like Sebi, Irda and PFRDA should also be inducted on this board. The RBI, or what is left of it, should be headed by the senior-most remaining Dy. Governor. Similarly, other regulators can be led by the senior-most of their second line. However, this arrangement is only to ease transition, after which all members and the Chairperson of this board will be appointed by the Central Government. All regulatory bodies should then function under the supervision of the Board which takes ownership for monetary policy and financial stability with measurable targets and complete accountability.

The RBI’s current stance is working against the emergence of a cohesive regulatory framework for the financial market as a whole. To designate a particular regulator as senior increases the risk of financial market development being skewed towards the industry it regulates. It’s not a risk India can afford to take.

But the speech was disappointing at another level as well. The CD Deshmukh Memorial Lecture is an event many look forward to, anticipating words of genuine wisdom. Well, this year, we got a political statement in the garb of wisdom. Extremely convenient wisdom.

The blogger is an independent macro-economic consultant and has been a part of the debt market for over 15 years. He also blogs at www.rajivshastri.com. Views are personal

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Just what kind of money is this?

August 6th, 2010

Is this a strange question? Think about it…

Just what kind of money is this, when the only way to preserve its value is to lend it? If you hold it idle, it loses value. If you invest it in anything other than debt you may beat inflation, but then again, you may not. So the only way to preserve its purchasing power with any certainty is to lend it, and lend it to someone who you’re certain will pay you back. Which in most cases is the government, because regardless of how badly they mess up, they can always create more money to pay you back. But this means modern currency serves only as a “medium of exchange” outsourcing the “store of value” function to debt. And if one of money’s primary functions is assigned to debt, is it any surprise that debt has become the foundation for our economies?

But is that all our money is meant to be? Something that has “value in exchange” but no “value in use”? And if it doesn’t have value in use, how can it have value in exchange and/or be an effective store of value? On the hope that this mysterious “value in exchange” would persist tomorrow, next month and next year?

From the time Richard Nixon decided to default on the US Dollar’s obligatory link to gold, mankind has wondered what money had become. But Milton Freidman, with glib tongue and circular reasoning, convinced all who needed to be convinced that this was everything money was ever meant to be. I believe he exhausted people into accepting his theories, though the only proof I can offer for this belief is experiential. Argue with a modern monetary theorist, and I can guarantee you a headache, even if you are Arnold Kling. Politicians in the 1970s didn’t stand a chance. It was either accept or suffer. They, being politicians, chose to accept.

Circularity characterizes every chartalist currency argument, not just those connected with the importance of central banks, as Arnold mentions in his post. Imagine this conversation:
Me: Modern money has no value in use, so how can it have value in exchange?

Demented Chartalist (DC): As long as it can be exchanged for something valuable, it has value.

Me: But how can something without value be exchanged for something valuable?

DC: I never said it didn’t have value. In fact, I remember telling you that it did.

Me: So tell me once again, why does it have value?

DC (rolling his eyes): Because it can be exchanged for valuable things!

Me: But how can it be exchanged for valuable things when it doesn’t have value?

DC (smiling benignly): But it can be, so it does.

Me: So if it can’t be, then it won’t?

DC: Precisely! But that’s not going to happen. The government won’t allow it.

Me: Aah! So it has value because the government says so?

DC: Don’t be obtuse. It has value because it does, and the government likes it that way.

Me: But why does the government like it?

DC: Well, because the government can make all it needs without spending any of it to do so. And even if it did have to spend some of it, it could always make more.

Me (kneading my temples): But if the government can make all it wants without spending any of it, then how does it have value?

DC (smiling tolerantly): Didn’t we get past that?

Me (in pain): No, we did not! If the government can get it without exchanging anything valuable for it, then how can it have value?

DC (slowly): Because the government can exchange it for valuable things.

Me (with quivering lower lip): But how can the government not exchange anything valuable for money and then exchange money for something valuable? How?

DC (pityingly): You still don’t get it, do you? Because it can… That’s the beauty of the system. It can.

Me (weeping): No, I don’t get it… How can they.. Why can they… but…

DC (gently): I think you’re too overwrought to have understood. Do you want me to start over, a bit slower this time?

