Why car sales did not rise and actually fell in August

carVivek Kaul
Statistics are like bikinis” said Aaron Levenstein. “What they reveal is suggestive, but what they conceal is vital.” Levenstein was an American professor of business administration who died in 1986.
In simple English, statistics never reveal the complete story and can lead to wrong inferences being made. Take the case of domestic passenger car sales number for August 2013. Media has gone to town highlighting the fact that car sales have risen by 15.4% in August 2013, in comparison to August 2012. Also, car sales have risen first time in ten months is another point that has been made. This has been used to infer that the Indian economy is looking up again and the consumer demand is coming back to the market. The situation is far from that.
Let’s look at the numbers. In August 2013, car sales stood at 1,33,486 units. This was 15.4% higher than 1,15,705 units sold in August 2012. So far so good.
This substantial jump in sales came because Maruti Suzuki managed to sell 76,018 units in August 2013. In comparison, it had sold only 50,129 units in August 2012. This 51.6% jump in sales of Maruti cars, helped the overall car sales jump by 15.4% in August 2013. What analysts call the base effect was at work.
The question to ask here is why did Maruti see a more than 50% jump in sales in August 2013 in comparison to August 2012? Smaller car manufacturers can see that sort of a jump in sales. But for the country’s biggest car manufacturer to see a 50% jump in sales under normal conditions, is almost impossible.
The answer lies in the fact that in August 2012 there was a lockout at the Manesar plant of Maruti, after labour troubles and this in turn affected the production of Maruti cars. So Maruti sold fewer cars in August 2012 not due to lower demand, but because it could not produce enough cars to meet the demand. And given that things in August 2013, have just got back to normal for the company.
Lets look at car sales in August 2011. During that month Maruti had managed to sell 77,086 units in the domestic market. Let’s assume that there had been no lockout at the Manesar plant of Maruti in August 2012, and the company had managed to sell 77,086 units during the month, like it had a year earlier in August,2011. In that case, it would have sold 26,957 units (77,086 – 50,129) extra, in comparison to the 50,129 units that it actually sold.
The overall car sales for August 2012 would have stood at 1,42,662 units (1,15,705 + 26,957) in comparison to the actual sales of 1,15,705 units. And this is the right number to use while comparing sales of August 2012 with that of August 2013, in order to adjust for the lockout at Maruti’s Manesar plant.
Hence, the overall car sales should have stood at 1,42,662 units in August 2012. Given this, the car sales for August 2013 are actually down by 9176 units (1,42,662 – 1,33,486) or 6.4%. This is something that is reflected in what Sugato Sen, the Deputy Director General of Society of Indian Automobile Manufacturers, told reporters yesterday “This (growth) is not a reflection of the market conditions. This is mainly due to Maruti’s numbers compared to last year. The tough market conditions still remain. Interest rates are high, fuel prices continue to be high while sentiments are extremely low.”
Car sales in India have slowed down for 10 consecutive months. And what that basically tells us is that people who can buy cars are worried about their economic prospects, and hence, are postponing their purchases. Floyd Norris writing in
The New York Times explains it best: “New-car sales can be a particularly sensitive economic indicator because few people really need to buy a new car, and thus tend not to do so when they feel uncertain about their economic prospects. Even if a car purchase can no longer be delayed, a used car is an alternative.”
Postponing the purchase of a car obviously has an impact on the car company. But it also has an impact on a host of other companies. As T N Ninan wrote in 
a brilliant column in Business Standard in January 2013 “The car industry is a key economic marker, because of its unmatched backward linkages – to component manufacturers, tyre companies, steel producers, battery makers, glass manufacturers, paint companies, and so on – and forward linkages to energy demand, sales and servicing outlets, et al.”
Car sales, unlike a lot of other numbers like inflation, GDP growth, which reflect the state of the economy, is not a theoretical construct. It is a real number. And if it is falling, what it clearly tells us is that the Indian economy is slowing down. There is no better number to show that.

