In a season of great jokes, Manmohan Singh cracked the best one yesterday

Manmohan-Singh_0Vivek Kaul 
Rhetoric, of any kind, needs to be delivered with a lot of passion.
When it is delivered in the deadpan style of our Prime Minister Manmohan Singh, it usually turns out to be a damp squib or comic (depends on how you look at it), like was the case with his speech in the Rajya Sabha yesterday.
In this speech, Singh, tried to explain why the rupee has been falling against the dollar, among other things. As Singh put it “we must realise that part of this depreciation was merely a needed adjustment. Inflation in India has been much higher than in the advanced countries. Therefore, it is natural that there has to be a correction in the exchange rate to account for this difference.”
That’s a valid explanation as far as the depreciation of the rupee goes. To be fair, you’d expect an Oxford educated economist to be able to do at least that. But what the explanation does not tell us, where did the inflation come from in the first place?
You and me did not create inflation. Singh’s government did. India has been battling high levels of consumer price inflation for sometime now. This has happened largely on account of the government increasing minimum support prices(MSPs) by a huge amount. 
As economist Surjit Bhalla writes in a column in The Indian Express As commented by me on several occasions over the last three years, this high food inflation was literally engineered by the UPA government via massive increases in procurement prices.”
Every year the Food Corporation of India (FCI), or a state agency acting on its behalf, purchases rice and wheat at MSPs set by the government. With the government offering increasing the MSPs, more and more of rice and wheat landed up at the godowns of the FCI and not the open market. A December 2012, report brought out by the Commission for Agricultural Costs and Prices, which comes under the Ministry of Agriculture points out “Since 2006-07, the procurement levels for rice and wheat have increased manifold…Currently, piling stocks of wheat with FCI has led to an artificial shortage of wheat in the market in the face of a bumper crop.”
This has led to a massive food inflation and in turn very high consumer price inflation because food constitutes nearly 50% of it. The irony is that no specific formula has been followed for deciding the minimum support prices. The Comptroller and Auditor General (CAG) of India in a recent report titled “Performance Audit of Storage Management and Movement of Food Grains in Food Corporation of India (FCI)
questioned the logic behind how the MSPs are being set.
The report was presented to the Parliament on May 7 ,2013. As the report points out “No specific norm was followed for fixing of the Minimum Support Price (MSP) over the cost of production. Resultantly, it was observed the margin of MSP fixed over the cost of production varied between 29 per cent and 66 per cent in case of wheat, and 14 per cent and 50 per cent in case of paddy during the period 2006-2007 to 2011-2012. Increase in MSP had a direct bearing on statutory charges levied on purchase of food grains by different State Government… All this resulted in rising of the acquisition cost of food grains.” To cut a long story short, inflation did not appear on its own, Singh’s government engineered it.
Singh also pointed out that the rupee was not the only currency falling against the dollar, but there were other currencies as well. As he said “However, foreign exchange markets have a notorious history of overshooting. Unfortunately this is what is happening not only in relation to the Rupee but also other currencies.”
Fair point. But the question Singh did not answer was why has the rupee fallen far more than these ‘other’ currencies that he is referring to? 
A report on the Reuters website published yesterday morning points out that “The rupee has tumbled 10.4 percent against the dollar so far this month, which would be its largest monthly depreciation ever if it ends around current levels, according to Thomson Reuters data.” In comparison “the rupiah has lost 5.9 percent so far in August, which would be its biggest monthly fall since November 2008.” The Philippine peso has fallen 2.7 percent. The Thai baht has slid 2.4 percent and the Malaysian ringgit has weakened 1.6 percent.
Our Oxford educated economist did not tell us why the Indian rupee has fallen much more against the dollar than other emerging market countries in Asia. The rupee crisis is largely a 
desi oneWe are paying the cost of running a high current account deficit over the last few years. (You can read a detailed argument here).
Singh also tried to set aside the concerns being raised about the ability of the government to meet its fiscal deficit target of 4.8% of GDP, that it had set for this financial year (i.e. the period between April 1, 2013 and March 31, 2014). Fiscal deficit is the difference between what a government earns and what it spends. As Singh said “There are questions about the size of the fiscal deficit. The government will do whatever is necessary to contain the fiscal deficit to 4.8% of GDP this year.”
Now the least one could expect from an Oxford educated economist is to explain what is this “whatever”? Does the Prime Minister plan to rein in the fiscal deficit by raising diesel prices? The latest available data on the under-recovery on diesel was published on August 16, 2013. The under-recovery on diesel was around Rs 10.22 per litre. At that point of time the price of crude oil was at Rs 6680.46 per barrel (around 159 litres). Since then the price of crude oil has gone up to Rs 7723.68 per barrel as on 29.08.2013. This means diesel under-recoveries must also have risen to roughly around Rs 12 per litre.
And if raising diesel prices is not an option, does the PM plan to raise fertilizer prices? Or does he plan to cut down on other planned expenditure? And if he cuts down the planned expenditure, will it not have an impact on economic growth? And if the economic growth slows down, how will the nation meet the economic growth target of 5.5%, of which Singh is so confident about?