At which point I run out wailing like a little girl, damaged for life…

Living in a world with modern currency is like being imprisoned in a Joseph Heller book.

And I am Yossarian.

The blogger is an independent macro-economic consultant and has been a part of the debt market for over 15 years. He also blogs at www.rajivshastri.com. Views are personal

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Of Governors and “Senior Officials”…

August 4th, 2010

Over the last few days, apart from the regular newspaper columns and opinions, many readers have emailed saying the RBI is either confused about what its doing, or is acting under political influence. This feeling was compounded when an unnamed “senior official”, in comments soon after the recent policy announcement said that the current inflationary environment needed “aggressive policy action” and current policy wouldn’t tame inflation.
I agree with the official partly. Current monetary policy will not tame inflation, but that’s where my agreement with the unnamed official ends. It won’t do so, not because more needs to be done, but because current inflation has less to do with monetary policy and more with supply side shocks and international market movements. Inflation will reduce, but purely due to statistical reasons I have outlined earlier. Also, if any form of monetary policy can have a meaningful impact on current inflation, it will have to be the exchange rate policy and not the interest rate policy. Granted that there are signs of inflation getting broad-based, but isn’t that expected after a sharp increase in fuel costs. After all, transportation is an significant part of final cost in virtually every product today.

Though comments of this nature confuse the market and observers about RBI’s real thoughts, this isn’t a new phenomenon. Dr Y V Reddy, when he was Dy Governor, frequently & publicly disagreed with his Governor, Dr Bimal Jalan. And it was always caused by his angst of Dr Jalan’s refusal to combat everything through interest rate hikes.

In reality, the formative years for most of the RBI’s middle & top brass were simpler times. Times when the exchange rate was decided by the RBI and obeyed by the market. Times when the possibility of attracting capital flows in excess of our requirements was unimaginable. Times when inflation was largely a domestic phenomenon (remember oil prices remained stable for a long long time before going through the roof only in the 21st century, and when they did spike we had ourselves a crisis) and India was still a nation where individuals could only save, and not borrow. Times when the government did not have to borrow from the market to fund its deficit and wasn’t affected by interest rate changes significantly.

In these times when inflation rose, interest rates were hiked regardless of what constituted inflation. And it wasn’t because  that was the right thing to do. It was the only thing they could do. As an added benefit, the purchasing power of savings was protected, at least partly, due to such higher rates which imparted moral underpinning to actions devoid of any other kind. To a section of these people, every step of the liberalization process has been accompanied by a growing feeling of inadequacy, driven by their inability to deal with the consequences. Consequences like excessive capital flows and their impact on the exchange rate, like domestic prices which are increasingly connected to global prices and the fact that inflation can now exist without any domestic reason whatsoever.

Some of them (a minority) faced by their own inadequacy and the lack of an incentive to change with the times, turned increasingly dogmatic and defended their beliefs with quasi-religious zeal. They oppose and object to anything that reduces the power they had over markets, like capital flows and flexible exchange rates. But more than anything else, they object when the only policy instrument they are familiar with is not used to impose sacrifice and austerity on an increasingly indulgent population.

Another minority, however, chose to adapt. Excited by liberalization and the opportunities it offered, they updated their knowledge and enhanced their skills. It is this minority that stood by Dr Jalan in his efforts to forge a new path for Indian monetary policy. One that was characterized by transparency and an open minded analysis of the suitability of traditional policies, parameters and goal posts. It was at this time when the foundation for India’s best economic years was cast. Monetary policy then was an eclectic mix of the traditional and the unconventional. But it wasn’t always so. In his initial years as governor, Dr Jalan was fairly tentative in his attempts to break the mold. He spent the first couple of years identifying and manning  key positions with the right people. It was in his third year as governor, in 2000 when he eventually succeeded, aided by the team he had painstakingly built.

But this divide doesn’t exist just within the RBI. Outside as well, we see a clear divide between those who look at headline inflation and demand hikes and those who analyze the components and request patience, realizing that there is nothing, absolutely nothing to be gained by hiking rates in the current environment. This divide existed during Dr Jalan’s time and exists now.