The article originally appeared on www.firstpost.com on September 11, 2013
(Vivek Kaul is a writer. He tweets @kaul_vivek) 

With gold imports almost zero, trade deficit unlikely to fall further

goldVivek Kaul 
The trouble with being a one trick pony is that the trick stops yielding dividends after sometime. Something similar seems to have happened to the efforts of the government of India to control the huge trade deficit. Trade deficit is the difference between imports and exports.”
Trade deficit for August 2013 was at $10.9 billion. This is a major improvement in comparison to the trade deficit of $14.17 billion in August 2012. The deficit was $12.27 billion in July, 2013.
This fall in trade deficit has come through the efforts of the government to bring down gold imports by increasing the import duty on it. India imported just 2.5 tonnes of gold in August and this cost $650 million. Now compare this to 47.5 tonnes imported in July, 31.5 tonnes in June, 162 tonnes in May and 142.5 tonnes in April of this year.
In April 2013, the 142.5 tonne of imported gold had cost $7.5 billion and the trade deficit was at $17.8 billion. If there had been no gold imports, then the trade deficit for April would have stood at $10.3billion($17.8 billion – $7.5 billion). If the gold imports had been at $650 million (or $0.65 billion) as has been the case in August 2013, then the trade deficit would have stood at $10.95 billion ($17.8 billion – $7.5 billion + $0.65 billion). This number is very close to the trade deficit of $10.9 billion that the country saw in August 2013.
So the point is that the government has been able to control the trade deficit by ensuring that the gold imports are down to almost zero. 
As the Indian Express reports “Gold imports stopped after July 22 due to confusion over a rule issued by the Reserve Bank of India, which required importers to re-export at least 20% of all the purchases from overseas.”
The confusion has now been cleared. Also, with Diwali in early November and the marriage season starting from October, gold imports are likely to pick up in September and October. Even if it doesn’t, the imports are already close to zero. So, any more gains on the trade deficit front by limiting gold imports, is no longer possible. 
The Indian Express report cited earlier quotes a senior executive of the Bombay Bullion Association as saying “Imports may again rise to around 30 tonne in September, as jewellers usually start building inventory to cater to the requirement during the festival and marriage season.”
At the same time, the government hasn’t been able to do much about oil, which is India’s biggest import. In August 2013, oil imports stood at $15.1 billion, up by 17.9% in comparison to the same period last year. Oil imports formed nearly 40.8% of the total imports of $37.05 billion. There isn’t much the government can do on this front, other than raising prices majorly to cut under-recoveries of oil marketing companies and limit demand for oil products at the same time.
But that may not be a politically prudent thing to do. The commerce minister, 
Anand Sharma, warned that with the international prices of crude oil rising over the past 10 days, the oil import bill may go up in the months to come. And this may lead to a higher trade deficit.
As Sonal Varma of Nomura Securities wrote in a report dated September 10, 2013, “Looking ahead, a seasonal rise in imports during the festive season and higher oil prices should result in a slightly higher trade deficit in Q4 2013(the period between Oct and Dec 2013), relative to Q3 (the period between July and Sep 2013).”
But imports form just one part of the trade deficit equation. Exports are the other part. Exports for August 2013, went up by nearly 13% to $26.4 billion, in comparison to August 2012. In July, exports were at $25.83 billion.
While exports may have gone up by in August due to a significantly weaker rupee, whether they will continue to go up in the months to come is a big question. As Ruchir Sharma, Head of Global Macro and Emerging Markets at Morgan Stanley, and the author of 
Breakout Nations, told me in a recent interview I did for Forbes India “Exports are dependent on multiple factors, exchange rate being only one of them. Global demand which is another major factor influencing exports, has been weak. If just changing the nominal exchange rate was the game, then it would be such an easy recipe for every country to follow. You could just devalue your way to prosperity. But in the real world you need other supporting factors to come through. You need a manufacturing sector which can respond to a cheap currency. Our manufacturing sector, as has been well documented, has been throttled by all sorts of local problems which exist.”
This something that another international fund manager reiterated when I met him recently. As he said “A part of the problem that India has is that the economic model has been based more on the service sector rather than manufacturing. The amount of manufactured products that become cheaper immediately and everyone says that I need more Indian products rather than Chinese products or Vietnamese products, is probably insufficient in number to give a sharp rebound immediately.”
The other big problem with Indian exports is that they are heavily dependent on imports. As commerce minister Anand Sharma admitted to “45% of exports have imported contents. I don’t think weak rupee has any impact on positive export results.”
In fact 
The Economic Times had quoted Anup Pujari, director general of foreign trade(DGFT) on this subject a few months back. As he said “It is a myth that the depreciation of the rupee necessarily results in massive gains for Indian exporters. India’s top five exports — petroleum products, gems and jewellery, organic chemicals, vehicles and machinery — are so much import-dependent that the currency fluctuation in favour of exporters gets neutralised. In other words, exporters spend more in importing raw materials, which in turn erodes their profitability.”
Also, the moment the rupee falls against the dollar, the foreign buyers try to renegotiate earlier deals, Pujari had said. “As most exporters give in to the pressure and split the benefits, the advantages of a weak rupee disappear.”
What all these points tell us is the simple fact that the trade deficit will be higher in the months to come. And given, this the market, like is the case usually, is probably overreacting.
The article originally appeared on www.firstpost.com on September 11, 2013 