The Prime Minster, like the minister of finance P Chidambaram has on occasions, blamed our fascination for buying gold for our problems. As he said “clearly we need to reduce our appetite for gold.” Our fetish for gold 
as this writer has explained on earlier occasions is not the problem. It is a symptom of the problem of high inflation.
High inflation has led to a situation where the purchasing power of the rupee has fallen dramatically over the last few years. And given that people have been moving their money into gold (though that may not be the case lately). As Dylan Grice writes in a newsletter titled 
On The Intrinsic Value Of Gold, And How Not To Be A TurkeyNow consider gold. In ten years’ time, gold bars will still be gold bars. In fifty years too. And in one hundred. In fact, gold bars held today will still be gold bars in a thousand years from now, and will have roughly the same purchasing power. Therefore, for the purpose of preserving real capital in the long run, gold has a property which is unique in comparison with everything else of which we know: the risk of a loss of purchasing power approaches zero as one goes further into the future. In other words, the risk of a permanent loss of purchasing power is negligible.”
The Prime Minister also went onto blame the high current account deficit on our coal imports. As he said “In 2010-11 and the years prior to it, our current account deficit was more modest and financing it was not difficult, even in the crisis year of 2008-09. Since then, there has been a deterioration, mainly on account of huge imports of gold, higher costs of crude oil imports and recently, of coal.”
The question is why does a country like India which has third largest coal reserves in the world, need to import coal? The Prime Minister who was also the coal minister between 2006 and 2009, should have had an answer for that.
The total geological reserves of coal blocks given away to private companies (excluding ultra mega power projects) for free between 1993 and 2009 amounted to 17397.22 million tonnes.  Of this, a total of 14060.34 million tonnes was allocated between 2006 and 2009, when the free giveaway of coal blocks was at its peak. Prime Minister Manmohan Singh was also the Coal Minister for a large part of this period. But the total production of coal from these mines was close to zero.
Guess the Prime Minister would have an explanation for that.
The Prime Minister went onto say several such other absurd things during the course of his speech. He asked the members of the parliament to “trust the ability of the government to tackle economic difficulties.” In a season of very good jokes on the Indian economy in general and the
Indian rupee in particular, this was by far the best joke.
If not for anything else, Manmohan Singh deserves kudos for being India’s best stand-up comedian with a deadpan expression.

 The article originally appeared on on August 31, 2013 
(Vivek Kaul is a writer. He tweets @kaul_vivek) 

What George Soros must be thinking about the rupee

george-soros-quantum-fundVivek Kaul
George Soros likes to believe that he has managed to make all the money that he has, by following what he calls the theory of reflexivity. Not everyone believes this though.
His son Robert, offers another explanation for his success in Michael Kaufman’s 
Soros: The Life and Times of a Messianic Billionaire. As Robert puts it “My father will sit down and give you theories to explain why he does this or that. But I remember seeing it as a kid and thinking, Jesus Christ, at least half of this is bullshit, I mean, you know the reason he changes his position in the market or whatever is because his back starts killing him. It has nothing to do with reason. He literally goes into a spasm, and it’s his early warning sign.”
Soros himself has some doubts. As he writes in 
The New Paradigm for Financial Markets – The Credit Crisis of 2008 and What It Means “To what extent my financial success was due to my philosophy is a moot question because the salient feature of my theory is that it does not yield any firm predictions. Running a hedge fund involves the constant exercise of judgement in a risky environment, and that can be very stressful. I used to suffer from backaches and other psychosomatic ailments, and I received as many useful signals from my backaches as from my theory. Nevertheless, I attributed great importance to my philosophy and particularly my theory of reflexivity.”
So what is the theory of reflexivity? As Soros writes “The crux of the theory of reflexivity is not so obvious, it asserts that market prices can influence the fundamentals. The illusion that markets manage to be always right is caused by their ability to affect the fundamentals that they are supposed to reflect…Buy and sell decisions are based on expectation about future prices, and future prices, in turn, are contingent on present buy and sell decisions.”
Now what does that mean in simple English? Let’s understand this in the context of the rupee which has depreciated rapidly against the dollar in the last few months.
The rupee largely fell because of our high current account deficit. The current account deficit is the difference between total value of imports and the sum of the total value of its exports and net foreign remittances. Simply put, our demand for dollars was more than their supply. The rupee was also adjusting for the high consumer price inflation that we have had for a long time now.
So the rupee falling against the dollar was a given. The fall in the value of the rupee was reflecting the economic fundamentals of India. Or as conventional economic theory goes, market prices reflect the fundamentals on most occasions.
The trouble is that rupee has had a free fall and this has led some economists to believe that it has fallen more than it should have to reflect India’s economic fundamentals. As Rohini Malkani, Prachi Mishra and Aman Mohunta 
write in The Economic Times “ However, with the rupee around 65-66 to a dollar, it has overshot its equilibrium value and is undervalued at current levels.”