Dr Subbarao is charting a course similar to Dr Jalan’s. In his latest monetary policy statement are signs of a new found independence in thought and a self assurance which was missing in earlier policy statements. And while current inflation still doesn’t demand the sharp interest rate increases he has imposed, neither rates nor liquidity are, at the moment, serious threats to growth. The 10 year GOI benchmark yield has remained stable moving from 7.89 per cent on March 19, 2010 just before the rate hikes began to, well, 7.89 per cent on August 3, 2010. Hardly a sign of bond market distress. While there are those who will see this as a worrying sign of inefficient monetary policy transmission and still others who would claim this to be a sure sign that RBI is behind-the-curve, I would contend that it reflects an increased certainty regarding the conduct of monetary policy which has compensated, at least in part, for higher overnight rates. The hands off approach to exchange rate volatility is another example of change. In refusing to control the exchange rate market on a day to day basis and increasing the range of tolerable movement, both positive & negative, Dr Subbarao has relieved the RBI and the Indian debt market of a great burden. This preference towards domestic stability at the cost of exchange rate volatility is welcome, more so when compared to Dr Reddy’s time when fixation with exchange rate stability caused unprecedented volatility in domestic overnight rates. The worst episode, in March 2007 saw interbank call rates move between 2.50 per cent and 75 per cent within the month (Source: RBI)

While I have, and continue to, oppose rate hikes, I sense light at the end of the tunnel. This isn’t a governor who is confused or tentative. This is a governor finding his feet and preparing to make a difference, allowing his detractors small victories that don’t cause much harm; gaining strength with each passing month.

I take the comments of the anonymous senior official as a sign that interest rate hawks are playing a smaller role in policy making. So now, all they can do is speak.

The blogger is an independent macro-economic consultant and has been a part of the debt market for over 15 years. He also blogs at www.rajivshastri.com. Views are personal

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Finally, a credit policy worth writing about!

July 27th, 2010

In Tuesday’s credit policy announcement the RBI hiked rates as expected. But for the first time in years, it hiked the reverse repo and repo rate unequally. This can only be good.

In times of surplus liquidity, the RBI borrows from the market at the reverse repo rate, the lower of the two policy rates. On the other hand, in a deficient liquidity scenario, it lends to the market at the repo rate. The difference between the two rates, which was 50 basis points (bps) at the time they evolved into policy rates was relentlessly widened to 150 bps during the governorship of Dr Y V Reddy.

The reasons behind this change were never explained fully, but then, Dr Reddy wasn’t inclined to explain most of his monetary policy actions. In use, however, this gap became a potent monetary weapon which could be wielded at any time to change rates dramatically without any apparent change in monetary policy. It gave the RBI power to change market conditions without changing policy rates and was used frequently, often with devastating effects.

The use of this weapon was considerably easy, using RBI’s almost complete control on systemic liquidity. Small changes in CRR can make the difference between a liquidity surplus and a liquidity deficient market. Moreover, with government tax collections being periodic and chunky, it is possible to turn a liquidity surplus system to a liquidity deficient one without an action. Since advance tax payments will be made as scheduled, by not taking any action to compensate market liquidity for such outflows, banks could move from lending to the RBI at the reverse repo rate to borrowing from the RBI at the repo rate.

Since such lending and borrowing operations decide the overnight rate, which is the foundation for the term structure of interest rates, it was possible for the RBI to change systemic interest rates by up to 150 bps without any monetary policy action. This allowed the RBI to conduct monetary policy in a covert manner, unbecoming of a government institution in a democracy. It also introduced uncertainty in the overnight rates, which resulted in higher spreads and consequently, higher rates for long term borrowers. How does one price a five-year loan/bond if one isn’t sure whether the overnight rate is 3.5% or 5.0%?

This first step in reducing the width of what is colloquially called the LAF “corridor” needs to be lauded despite the fact that this corridor is still too wide. More such steps will be needed which will, hopefully, reduce the gap to either 25 or 50 bps. This will stabilise overnight rates across liquidity conditions, stabilise overnight rate expectations and result in finer pricing for the term structure. Ultimately, it will lend more credibility to monetary policy actions by improving their transmission to the banking system and the real economy.