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

The Great Indian FDI conundrum

ghemawat 2

Our politicians think our problems come from being connected with the world, but the reality is we are too little connected to the world, says Pankaj Ghemawat.

Vivek Kaul

The United Progressive Alliance government is fond of telling us that India’s weakening macroeconomic indicators – a falling rupee, a declining stock market, rising bond yields – are the result of being tied to a weak global economy and factors external to India. But if you were to ask Pankaj Ghemawat, Anselmo Rubiralta Professor of Global Strategy at IESE Business School in Barcelona, Spain, India is not exactly as globally connected as we think it is.
Ghemawat has constructed a broad index of international integration, the DHL Global Connectedness Index, which was first released in November 2011. The 2012 version of this index was released last year and it shows India closer to the bottom. “This index extends beyond trade to incorporate capital, information and people flows as well, and covers 140 countries that account for 95% of the world’s population and 99% of its GDP,” says Ghemawat.
India ranks 119 out of 140 countries on the depth of its global connectedness. “When it comes to trade intensity, India still ranks in the bottom 25% in the sample. As far as capital connectedness is concerned, it is closer to the median,” says Ghemawat.
Capital connectedness is calculated from measures of foreign direct investment (FDI) and foreign portfolio equity investment into the stock market of the concerned country. India’s decent performance on capital connectedness is primarily on account of the huge money that has come into the Indian stock market from abroad in the last decade and big outward FDI flows in the form of overseas acquisitions by Indian corporates.
If one looks at just inward FDI, the performance is dismal. As Ghemawat puts it, “In terms of inward FDI stock (i.e. foreign companies having built or bought businesses in India) expressed as a percentage of GDP, India comes in the bottom 10%.”
FDI flows into India have also fallen in three out of the last four years. For 2012-13, FDI fell by 21% to $36.9 billion, government data show. The United Nations Conference on Trade and Development (UNCTAD), in a recent release, said that FDI inflows to India declined by 29% to $26 billion in 2012.
The government has, faced with an unsustainable current account deficit (CAD), has been trying to encourage FDI into the country to firm up the rupee against the dollar. Last year in September, the government opened up FDI in multi-brand retailing with the rider that each state can decide whether it wants companies like Wal-Mart to set up shop within its borders.
But since then not a single dollar has come into the sector. “One reason for foreign money not coming in is that investors are not sure whether the policy will continue as and when a new government comes in. Also, letting states set their own rules on such an international economic policy matter is basically unheard of elsewhere,” said Ghemawat. Towards the middle of July 2013, the government relaxed FDI norms in 12 sectors, including telecom, insurance, asset reconstruction, petroleum refining, stock exchanges and so on. 
Ghemawat feels that there is a lot that India can learn from China on this front. China started opening up its retail sector to FDI in 1992, initially with various restrictions, but ultimately allowing 100% FDI in 2004. This benefited them with foreign players bringing in new management practices along with supporting technology and investment capital. And we shouldn’t forget the complementarity for foreign retailers between sourcing from China (contributing to China’s export boom) and selling there.
Ghemawat argues that much of the fear about FDI in retail is exaggerated, because even with full liberalisation, foreign retailers would hardly come to dominate the Indian market. “Retail is a very local business, where an intimate understanding of customers, real estate markets, and so on, is essential to success.” He cites a recent estimate that 40 foreign players account for only about 20% of organised retail in China, to suggest that foreign and domestic retail could thrive side-by-side in India.
“Foreign retailers don’t always win out against domestic rivals,” he adds. “Electronics retailers Best Buy from the US and Media Markt from Germany both shut down their stores in China in the last few years. They just couldn’t compete with local rivals Gome and Suning, which had greater domestic scale and business models more attuned to the Chinese market. Home Depot also exited China in 2012. But Chinese consumers gained anyway – competition against foreign retailers spurred locals to improve customer service, one of their weak points.”
Coming back to data from the Indian market, Ghemawat notes an interesting factoid from the 2013 Economist Corporate Network Asia. The nominal GDP of India grew by 12.6% in 2012. In comparison, the sales of MNCs (mainly Western) in India grew by only 6.3%, only half as fast as the GDP. “While this could be viewed as positive regarding Indian firms, a difference of such a big magnitude is probably reflective of a lack of openness,” said Ghemawat.
There are multiple reasons for India’s poor showing on these indicators India regularly figures in the bottom tier of countries in terms of the extent to which its policies promote trade. In the World Economic Forum’s 2012 Global Enabling Trade Index, India figures in the bottom tier. On the market access parameters, in particular, it figures third from last in a list of 132 countries. Ghemawat also cites the OECD’s FDI restrictiveness index which he has inverted into the FDI Friendliness Index. “India again figures in the bottom 10% of 50 countries in terms of the extent to which it encourages FDI.” No amount of ministerial cajoling of potential foreign investors is likely to outweigh the impact of such protectionist policies.
These indicators, of course, translate into low productivity and lack of infrastructure required to carry out a profitable business. “The Global Competitiveness Report tells us all we need to know about India’s poor infrastructure and low productivity,” says Ghemawat. “India currently ranks 59th on the list (out of 144 countries). It has fallen 10 places since peaking at the 49th spot in 2009. Once ahead of Brazil and South Korea it is now 10 places behind them. China is 30 places ahead of India,” he adds.