Simply put, the value of the rupee against the dollar has fallen more than it should have to reflect India’s economic fundamentals. The trouble with this argument, like most arguments made by theoretical economists is that it tends towards ‘equilibrium’.
While the fall in the value of the rupee reflects India’s economic fundamentals, at the same time the fall in the value of the rupee also impacts India’s economic fundamentals. Malkani, Mishra and Mohuna do not take the second factor into account.
As the rupee falls, Indian oil companies need to pay more for the oil that they import. If the government chooses not to pass on the higher cost onto the end consumers ( as it has done in the past) this means that the oil companies need to be compensated for the “under-recoveries”.
This means a higher expenditure for the government. A higher expenditure in turn means a higher fiscal deficit. Fiscal deficit is defined as the difference between what a government earns and what it spends. This will lead to more borrowing by the government and will crowd out private sector borrowing (for banks as well as corporates) leading to higher interest rates. Higher interest rates will have slowdown economic growth further.
If the government chooses to pass on the increase in the cost of importing oil to the end consumer, it will lead to higher inflation. A higher inflation can’t be good for economic growth either. A weaker rupee will also make other important imports like fertilizer, coal, palm oil etc, costlier. This will have its own impact on economic growth as people will cut down on consumption to meet higher expenses.
India’s external debt as on March 31, 2013, stood at at $ 390 billion. Of this nearly 79% debt is non government debt. External commercial borrowings(ECBs) made by corporates form nearly 31% of the external debt. This is not surprising given that the Credit Suisse analysts point out that 40-70% of the loans of 10 big corporate groups that they studied for a recent research report, are foreign currency denominated.
With a weaker rupee, as these loans mature, corporates will need more rupees to buy dollars. And this will have a huge impact on their profit and loss accounts. Lower profits or losses are obviously not good news.
A weaker rupee also has an impact on Indian exports, given that India’s top exports like gems and jewellery, organic chemicals, vehicles, machinery and petroleum products, are all heavily import dependent. Hence, people in this business will have to pay more in rupee terms to import raw materials that they need to make their finished products. This will have an impact on the pricing of exports and explains to a large extent why a weaker rupee doesn’t necessarily always lead to higher exports.
What this means is that a fall in the value of the rupee will soon start impacting India’s economic fundamentals or perhaps it already has. And this in turn will mean a further fall in the value of the rupee. Swaminathan Aiyar explained it best 
in a recent column in The Economic Times “Many experts say the rupee has overshot and will come back. Really? Remember the same thing was said about the Indonesian rupiah when it depreciated from 2,500 to 3,000 to the dollar in 1997, but it eventually went all the way to 18,000. Estimates based on fundamentals quickly become meaningless because a crisis changes fundamentals hugely. The crashing rupee has already changed the economy’s fundamentals.”
Disclosure: The idea for this article came from Swaminathan Aiyar’s column Get ready for another Asian Financial Crisis in The Economic Times
The article originally appeared on on August 30, 2013
(Vivek Kaul is a writer. He tweets @kaul_vivek)

Food Security – The biggest mistake India might have made till date

250px-Gandhisonia05052007Vivek Kaul 
Historians often ask counterfactual questions to figure out how history could have evolved differently. Ramachandra Guha asks and answers one such question in an essay titled A Short History of Congress Chamchagiri, which is a part of the book Patriots and Partisans.
In this essay Guha briefly discusses what would have happened if Lal Bahadur Shastri, the second prime minister of India, had lived a little longer. Shastri died on January 11, 1966, after serving as the prime minister for a little over 19 months.
The political future of India would have evolved very differently had Shashtri lived longer, feels Guha. As he writes “Had Shastri lived, Indira Gandhi may or may not have migrated to London. But even had she stayed in India, it is highly unlikely that she would have become prime minister. And it is certain that her son would have never have occupied or aspired to that office…Sanjay Gandhi and Rajiv Gandhi would almost certainly still be alive, and in private life. The former would be a (failed) entrepreneur, the latter a recently retired airline pilot with a passion for photography. Finally, had Shastri lived longer, Sonia Gandhi would still be a devoted and loving housewife, and Rahul Gandhi perhaps a middle-level manager in a private sector company.”
But that as we know was not to be. Last night, the Lok Sabha, worked overtime to pass Sonia Gandhi’s passion project, the Food Security Bill. India as a nation has made big mistakes on the economic and the financial front in the nearly 66 years that it has been independent, but the passage of the Food Security Bill, might turn out to be our biggest mistake till date.
The Food Security Bill guarantees 5 kg of rice, wheat and coarse cereals per month per individual at a fixed price of Rs 3, 2, 1, respectively, to nearly 67% of the population.
The government estimates suggest that food security will cost Rs 1,24,723 crore per year. But that is just one estimate.