It’s easy to say that more could have been done, but to my mind, even if the credit policy statement consisted of just this one sentence, it would still be a good policy. Well begun is half done, the saying goes, and it’s apt in this context. At this time, we need to celebrate RBI’s tacit acknowledgement that this is a problem which needs to be corrected.

Another issue that needs to be addressed is the use of CRR as an instrument of monetary policy. Encouraged by China’s success in using CRR to manage system liquidity, recent statements by senior RBI officials show the inclination to use it here is rising. The width of the LAF corridor, no doubt, added to its attraction with one monetary tool influencing both liquidity and interest rates. However, considerable challenges exist in its use in India when compared to China. The banking system in China is characterised by its homogeneity in ownership and to a certain extent, size. In this environment, an increase in reserve requirements impacts all banks almost equally resulting in efficient transmission. This isn’t the case in India.

With banks of all size and ownership structures co-existing, changes in reserve requirements have an unequal impact which can result, and has historically resulted, in occasional existential problems for banks disadvantaged by such changes. And if this tool is used in place of, rather than along with other liquidity intervention methods, it can disrupt normal functioning of the banking system. This has been proved in the past, with October 2008 being the most extreme manifestation of its impact.

It is expected that a reduction in the width of the LAF corridor would reduce the attractiveness of using CRR as an all-in-one tool and result in distinct monetary tools being used for managing liquidity and interest rates. But this is merely an expectation. As in the case of narrowing the LAF corridor, we need to wait for evidence in either words or action.

The blogger is an independent macro-economic consultant and has been a part of the debt market for over 15 years. He also blogs at www.rajivshastri.com. Views are personal

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The rise of hedonistic economics

July 1st, 2010

It’s been a while since my last post and its not because I’ve been busy otherwise. I’ve been working on a currency model that has the potential to resolve some of the global imbalances that exist. But like with any model, its throws up new problems and ultimately, one has to make a choice between the existing problems and new ones.

I have never seen a model or an economic school of thought that solves all problems without creating new ones. If that were possible, we would all be in economic utopia. There are times when the Libertarian model seems to work better and times when substantial benefits are to be had by following Keynes, and these aren’t the only choices available. In the end, economic decision making boils down to making a choice between immediate problems and future problems. Its the difference between being hedonistic and ascetic.

If one looks at individual decisions as well, there are obvious differences to be seen. There are consumption-oriented individuals and savings-oriented individuals. Hedonistic & ascetic respectively. A nation’s orientation is derived from its citizens and consequently, there are nations which are either hedonistic or ascetic. With the demise of communism (or at least its most powerful manifestations) the economic war has now changed. The war is now between Hedonists and Ascetics.

The choice between the two isn’t purely economic in nature. A nation can be capitalistic and still be ascetic, with Germany being a prime example. It is also possible to be socialistic and hedonistic, with Greece leading the charge here. The choice is cultural and affects almost all aspects of life. But it is economics where this divide becomes the most apparent and Gross National Savings is an indicator one can look at to determine this.

As things stand, Greece has the lowest Gross National Savings (GNS) rate in the world. It is followed by Portugal, the US and the UK amongst others.  Data for Greece and Portugal isn’t easily available, but estimated savings for 2010 are 6 per cent and 7.5 per cent of GDP respectively. For the 10 year period 2000-2009, average GNS rate for the world has been close to 22.50 per cent, the US and UK have managed an average of just over 14.75 per cent. The difference of close to 7.75 per cent grew to over 9.50 per cent in the case of the US and 8.9 per cent for the UK over the last five years. These nations can very easily be classified as the most hedonistic in the world.

Looking at the Euro Area in general, the average GNS rate over the last 10 years has been close to 21.25 per cent, lower than the global average by just over 1.25 per cent. For Germany these numbers are 22 per cent and 0.50 per cent respectively. The Euro Area (with the exception of Greece & Portugal) along with Canada  are ascetic in absolute terms, but on the margin in relative terms.

Turning to the  Middle East, Asia and the Commonwealth of Independent States. Savings rates in these regions has always been higher than the global mean, averaging 35.50 per cent, 31.85 per cent & 28.90 per cent respectively. These regions can be easily classified as ascetic, both in absolute and relative terms.