When it comes to the supply of transport, energy and ICT (information, communications technology) infrastructure, India is 84th on the list. This lack of infrastructure is the single biggest hindrance to doing business in India, feels Ghemawat. And this has kept foreign investors away from the country. Also given India’s weak health and basic education infrastructure (where it is 101st on the list), India remains low on productivity, which is an important factor for any foreign investor looking to make an investment. And as if all this was not enough it is worth remembering that it is not easy to start any business in India. Every year the World Bank puts out a ranking which measures the Ease of Doing Business across countries. In the 2013 ranking, India came in at rank 132 on the list – the same as in 2012. When it comes to starting a new business In
dia is 173rd on the list. Hence, foreign investors have an option of starting their business in a much easier way in many other countries. Given this, why should they be hurrying to India?
The spate of recent scams also has not helped the way India is viewed abroad. There is significant evidence to show that corruption hampers trade. Says Ghemawat: “According to one study, an increase in corruption levels from that of Singapore to that of Mexico has the same negative effect on inward foreign investment as raising the tax rate by over 50 percentage points.” India stood at 94th position in Transparency International’s 2012 Corruption Perception Index. “Given this, tackling corruption has to be a priority,” adds Ghemawat.
The moral of the story is that although India is much more open than it used to be 20 years ago, there is a lot that still needs to be done. And this is important because there is a clear connect between the global connectedness of a country and measures of prosperity. As Ghemawat puts it, “There is a strong positive correlation across countries between the depth of a country’s global connectedness and measures of its prosperity, such as its GDP per capita and its ranking on the UN’s Human Development Index. To be sure, correlation is not the same as causation, but statistical analysis indicates that after controlling for initial income levels, countries with deeper global connectedness have tended to grow faster than less-connected countries.”
The point is further buttressed by one look at the list of countries that are on the top of 2012 DHL Global Connectedness Index created by Ghemawat. These countries are the Netherlands, Singapore, Luxembourg, Ireland, Switzerland, the United Kingdom, Belgium, Sweden, Denmark, and Germany. In the recent past some of these countries have been caught up in the aftermath of the financial crisis, but it’s important not to let recent growth rates overshadow measures of current prosperity, on which all of these countries far surpass India.
Ghemawat gives the example of the Indian information technology sector. “Ask this simple question to yourself: Would Indian IT companies have been as globally competitive if we had protected them from international competition?” The answer of course is no. But that is the case with the business services sector. There is a huge protective moat around it. This, despite the fact that the sector has a huge potential to create jobs.”
And he backs his argument with numbers. “Although some services (like haircuts) will always be delivered locally, liberalizing trade in services alone could boost global GDP by at least 1.5%.” In India’s case, opening up business services is even more important given that we don’t trade much with our neighbours due to various reasons. “For example, Indian trade with Pakistan, according to one study, is only 2 to 4% of what it might be under friendlier circumstances. The rest of India’s neighbours are relatively small and poor, presenting limited opportunities compared with, for example, the benefits China realised by tying into Japanese and Korean production networks. It is neither exaggerated nor xenophobic to say that one of India’s key structural problems is that it is located in a difficult neighbourhood,” says Ghemawat.
Countries tend to trade the most with their neighbours.  Ghemawat explains, “all else being equal, if you cut the distance between a pair of countries in half, their trade volume will go up almost 200%.  Add a common border, and trade rises another 60%.  That’s why more trade happens within world regions than across them, and the US’s top export destinations are Canada and Mexico.”
In India’s case, at least over the short-to-medium term, trading primarily with neighbours won’t be workable (though Ghemawat does urge India to take the lead on regional integration in South Asia). Hence, he feels that some business services can be outsourced over greater distances than many categories of merchandise are traded, since physical shipment of products is not required. 
One exception he notes is how, recently, China became India’s biggest trading partner, overtaking the United States. But Ghemawat feels that caution is in order. “India runs a huge trade deficit with China and exports mainly primary products there: Cotton, copper and iron ore account for nearly one-half of the total. Given the limited progress the US has made in rebalancing its trade with China, it’s hard to see what India might accomplish within any reasonable timeframe,” he says. Trade deficit is the difference between imports and exports.
Ghemawat also feels that India has a lot to gain by encouraging trade within states. “I have been trying unsuccessfully for years to get hold of data on trade between Indian states,” he says. “India has a lot to gain by encouraging and increasing trade between states. As the former Chairman of Suzuki once put it to me, what India needs is not external trade liberalisation but internal trade liberalisation. And I heard Ratan Tata say something similar about the need for more integration and fewer barriers within India. For a large country, the potential gains from internal trade are typically much larger than those from international trade,” Ghemawat concludes. 