 Andy Mukherjee, a columnist with Reuters, puts the cost at around $25 billion. The Commission for Agricultural Costs and Prices(CACP) of the Ministry of Agriculture in a research paper titled National Food Security Bill – Challenges and Optionsputs the cost of the food security scheme over a three year period at Rs 6,82,163 crore. During the first year the cost to the government has been estimated at Rs 2,41,263 crore.
Economist Surjit Bhalla in a column in The Indian Express put the cost of the bill at Rs 3,14,000 crore or around 3% of the gross domestic product (GDP). Ashok Kotwal, Milind Murugkar and Bharat Ramaswamichallenge Bhalla’s calculation in a column in The Financial Express and write “the food subsidy bill should…come to around 1.35% of GDP, which is still way less than the numbers he(i.e. Bhalla) put out.”
The trouble here is that by expressing the cost of food security in terms of percentage of GDP, we do not understand the seriousness of the situation that we are getting into. In order to properly understand the situation we need to express the cost of food security as a percentage of the total receipts(less borrowings) of the government. The receipts of the government for the year 2013-2014 are projected at Rs 11,22,799 crore.
The government’s estimated cost of food security comes at 11.10%(Rs 1,24,723 expressed as a % of Rs 11,22,799 crore) of the total receipts. The CACP’s estimated cost of food security comes at 21.5%(Rs 2,41,623 crore expressed as a % of Rs 11,22,799 crore) of the total receipts. Bhalla’s cost of food security comes at around 28% of the total receipts (Rs 3,14,000 crore expressed as a % of Rs 11,22,799 crore).
Once we express the cost of food security as a percentage of the total estimated receipts of the government, during the current financial year, we see how huge the cost of food security really is. This is something that doesn’t come out when the cost of food security is expressed as a percentage of GDP. In this case the estimated cost is in the range of 1-3% of GDP. But the government does not have the entire GDP to spend. It can only spend what it earns.
The interesting thing is that the cost of food security expressed as a percentage of total receipts of the government is likely to be even higher. This is primarily because the government’s collection of taxes has been slower than expected this year. The Controller General of Accounts 
has put out numbers to show precisely this. For the first three months of the financial year (i.e. the period between April 1, 2013 and June 30, 2013) only 11.1% of the total expected revenue receipts (the total tax and non tax revenue) for the year have been collected. When it comes to capital receipts(which does not include government borrowings) only 3.3% of the total expected amount for the year have been collected.
What this means is that the government during the first three months of the financial year has not been able to collect as much money as it had expected to. This means that the cost of food security will form a higher proportion of the total government receipts than the numbers currently tell us. And that is just one problem.
It is also worth remembering that the government estimate of the cost of food security at Rs 1,24,723 crore is very optimistic. The CACP points out that this estimate does not take into account “additional expenditure (that) is needed for the envisaged administrative set up, scaling up of operations, enhancement of production, investments for storage, movement, processing and market infrastructure etc.”
Food security will also mean a higher expenditure for the government in the days to come. A higher expenditure will mean a higher fiscal deficit. Fiscal deficit is defined as the difference between what a government earns and what it spends.
The question is how will this higher expenditure be financed? Given that the economy is in a breakdown mode, higher taxes are not the answer. The government will have to finance food security through higher borrowing.
Higher government borrowing by the government as this writer has often explained in the past crowds out private borrowing. The private sector (be it banks or companies) in order to compete with the government for savings will have to offer higher interest rates. This means that the era of high interest rates will continue, which will not be good for economic growth.
Also, it is important to remember that the food security scheme is an open ended scheme. 
As Nitin Pai, Director of The Takshashila Institution, writes in a column “The scheme is open-ended: there’s no expiry date, no sunset clause. It covers around two-thirds of the population—even those who are not really needy. This means that the outlays will have to increase as the population grows.”
This might also lead to the government printing money to finance the scheme. It was and remains easy for the government to obtain money by printing it rather than taxing its citizens. F P Powers aptly put it when he said that money printing would always be “the first device thought of by a finance minister when a large quantity of money has to be raised at once”. History is full of such examples.
Money printing will lead to higher inflation. Prices will rise due to other reasons as well. Every year, the government declares a minimum support price (MSP) on rice and wheat. At this price, it buys grains from farmers. This grain is then distributed to those entitled to it under the various programmes of the government.
The grain to be distributed under the food security programme will also be procured in a similar way. But this may have other unintended consequences which the government is not taking into account. As the CACP points out “Assured procurement gives an incentive for farmers to produce cereals rather than diversify the production-basket…Vegetable production too may be affected – pushing food inflation further.”
And this will hit the very people food security is expected to benefit. A
 discussion paper titled Taming Food Inflation in India released by CACP in April 2013 points out the same. “Food inflation in India has been a major challenge to policy makers, more so during recent years when it has averaged 10% during 2008-09 to December 2012. Given that an average household in India still spends almost half of its expenditure on food, and poor around 60 percent (NSSO, 2011), and that poor cannot easily hedge against inflation, high food inflation inflicts a strong ‘hidden tax’ on the poor…In the last five years, post 2008, food inflation contributed to over 41% to the overall inflation in the country.”