Net National Savings reinforce this point with Greece, Portugal and the US all in negative territory. The UK is marginally positive, but the recent budget with it’s much vaunted austerity measures may be the first step towards correcting this. Almost every other country in the world saves a portion of its Gross National Income for the future. Time series data for Net National Savings isn’t easily available as well for all nations, but occasional data indicates the above equally clearly.

All of us are born hedonists. As babies and children, we tend not to think about the future impact of our need for instant gratification. As we grow, we begin to worry about the future impact of our decisions and this is reflected in our actions, words and overall approach to life. Juxtaposing this to the global stage, it would be fair to conclude that today’s hedonistic nations are the children of the world. Like any child, they want their problems to go away now, regardless of whether this hurts their future. And now these children want the adults to follow their way of life. And are going to great lengths to ensure this.

The battleground for the recent war of words between New Keynesians like Paul Krugman, Mark Thoma, Martin Wolf etc) and “Austerians” (almost everyone else) seems to be continuation of the fiscal stimulus undertaken by most nations to tackle the recent crisis. But scratch the surface and one can clearly see that the war is, in effect, between Hedonists and Ascetics. New Keynesian economists believe that the only way out of the current mess the US finds itself in (unemployment @ 10 per cent-plus) is to continue spending money the government doesn’t have in the hope that it’ll create enough jobs and pay for itself going forward. The fact that this kind of profligacy added to the intensity of the recent crisis is but a matter of detail. And the possibility that this may result in a bigger mess is something that they will face in the future. The battle cry is to make things better now, no matter how it hurts the future.

Much like a parent giving in to a child’s tantrums, the actions of global leaders are being guided by this noise. And as is normal, the adults will pay for this as well.

The blogger is an independent macro-economic consultant and has been a part of the debt market for over 15 years. He also blogs at www.rajivshastri.com. Views are personal

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The “threat” from austerity

June 23rd, 2010

If one were to read blogs and columns of, well, pretty eminent US economists, one would be forgiven for thinking that the next major threat to global recovery was Germany. When Angela Merkel announced that the German government would strive to achieve a fiscal balance through austerity measures, Dani Rodrik, Paul Krugman, Brad DeLong, Mark Thoma et al exclaimed in shock and disbelief. They believe that the global economy needs all the demand that it can get right now, even if this demand comes from governments spending more than they earn. And they are partly correct.

The global economy is short of demand at the moment and additional demand won’t hurt. But that’s where it ends. The global economy also needs stable governments. And with Germany’s debt inching closer to 80% of GDP, the Germans want to tighten their belt. Despite the high debt-GDP ratio, Germany has been extremely disciplined in recent years. It has generated a primary surplus for six of the last 12 years and its average fiscal deficit over the same period was 2.3% of GDP. In four of these 12 years it has ended the year with lower relative debt than the previous year.

But the “progressive” group believes that this is wrong. They use Germany’s current account surplus to assert their belief that Germany isn’t ready to pull its weight in inducing a global recovery. Germany is third on the list of nations ranked by their current account balance. The first two are China and Japan. But there are critical differences between them. China is a known currency manipulator and suppresses domestic demand as a matter of policy. By making imports more expensive and exports cheaper, it lends systemic support to the continuation of its trade support. This policy is at the root of the world’s consternation with China.

At its peak, Japan openly intervened in the currency market to intentionally weaken its currency. But since 1990, Japan has been going downhill with fiscal woes of a magnitude not imagined earlier. No one can ask the Japanese government to do more than what it already does. Which brings us to Germany. Germany doesn’t own its currency anymore and cannot manipulate its value unilaterally. It has managed to achieve its current account surplus, not through low wages and currency manipulation, but through innovation and productivity. It has remained fiscally disciplined through good times which gave it the ability to exert countercyclical support to its economy in bad times. Which it did, but if you take Dani Rodrik’s logic, it didn’t do enough.

It didn’t do enough because it didn’t allow its fiscal deficit to rise as much as the US. But Germany doesn’t own the Euro and doesn’t have the ability to monetise its way out of fiscal hell like the US. So while the US can spend merrily, secure in the knowledge that it can monetise its way out of debt servicing and current account deficits, Germany has to think of earning its way out. Or would Mr Rodrik rather see Germany in Greece’s position in a few years just so that it can help Greece recover? Does that make sense at all?