The interview originally appeared in the Forbes India magazine in the edition dated Sep 20, 2013

 

Why Federal Reserve ‘really’ wants to go slow on money printing

ben bernankeVivek Kaul 
Over the last few months, there has been talk about the Federal Reserve of United States, the American central bank, wanting to slowdown its money printing and gradually doing away with it altogether.
Every month the Federal Reserve prints $85 billion and puts that money into the American financial system, by buying bonds of different kinds. The idea is that with enough money floating around in the financial system, the interest rates will continue to remain low.
At lower interest rates people are more likely to borrow and spend more. And this in turn will help economic growth, which has been faltering, in the aftermath of the financial crisis, which started in late 2008.
Some economic growth has returned lately. Recently the GDP growth for the period of three months ending June 30, 2013, 
was revised to 2.5% from the earlier 1.7%. But even an economic growth of 2.5% is not enough, primarily because the country needs to make up for the slow economic growth that it has experienced over the past few years.
The fear is that with all the money floating around in the financial system, too much money will start chasing too few goods, and finally lead to high inflation. But that hasn’t happened primarily because even at low interest rates, borrowing has been slow. Hence, what economists call the velocity of money (or how fast money changes hands) has been low. Given this, inflation has been low. Consumer price inflation in the United States, for the period 
of twelve months ending June 2013, stood at 1.3%.
The rate of inflation is well below the inflation target of 2% that the Federal Reserve is comfortable with. So if inflation isn’t really a concern, and the economic growth is still not good enough, why is the Federal Reserve in a hurry to go slow on printing money?
As Gary Dorsch, the 
Editor – Global Money Trends newsletter, writes in his latest column “The fragile US-economy might find itself sinking into a full blown recession by the first quarter of 2014. However, the Fed’s determination to start scaling down QE-3 is essentially in reaction to the demands of the Bank of International Settlements (BIS), – the central bank of the world – which says it is time to rethink US-monetary policy. The BIS argues that blowing even bigger bubbles in the US-stock market can do more harm to the US-economy than the old enemy of high inflation. Thus, going forward, the costs of continuing with QE now exceed the benefits.”
Quantitative easing or QE is the technical term that economists have come up with for money printing that is happening across different parts of the western world.
What Dorsch has written needs some detailed examination. The argument for keeping the money printing going has been that it has not led to any serious inflation till now, so let us keep it going. While inflation may not have cropped up in everyday life, it has turned up somewhere else. A lot of the money printed by the Federal Reserve has found its way into financial markets around the world, including the American stock market. And this has led to investment bubbles where prices have gone up way over what the fundamentals justify.
The Federal Reserve, meanwhile, has continued with the money printing because it hasn’t shown up in inflation. Central banks work with a certain inflation target in mind. If the inflation is expected to cross that level, then they start taking steps to ensure that interest rates go up.
At 1.3%, inflation in the United States
 is well below the Federal Reserve’s target of 2%. Some recent analysis coming out suggests that inflation-targeting might be a risky strategy to pursue. Stephen D King, Group Chief Economist of HSBC makes this point in his new book When the Money Runs Out. As he writes “the pursuit of inflation-targetting…may have contributed to the West’s financial downfall.”