Higher food prices will mean higher inflation and this in turn will mean lower savings, as people will end up spending a higher proportion of their income to meet their expenses. This will lead to people spending a lower amount of money on consuming good and services and thus economic growth will slowdown further. It might not be surprising to see economic growth go below the 5% level.
Lower savings will also have an impact on the current account deficit. As 
Atish Ghosh and Uma Ramakrishnan point out in an article on the IMF website “The current account can also be expressed as the difference between national (both public and private) savings and investment. A current account deficit may therefore reflect a low level of national savings relative to investment.” If India does not save enough, it means it will have to borrow capital from abroad. And when these foreign borrowings need to be repaid, dollars will need to be bought. This will put pressure on the rupee and lead to its depreciation against the dollar.
There is another factor that can put pressure on the rupee. In a particular year when the government is not able to procure enough rice or wheat to fulfil its obligations under right to food security, it will have to import these grains. But that is easier said than done, specially in case of rice. “Rice is a very thinly traded commodity, with only about 7 per cent of world production being traded and five countries cornering three-fourths of the rice exports. The thinness and concentration of world rice markets imply that changes in production or consumption in major rice-trading countries have an amplified effect on world prices,” a CACP research paper points out. And buying rice or wheat internationally will mean paying in dollars. This will lead to increased demand for dollars and pressure on the rupee.
The weakest point of the right to food security is that it will use the extremely “leaky” public distribution system to distribute food grains. As Jagdish Bhagwati and Arvind Panagariya write in 
India’s Tryst With Destiny – Debunking Myths That Undermine Progress and Addressing New Challenges “A recent study by Jha and Ramaswami estimates that in 2004-05, 70 per cent of the poor received no grain through the pubic distribution system while 70 per cent of those who did receive it were non-poor. They also estimate that as much as 55 per cent of the grain supplied through the public distribution system leaked out along the distribution chain, with only 45 per cent actually sold to beneficiaries through fair-price shops. The share of food subsidy received by the poor turned out to be astonishingly low 10.5 per cent.”
Estimates made by CACP suggest that the public distribution system has a leakage of 40.4%. “In 2009-10, 25.3 million tonnes was received by the people under PDS while the offtake by states was 42.4 million tonnes- indicating a leakage of 40.4 percent,” a CACP research paper points out.
Bhagwati and Panagariya also point out that with the subsidy on rice being the highest, the demand for rice will be the highest and the government distribution system will fail to procure enough rice. As they write “recognising that the absolute subsidy per kilogram is the largest in rice, the eligible households would stand to maximize the implicit transfer to them by buying rice and no other grain from the public distribution system. By reselling rice in the private market, they would be able to convert this maximized in-kind subsidy into cash…Of course, with all eligible households buying rice for their entire permitted quotas, the government distribution system will simply fail to procure enough rice.”
jhollawallas’ big plan for financing the food security scheme comes from the revenue foregone number put out by the Finance Ministry. This is essentially tax that could have been collected but was foregone due to various exemptions and incentives. The Finance Ministry put this number at Rs 480,000 crore for 2010-2011 and Rs 530,000 crore for 2011-2012. Now only if these taxes could be collected food security could be easily financed the jhollawallas feel.
But this number is a huge overestimation given that a lot of revenue foregone is difficult to capture. As Amartya Sen, the big inspiration for the 
jhollawallasput it in a column in The Hindu in January 2012 “This is, of course, a big overestimation of revenue that can be actually obtained (or saved), since many of the revenues allegedly forgone would be difficult to capture — and so I am not accepting that rosy evaluation.”
Also, it is worth remembering something that 
finance minister P Chidambaram pointed out in his budget speech. “There are 42,800 persons – let me repeat, only 42,800 persons – who admitted to a taxable income exceeding Rs 1 crore per year,” Chidambaram said.
So Indians do not like to pay tax. And just because a tax is implemented does not mean that they will pay up. This is an after effect of marginal income tax rates touching a high of 97% during the rule of Indira Gandhi. A huge amount of the economy has since moved to black, where transactions happen but are never recorded.To conclude, the basic point is that food security will turn out to be a fairly expensive proposition for India. But then Sonia Gandhi believes in it and so do other parties which have voted for it.
With this Congress has firmly gone back to the 
garibi hatao politics of Indira Gandhi. And that is not surprising given the huge influence Indira Gandhi has had on Sonia.
As Tavleen Singh puts it in 
Durbar “When she (i.e. Sonia) refused to become Congress president on the night Rajiv died, it was probably because she knew that if she took the job, she would be quickly exposed. In her year of semi-retirement she learned to speak Hindi well enough to read out a speech written in Roman script, and studied carefully the politics of her mother-in-law. There were rumours that she watched videos of the late prime minister Indira Gandhi so she could learn to imitate her mannerisms.”