And Dani Rodrik isn’t alone. Paul Krugman also agrees.

Really? Time to get tough with what, Prof Krugman? It’s one thing to threaten a currency manipulator like China, but completely another to extend the threat to Germany. If everyone is counting on the US to become the consumer of the last resort, what steps is the US taking to protect itself? The US is able to run sustained current account deficits because, unlike other lesser nations, it owns the global currency and cannot face a balance of payments crisis. What these economists want is a continuation of the system with other nations adjusting their economic policies and costs so that the US current account balances. But why should they? Is the US doing them any favour by owning the world’s reserve currency?

If the US wants its current account deficit to shrink, the US dollar will have to stop being the world’s reserve currency. Once capital flows to the US slow down, or are denominated in another currency, the US’ ability to pay for its imports will shrink, causing the currency to depreciate and the US will be a few steps closer to a current account balance. And it doesn’t take much for that to happen. All the US has to do is institute capital controls. The US is completely and totally responsible for the position it is in. It wants the US dollar to continue as a reserve currency because it suits its profligate ways, not as a favour to other nations. Changing this is in its hands. But rather than take this route, which will require it to change its ways, the US wants its trading partners to change theirs. Rather than act to weaken its currency, the US wants its trading partners to act to strengthen theirs.


The blogger is an independent macro-economic consultant and has been a part of the debt market for over 15 years. He also blogs at www.rajivshastri.com. Views are personal

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The economics of plenty - II

June 16th, 2010

In my previous post, I argued for India discarding its existing economic policies formulated in times of shortages. India’s problems have changed and we now face a problem of plenty, especially when it comes to foreign exchange inflows.

Capital inflows, have outstripped our trade deficit over the last few years. However, India’s polices remain rooted in a time when capital inflows were miniscule and India was subject to a full blown balance of payments crisis.

In continuing with these policies, India is ignoring its changed position in the  world and its changed circumstances. It isn’t accounting for its strengths, overemphasizing its weaknesses, ignoring opportunities and losing sleep over threats.

India’s strength today is its population. After years of fearing India’s population problem, we are now in a beneficial demographic period. The rising middle class and its capacity to consume positions India firmly as one of the largest markets in the world.

So why does this not show in our GDP? We need to look no further than our currency. India’s weak currency policy has many repercussions and an understatement of our GDP in terms of other currencies is just one of them.

A weak currency makes all products more expensive for the domestic population. It is futile to say that it affects only imported goods. In an economy which imports most of its fuel, currency related inflation is all pervasive.

In addition, India’s domestic market for commodities is closely linked to international markets and a weak currency also causes domestic prices of locally  produced commodities to rise. If it weren’t so, most of India’s domestic commodities would be exported. These increased prices reduce the ability of our domestic population to consume, reducing domestic growth.

A weak currency also makes it more expensive for Indian companies to buy foreign companies. While this is not an end in itself, it is a means to a very important goal; the ownership of Intellectual Property. When Tata bought Corus and Jaguar-Land Rover, it didn’t just but their capacity to produce steel and cars. It bought the technology which allowed production of superior quality steel and cars. Profits follow technology. Tata Steel and Tata Motors will show that to be true. 

And there is no better example of this than Apple. The iPhone says its designed by Apple in California and assembled in China. Guess where the profits reside. India’s technological disadvantage can only be overcome by buying technology and then developing it further. If we start from scratch, by the time we reach where the world is today, the world would have moved on.

Looking at our conundrum from another angle, the capital needs of India’s infrastructure sector cannot be met domestically. We need global savings. Our policies should reflect our need to attract savings and the strength of our domestic market.
Our current policy framework, in contrast, is making a case for capital controls which will stop global savings from reaching us, to allow us to continue exporting goods and services to other markets. Infrastructure is key to ensuring that our rural population benefits from growth. In most parts of the country rural connectivity is atrocious.
Rather than taking our prosperity to our villages, we have succeeded in bringing our rural population to our cities. In a distorted understanding of urbanisation in growing economies, we believe it is normal for our cities to grow and our villages to shrink. We seem to ignore the possibility of basic urban comforts reaching the villages instead.