King gives the example of United Kingdom to elaborate on his point. As he writes “Take, for example, inflation targeting in the UK. In the early years of the new millennium, inflation had a tendency to drop too low, thanks to the deflationary effects on manufactured goods prices of low-cost producers in China and elsewhere in the emerging world. To keep inflation close to target, the Bank of England loosened monetary policy with the intention of delivering higher ‘domestically generated’ inflation. In other words, credit conditions domestically became excessive loose…The inflation target was hit only by allowing domestic imbalances to arise: too much consumption, too much consumer indebtedness, too much leverage within the financial system and too little policy-making wisdom.”
Hence, the Bank of England, kept interest rates too low for too long because the inflation was low. With interest rates being low banks were falling over one another to lend money to anyone who was willing to borrow. And this gradually led to a fall in lending standards. People who did not have the ability to repay were also being given loans. As King writes “With the UK financial system now awash with liquidity, lending increased rapidly both within the financial system and to other parts of the economy that, frankly, didn’t need any refreshing. In particular, the property sector boomed thanks to an abundance of credit and a gradual reduction in lending standards.”
So the British central bank managed to create a huge real estate bubble, which finally burst, and the after effects are still being felt. And all this happened while the inflation continued to be at a fairly low level.
But this focus on ‘low inflation’ or ‘monetary stability’ as economists like to call it, turned out to be a very narrow policy objective. As Felix Martin writes in his brilliant book 
Money- The Unauthorised Biography “The single minded pursuit of low and stable inflation not only drew attention away from the other monetary and financial factors that were to bring the global economy to its knees in 2008 – it exacerbated them…Disconcerting signs of impending disaster in the pre-crisis economy – booming housing prices, a drastic underpricing of liquidity in asset markets, the emergence of shadow banking system, the declines in lending standards, bank capital, and the liquidity ratios – were not given the priority they merited, because, unlike low and stable inflation, they were simply not identified as being relevant.”
The US Federal Reserve wants to avoid making the same mistake that led to the dotcom and the real estate bubble and finally a crash. As Dorsch writes “A BIS working paper that traces booming stock markets over the past 110-years, finds that they nearly always sink under their own weight, – and causing lasting damage to the local economy. Asset bubbles often arise when consumer prices are low, which is a problem for central banks who solely target inflation and thereby overlook the risks of bubbles, while appearing to be doing a good job.”
Over the last 25 years, the US Federal Reserve has been known to cut interest rates at the slightest sign of trouble. But only on rare occasions has it raised interest rates to puncture bubbles. Alan Greenspan let the dotcom bubble run full steam. Then he, along with Ben Bernanke, let the real estate bubble run. By the time the Federal Reserve started to raise interest rates it was a case of too little too late.
A similar thing seems to have happened with the current stock market bubble, where the Federal Reserve has printed and pumped money into the market, and managed to keep interest rates low. But this money instead of being borrowed by American consumers has been borrowed by investors and found its way into the stock market.
As Claudio Borio and Philip Lowe wrote in 
the BIS working paper titled Asset prices, financial and monetary stability: exploring the nexus (the same paper that Dorsch talks about) “lowering rates or providing ample liquidity when problems materialise but not raising rates as imbalances build up, can be rather insidious in the longer run. They promote a form of moral hazard that can sow the seeds of instability and of costly fluctuations in the real economy.”
Guess, the Federal Reserve is finally learning this obvious lesson.