Other than imitating the mannerisms of Indira Gandhi, Sonia has also ended up imitating her politics and her economics. Now only if Lal Bahadur Shastri had lived a few years more…
The article originally appeared on on August 27, 2013
(Vivek Kaul is a writer. He tweets @kaul_vivek) 

Why most economists did not see the rupee crash coming

rupeeVivek Kaul
Economists and analysts have turned bearish on the future of the rupee, over the last couple of months. But very few of them predicted the crash of the rupee. Among the few who did were,SS Tarapore, a former deputy governor of the Reserve Bank of India, and Rajeev Malik of CLSA.
Tarapore felt that the rupee should be closer to 70 to a dollar. As he pointed out in a column published in The Hindu Business Line on January 24, 2013 “
With the inflation rate persistently above that in the major industrial countries, the rupee is clearly overvalued. Adjusting for inflation rate differentials, the present nominal dollar-rupee rate of around $1 = Rs 54 should be closer to $1 = Rs 70. But our macho spirits want an appreciation of the rupee which goes against fundamentals.”
Rajeev Malik of CLSA said something along similar lines in a column published on Firstpost on January 31, 2013. “
The worsening current account deficit is partly signalling that the rupee is overvalued. But the RBI and everyone else are missing that clue,” he wrote. The current account deficit is the difference between total value of imports and the sum of the total value of its exports and net foreign remittances
What Tarapore and Malik said towards the end of January turned out to be true towards the end of May. The rupee was overvalued and has depreciated 20% against the dollar since then. The question is why did most economists and analysts not see the rupee crash coming, when there was enough evidence available pointing to the same?
One possible explanation lies in what Nassim Nicholas Taleb calls the turkey problem (something I have talked about in a slightly different context earlier). As Taleb writes in his latest book
Anti Fragile “A turkey is fed for a thousand days by a butcher; every day confirms to its staff of analysts that butchers love turkeys “with increased statistical confidence.” The butcher will keep feeding the turkey until a few days before thanksgiving. Then comes that day when it is really not a very good idea to be a turkey. So, with the butcher surprising it, the turkey will have a revision of belief—right when its confidence in the statement that the butcher loves turkeys is maximal … the key here is such a surprise will be a Black Swan event; but just for the turkey, not for the butcher.”
The Indian rupee moved in the range of 53.8-55.7 to a dollar between November 2012 and end of May 2013. This would have led the ‘economists’ to believe that the rupee would continue to remain stable against the dollar. The logic here was that rupee will be stable against the dollars in the days to come, because it had been stable against the dollar in the recent past.
While this is a possible explanation, there is a slight problem with it. It tends to assume that economists and analysts are a tad dumb, which they clearly are not. There is a little more to it. Economists and analysts essentially feel safe in a herd. As Adam Smith, the man referred to as the father of economics, once asserted,
“Emulation is the most pervasive of human drives”.
An economist or an analyst may have figured out that the rupee would crash in the time to come, but he just wouldn’t know when. And given that he would be risking his reputation by suggesting the obvious. As John Maynard Keynes once wrote
“Worldly wisdom teaches us that it’s better for reputation to fail conventionally than succeed unconventionally”.
An economist/analyst predicting the rupee crash at the beginning of the year would have been proven wrong for almost 6 months, till he was finally proven right. This is a precarious situation to be in, which economists/analysts like to avoid. Hence, they tend to go with what everyone else is predicting at a particular point of time.
Research has shown this very clearly. As Mark Buchanan writes in
Forecast – What Physics, Meteorology and the Natural Sciences Can Teach Us About Economics “Financial analysts may claim to be weighing information independently when making forecasts of things like inflation…but a study in 2004 found that what analysts’ forecasts actually follow most closely is other analysts’ forecasts. There’s a strong herding behaviour that makes the analysts’ forecasts much closer to one another than they are to the actual outcomes.” And that explains to a large extent why most economists turned bearish on the rupee, after it crashed against the dollar. They were just following their herd.
There is another possible explanation for economists and analysts missing the rupee crash. As Dylan Grice, formerly an analyst with Societe Generale, and now the editor of the Edelweiss Journal, put it in a report titled
What’s the point of the macro? dated June 15, 2010 “Perhaps a more important thought is that we’re simply not hardwired to see and act upon big moves that are predictable.”
A generation of economists has grown up studying and believing in the efficient market hypothesis. It basically states that financial markets are largely efficient,meaning that at any point of time they have taken into account all the information that is available. Hence, the markets are believed to be in a state of equilibrium and they move only once new information comes in. As Buchanan writes “the efficient market theory doesn’t just claim that information should move markets. It claims that
only information moves markets. Prices should always remain close to their so called fundamental values – the realistic value based on accurate consideration of all information concerning the long-term prospects.”
What does this mean in the context of the rupee before it crashed? At 55 to a dollar it was rightly priced and had incorporated all the information from inflation to current account deficit, into its price. And given this, there was no chance of a crash or what economists and analysts like to call big outlier moves.
Benoit Mandlebrot, a mathematician who spent considerable time studying finance, distinguished between uncertainty that is mild and that which is wild. Dylan Grice explains these uncertainties through two different examples.