If we persist with our current policies, India will always remain an infrastructure-starved nation which can only dream of inclusive growth, not achieve it. And why are capital flows inferior to trade flows? Is it because the ones we focus on are those which can be reversed easily? FII flows can be reversed at the push of a button. So we design policies to allow only those flows which are subject to substantial market costs if reversed.

If we were to look beyond these, its easy to recognise the impact of our weak currency policy on long-term stable flows. Who will want to invest in a currency, or in assets denominated in a currency which is intentionally weakened by policy. Our currency policy increases targeted returns and reduces targeted time span. So rather than
incentivizing investors to start new companies in India, we are content with
allowing them to own our existing companies. A perversity, if the stated intention is to achieve growth, isn’t it?

Times have clearly changed and our minds have to keep pace. Its not India’s growth which is at risk. As mentioned in my earlier post, India will continue to grow regardless. But whether it’ll grow enough to satisfy the needs of a young nation will depend on what drives our policies. Fear or self-belief.

The blogger is an independent macro-economic consultant and has been a part of the debt market for over 15 years. He also blogs at www.rajivshastri.com. Views are personal


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The economics of plenty

June 10th, 2010

Among other things, the Financial and Eurozone crises have imparted a significant degree of clarity to economic beliefs, despite the profusion of over-simplified economic rules which surround them. Standard debt-GDP ratios and requirements of fiscal discipline have given way to rules specific to each country’s economic situation. They have proved, with some finality that different rules apply to Europe, the US and countries like India.

Countries adopting the euro face a particularly challenging environment. Being used to the luxury of owning their respective currencies, they failed to fathom their changed circumstances after adopting the euro. Most of the PIIGS (Portugal, Ireland, Italy, Greece and Spain) nations will default at some point. It’s no longer if… just when.

At the other extreme is the US. Despite borrowing and spending way beyond its capacity to repay, the US will not default. Neither on its explicit debt and nor on its implicit debt, not for a decade or two. Its currency is desired by the rest of the world and is, for all practical purposes, its primary export. Till such time that foreigners, including foreign governments, buy the US dollar and invest it back in the US, there is no reason for the US to default. But only till such time…. If this inflow of foreign funds stops and the US needs to earn a currency foreign to it, default would be a heartbeat away. Right now, the bigger fool theory is firmly in place. Everyone believes they will get out before getting splattered by the fan.

Which brings us to India. As one would expect, India is floundering somewhere between the two. We own our currency, but aren’t really sure how much the world wants it. Capital account flows would suggest that demand exists, but we haven’t yet reached a stage where the world wants our currency for itself and not for the assets it can buy. No one wants to own a weakening asset and we don’t want an appreciating rupee.
India has choices to make. It is at a point in its existence when it can go any way it wishes to. It could continue with policies formed during times of shortage and tweak them to reflect our current surpluses. This positions India as a producer for goods and services demanded by other nations. It would necessitate a weak currency which would assist competitiveness, but deprive the local population of the purchasing power they desperately need.

Or we can discard these policies and adopt the “economics of plenty”. This would position us as a nation of 1.2 billion consumers, not 1.2 billion hungry mouths and necessitate a strong currency which increases our purchasing power. Yes, it would increase our current account deficit but, coupled with the right policies, increase demand for the rupee as an asset in itself.

In our current policy framework, India competes in other markets for a share of their business against players who have set the rules. True progress will lie in changing the rules, in becoming the market others want to compete for. In an environment where major markets are shrinking, or growing at a snail’s pace, India’s emergence as a market will be welcomed by the world. In changing its policies to favour domestic consumption over exports, India will have to change the way it thinks. And the first change will need to be our currency policy.

India’s future lies in this choice. India will grow regardless, probably faster than most countries in the world. But, in the former we will need other markets to grant us our progress. In the latter, we will drive it ourselves.

The blogger is an independent macro-economic consultant and has been a part of the debt market for over 15 years. He also blogs at www.rajivshastri.com. Views are personal

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