 The article originally appeared on www.firstpost.com on September 6, 2013 
(Vivek Kaul is a writer. He tweets @kaul_vivek) 
 

Aaya Toofan, Bhaga Shaitan: Why Raghuram Rajan is no Amitabh Bachchan

amitabh bachchan
Raghuram Rajan is currently having what I would like to call an “aaya aaya toofan, bhaga bhaga shaitan” moment. For those who are not as fond of trashy 80s cinema as I am, this needs some explanation. “Aaya aaya toofan, bhaga bhaga shaitan (Here comes Toofan, there runs the devil),” is a song from the Amitabh Bachchan starrer Toofan, which released in 1989.
The film has a character called Toofan (played by Bachchan) who plays a superhero, fighting evil. And the song keeps playing in the background whenever Toofan is out taking on the evil forces.
Rajan took over as the twenty third governor of the Reserve Bank of India (RBI), yesterday. He had his first press conference at 5.30pm in the evening. In this press conference he outlined a stream of measures that he plans to take over the next few months.
Within seconds of his press conference ending television channels, started to go gaga over his performance. The feeling one got while watching was that all of India’s economic problems have/will come to an end because Raghuram Rajan had taken over as the governor of the RBI.
This excitement seems to have rubbed off on the newspapers as well. The Economic Times has compared him to James Bond. The Times of India called Rajan’s entry “a big bang entry”. Business Standard said that “Rajan hits the ground running” and so did The Indian ExpressFirstpost has called Rajan a Rockstar.
The impact of Rajan’s maiden performance has been seen great. The rupee has risen against the dollar and is currently quoting at 66 to a dollar. The stock market has rallied around 400 points, as I write this. This is in response to a slew of measures that Rajan announced yesterday.
Rajan announced plans to internationalize the rupee, several steps to improve the inflow of dollars into India and improve exports. He also said that the RBI would allow ‘good’ banks to open branches without approaching the RBI for a license. To control the appetite Indians have for gold, he announced that the RBI would soon launch bonds indexed to consumer price inflation.
Some of the capital controls introduced sometime back to prevent the rupee from falling have also been done away with. Individuals will be allowed to spend more than $75,000 per year abroad, if the money is being spent on education and medical treatment. Rajan also announced plans for a nation wide bill payment system for payment of utilities like medical bills and school fees. A string of technical measures to shore up the value of the rupee against the dollar, were also announced. All in all, a great first day at work.
Having said that, there isn’t much that Rajan can do to improve the major ills that are plaguing the Indian economy. Let’s start with inflation. As Rajan said yesterday “the RBI takes its mandate from the RBI Act of 1934, which says the Reserve Bank for India was constituted “to regulate the issue of Bank notes and the keeping of reserves with a view to securing monetary stability in India and generally to operate the currency and credit system of the country to its advantage.””
Hence, the primary role of the RBI is to ensure monetary stability. Or as Rajan put it “That is, to sustain confidence in the value of the country’s money. Ultimately, this means low and stable expectations of inflation, whether that inflation stems from domestic sources or from changes in the value of the currency, from supply constraints or demand pressures.”
There isn’t much that the RBI can do to control inflation. The primary reason for the same is that the government of India is the main creator of inflation. The expenditure of the government has jumped considerably over the last few years and this has created inflation. As Ashok Gulati and Shweta Saini write in a research paper titled Taming Food Inflation in India “RBI has indicated time and again that government needs to rein-in the fiscal deficit before it can reduce interest rates,else, too much money in the system will be putting further pressures on prices in general and food prices in particular… The Economist in its February 2013 issue highlights that it was the increased borrowings by the Indian government which fuelled inflation and a balance-of-payments gap. It categorically puts the responsibility on the government for having launched a pre-election spending spree in 2008, which continued even thereafter.”
There is nothing that the RBI can do about this. With many state elections due this year and a Lok Sabha election due towards the middle of next year, the chances are the government is likely to continue spending big money. Several boondogles to influence the voters, might be on their way.
Also, a lot of the inflation created by the government shows up as food inflation, on which RBI has no control. As Gulati and Saini write “High food inflation, which has averaged 10 percent during FY 2008-09 to December 2012, has been a major concern for policy makers in India.” Even after December 2012, food inflation continues to be higher than 10%.