As he writes “Imagine taking 1000 men at random and calculating the sample’s average weight. Now suppose we add the heaviest man we can find to the sample. Even if he weighed 600kg – which would make him the heaviest man in the world – he’d hardly change the estimated average. If the sample average weight was similar to the American average of 86kg, the addition of the heaviest man in the world (probably the heaviest ever) would only increase the average to 86.5kg.”
This is mild uncertainty.
Then there is wild uncertainty, which Dylan Grice explains through the following example. “For example, suppose instead of taking the weight of our 1000 American men, we took their wealth. And now, instead of adding the heaviest man in the world we took one of the wealthiest, Bill Gates. Since he’d represent around 99.9% of all the wealth in the room he’d be massively distorting the measured average so profoundly that our estimates of the population’s mean and standard deviation would be meaningless…If weight was wildly distributed, a person would have to weight 30,000,000kg to have a similar effect,” writes Grice.
Financial markets are wildly random and not mildly random, like economists like to believe. This means that financial markets can have big crashes. But given the belief that economists have in the efficient market hypothesis, most of them can’t see any crash coming.
In fact, when it comes to worst case predictions it is best to remember a story that Howard Marks writes about in his book The Most Important Thing (and which Dylan Grice reproduced in his report titled Turning “Minimum Bullish” On Eurozone Equities dated September 8,2011). As Marks writes “We hear a lot about “worst case” projections, but they often turn out not to be negative enough. I tell my father’s story of the gambler who lost regularly. One day he heard about a race with only one horse in it, so he bet the rent money. Halfway around the track the horse jumped over the fence and ran away. Invariably things can get worse than people expect. Maybe “worse case” means “the worst we have seen in the past”. But it doesn’t mean things can’t be worse in the future.” 
Disclosure: The examples of SS Tarapore and Rajeev Malik were pointed out by the Firstpost editor R Jagannathan in an earlier piece. You can read it here)
The article originally appeared on on August 26, 2013
(Vivek Kaul is a writer. He tweets @kaul_vivek) 

Rupee at 65: India Inc in a debt trap just when money is tighter

rupeeVivek Kaul 
During the past few months I have often pointed out the economic mess that the Congress led United Progressive Alliance (UPA) government has landed us into. But that is not the only mess going around. Corporate India is in an equally messy situation on the debt that it has managed to accumulate over the last few years.
Analysts Ashish Gupta, Kush Shah and Prashant Kumar of Credit Suisse in a report titled 
House of Debt – Revisited, dated August 14, 2013, put out numbers showing the same. They estimate that the gross debt of ten Indian corporate groups for the financial year 2012-2013 (i.e. the period between April 1, 2012 and March 31, 2013) stood at Rs 6,31,024.7 crore. Their debt has risen by 15% over the financial year 2011-2012 (i.e. the period between April 1, 2011 and March 31, 2012).
Interestingly, in the financial year 2006-07( i.e. the period between April 1, 2006 and March 31, 2007) the gross debt of these groups had stood at Rs 99,300 crore. So their debt has increased six fold in the period between March 31, 2007 and March 31, 2013.
And this has landed these groups (which include the likes of Videocon, Adani, Essar, JSW, Reliance ADA, Vedanta, GMR, GVK etc) into serious trouble. The overall interest coverage ratio of these groups as on March 31, 2013, stands at 1.4. The interest coverage ratio is essentially a measure of the capability of a company to pay interest on its outstanding debt. It is calculated by dividing a company’s earnings before interest and taxes (EBIT or operating profit) for a year by the interest to be paid on the outstanding debt for the same year.
An interest coverage ratio of 1.4 essentially means that for every Rs 1 of interest that the company has to pay, it makes Rs 1.4 of operating profit. This basically means that around 71.4%(1/1.4) of the operating profit of the ten groups cited in the report, will go towards interest payment. This is a very tricky situation to be in.
The interest coverage ratio of the ten corporate groups cited in the report has dropped from 1.6 as on March 31, 2012, to 1.4 as on March 31, 2013. What this means is that as on March 31, 2012, these groups would have had to pay 62.5% of their operating profits to pay interest on their oustanding debt. That has now jumped to 71.4%.
In fact, some of the groups have an interest coverage ratio of less than one. This basically means that they are not making enough money to repay the interest on their debt. As the Credit Suisse analysts point out “Aggregate interest cover for these top ten groups has dropped from 1.6x to 1.4x. Interest cover ratios at groups such as Essar, GMR, GVK and Lanco are already under 1. Interest cover at Adani and Jaypee have also fallen to <1.5x. Interest coverage ratio has come down from 1.2x to 0.6x for Lanco Infratech…Similarly, for GVK infra, the coverage ratio has come down from 1.0x to 0.4x.”
In fact the situation gets much worse if one takes into account the fact that the groups are currently not expensing the entire interest cost in their profit and loss account. This is because the money raised through debt has been used to construct projects. A large part of these projects are currently under construction and haven’t come on stream. Hence, a lot of interest is currently being capitalised, which basically means that it is being shown on the asset side of a balance sheet and hasn’t been shown as an expense in the profit and loss account.
As the Credit Suisse analysts point out “ As most of these groups have capacities under construction, a large share of interest expense is also currently capitalised. With capitalised interest currently 30- 250% higher than the P&L expense, the interest burden may also sharply rise as projects come on stream.”
Take the case of Reliance Power. The company is currently showing an interest of Rs 580 crore in its profit and loss account. At the same time the company has a capitalised interest of Rs 1470 crore. Once this interest moves from the balance sheet to the profit and loss account, the interest coverage ratio of the company will fall from 2.4 to 0.7. This basically means is that the company will not make enough of an operating profit to pay the interest on its outstanding debt.
The depreciating rupee has been adding to the problem because a huge proportion of the oustanding debt of these corporate groups is in foreign currency. “Many corporates’ loans are 40-70% foreign currency denominated; therefore, the sharp depreciation in the rupee is adding to their debt burden. Adani Enterprise and Reliance Comm have the largest percentage of borrowings through forex loans,” write the analysts.
One dollar was worth around Rs 55 in mid May. Now it is worth around Rs 65. Hence, this means that these corporate groups will have to pay more rupees to buy dollars to repay their foreign currency loans.
India’s external debt as on March 31, 2013, stood at at $ 390 billion. Of this nearly 79% debt is non government debt. External commercial borrowings(ECBs) made by corporates form nearly 31% of the external debt. This is not surprising given that the Credit Suisse analysts point out that 40-70% of the loans of the 10 corporate groups that they studied are foreign currency denominated. As these loans mature in the time to come corporates will need dollars to repay them, and this will put further pressure on the rupee.
What makes the situation more scary is the fact that ECBs of $21 billion raised by corporates need to be repaid before March 31, 2014. Corporates which are in a position to repay earlier, will make a dash for it. This is primarily because as the rupee depreciates against the dollar, a greater amount is needed to buy dollars.
So if companies have idle cash lying around, it makes tremendous sense for them to prepay foreign currency loans. The trouble is that if a lot of companies decide to prepay loans then it will add to the demand for dollars and thus put further pressure on the rupee.
All this debt, also means that the situation can’t be good for Indian banks which have lent money to these corporate groups. As analysts Ashish Gupta and Prashant Kumar of Credit Suisse pointed out in report titled 
House of Debt and dated August 12, 2012, “Over the past five years, Indian banks have witnessed strong (20% CAGR) loan growth. However, this growth is increasingly being driven by a select few corporate groups. In FY12, over 20% of the incremental loans came from just ten groups. The total debt level of these ten (Adani, Essar, GMR, GVK, JSW, JPA, Lanco, Reliance ADA, Vedanta and Videocon) has jumped 5 times in the past five years (40% CAGR) and now equates to 13% of the total bank loans and 98% of the net worth of the banking system.” The situation could have only gotten worse for Indian banks since then.
Of course the question is how did the big Indian corporate groups land up in this mess? 
As a recent report in The Hindu Business Line points out “Between 2002-03 and 2007-08, private corporate investment as a percentage of India’s GDP rose from 5.7 to 17.3. Subsequently, it fell to 13.4 in 2010-11, but was still higher than the single-digit levels till the early 2000s. The above investment binge was significantly financed through large-scale borrowings, contracted with the confidence that the projects executed would generate sufficient returns to service the debts. Moreover, the large differential between domestic and overseas interest rates, besides the belief in a perennially strong rupee, emboldened corporates to increasingly resort to ECBs (external commercial borrowings).”
Interest rates in India over the last few years have been higher in comparison to interest rates abroad. This is primarily because the Reserve Bank of India had been raising interest rates to tackle inflation. At the same time the Western Central banks had been running easy money policies where they were printing and pumping money into the economy. With a surfeit of money going around interest rates abroad were thus lower, leading to the Indian corporates borrowing abroad rather than in India.
The government helped corporates in this borrowing binge. As 
The Hindu Business Line report cited earlier points out “All this was further actively encouraged by policy makers at the Finance Ministry, RBI and Planning Commission. Among other things, corporates were permitted to access up to $500 million of ECB under the ‘automatic approval’ route every year, which got subsequently enhanced to $750 million.”
But now with the rupee rapidly against the dollar, all this debt will end up creating huge problems for these overleveraged corporate groups. One way out of this mess is by generating money through the sale of assets that these groups have. The trouble here is that who do they sell to? As the Credit Suisse analysts pointed out in their August 2012 report “Given the high leverage levels, poor profitability and pressure from lenders, virtually all of the ten debt-heavy groups have initiated to divest part of their assets (cement plants/power/road projects). However, given that most of the domestic infra developers are already over-geared, demand for these assets may be limited.”
The chickens, as they say, will come home to roost for India Inc.
The article originally appeared on on August 23, 2013 

(Vivek Kaul is a writer. He tweets @kaul_vivek)