The RBI has tried to control high inflation by maintaining interest rates at high levels. One school of thought goes that since the RBI cannot do much to control food inflation, so it might as well cut interest rates. The risk here is that low interest rates might fuel other kinds of inflation. So, it remains to be seen whether Rajan is ready to take on that risk or not.
High inflation can come in from other areas which Rajan has absolutely no control over. It can come from rising oil prices due to threat of an American attack on Syria. As an international fund manager told me earlier this week “if that happens(i.e. American does attack Syria) we can have oil prices touching even $150 per barrel.” In that scenario, inflation will spike and that will have a huge impact on economic growth, something an RBI governor has no control over.
Also, if the Federal Reserve of United States, RBI’s American counterpart, decides to go slow on printing money, that will lead to further economic problems in India. The Fed has indicated in the recent past that it plans to go slow on the $85 billion it has been printing and pumping into the American financial system every month, to keep interest rates low. The hope is that at low interest rates Americans will borrow and spend more, and that will help revive the American economy.
The danger of course is that all the money being printed and pumped into the financial system can create high inflation. So at some point of time the Federal Reserve needs to start going slow on printing money.
If the Federal Reserve decides to go slow on money printing, as it has said in the recent past, interest rates in America will go up. This will lead to foreign investors selling out of India and other emerging markets. This will put further pressure on the rupee against the dollar. As the rupee will lose value, it will mean that our main imports i.e. oil, coal, fertilizer, palm oil etc, will become costlier, leading to a rise in inflation. If this scenario plays out, there is not much that Rajan can do about it. The RBI can sell dollars and buy rupees to stop the rupee from depreciating against the dollar. But it is worth remembering that the RBI does not have an unlimited supply of dollars.
Another worrying factor is the slowdown in economic growth and the impact that it will have on government borrowings. The government expects the GDP to grow by 13.4%(in nominal terms) during this financial year (as per the annual budget). This is unlikely to happen.
As Dylan Grice, formerly with Societe Generale and now the editor of the Edelweiss Journal wrote in a February 2010 research report titled Government hedonism and the next policy mistake “If I’m a finance minister mulling out how much money I should be borrowing, I want my GDP growth (and therefore my tax revenue growth) to pay coupons (i.e. interest) on any debt that I take on today…If the interest rate is higher than GDP growth, my incremental tax revenue won’t cover interest payments. I’ll be in deficit and I’ll have to issue more debt to plug the gap and my debt ratio will rise.”
What this means is that the tax revenue collected by the government should be rising at a rate which is good enough to pay the interest on the accumulated debt. If that does not happen, the government will have to borrow more money to make its interest payments. And that is not a good sign. The government will either end up with a higher fiscal deficit or it will have to cut its expenditure in other areas to maintain the fiscal deficit. Fiscal deficit is the difference between what a government spends and what it earns. India is in that kind of a situation right now and there is nothing that Rajan can do about it.
Also, to repeat a point that is made often, India’s economic growth is being hurt by the poor physical infrastructure that we have. The country needs better roads, more ports, better railway infrastructure and so on. These are things the RBI governor cannot do much about, even though as Rajan said the RBI has “additional tools to generate growth”.
All this is not to suggest that Rajan is not a good choice for the governor’s job. He is an excellent choice given his impeccable credentials, but expecting him to do miracles is unjustified.
To conclude, let me quote what Jerry Tsai, a famous American fund manager had to say about the penchant of the media to create heroes. “And I can say this from experience: the trouble with getting a little bit of good publicity is, when something goes wrong they love to kill you on the way down. The media like to build things up so they can tear them down.” (Source: What Goes Up – The Uncensored History of Modern Wall Street by Eric J Weiner). Rajan should keep that in mind as he goes about his business of rescuing the troubled Indian economy.

The article originally appeared on www.firstpost.com on September 5, 2013
(Vivek Kaul is a writer. He tweets @kaul_vivek)