Month: April 2015 | Page 4

16 April, 2015

Why politicians love paper money

Money makes money, and the more money that money makes, makes more money—Benjamin Franklin

John Maynard Keynes was the most influential economist of the twentieth century. Keynes really came into his own in 1936, when his magnum opus The General Theory of Employment, Interest and Money was published.
One of the core points of the book was that when it came to thrift or saving, the economics of the individual differed from the economics of the entire system. For an individual to save by cutting down on expenditure made tremendous sense. But when a society, as a whole, began to save more, there was a problem.
This was because the expenditure of one person was the income for another. Hence, when expenditure began to go down, incomes would fall too, leading to a further reduction in expenditure. And so the cycle would continue. The aggregate demand of a society as a whole would fall in the end, leading to either lower prices or lower production or both, thus impeding economic growth and causing economic contraction.
As per Keynes, the way out of this situation was for someone to spend more. Citizens and businesses were not willing to spend more, given the state of the economy. So, the only way out of this situation was for the government to spend more on public works and other programs. This would act as a stimulus and thus cure the recession.
This has been standard prescription given by economists when countries are not doing well. Having said that the basic idea put forward by Keynes had been known for a very long time. Even Roman kings had practised it.
As Kabir Sehgal writes in Coined—The Rich Life of Money and How Its History Has Shaped Us: “Julius Caesar left his stamp on Roman monetary history by using the gold treasure he pillaged from Gaul to increase the quantity of the aureus in circulation…These new coins helped Rome cope with a financial crisis of 49BC.” So, even Julius Caesar had used Keynes’ prescription of increasing government spending during recessionary times and thus helped revive the economy.
Caesar’s successor Augustus followed the same prescription in order to revive the Roman economy when it was suffering from a depression, during the course of his rule. As Sehgal writes: “Augustus used loot captured from Egypt to spend lavishly on civil projects and enhanced welfare programs…In time…the economy recovered.”
Interestingly, the rulers that followed Julius and Augustus, followed their model. One such ruler was Nero who ruled Rome between AD 54 and AD 68 and had to face a depression in AD 62. In AD 64, a fire blazed through Rome and this created further problems. But Nero got through this by increasing “food subsidies for the public” and “spending on civil projects like canals”.
But along with following the Keynesian model, Nero did something else as well. He started reducing the quantity of metal in the Roman coins. Nero reduced the silver content of denarius (a silver coin) by 10%. He also reduced the gold content of the aureus by 10 percent in AD 64. By reducing the metal content in coins Nero was able to produce more coins. In the modern sense, he was thus able to increase money supply by around 7%.
What was the idea behind this debasement of metallic money? “The story goes that with more money flowing through the economy, prices will rise to reflect the reduced value of the currency, which will spur individuals and businesses to spend now rather than later, leading to a bump in economic activity,” writes Sehgal.
Nero was the not the first ruler to practice this strategy. Neither was he the last one. This is a practise that has been regularly resorted to by kings, queens, dictators, general secretaries, and politicians ever since.
In fact, Nero couldn’t have gone about it as well as politicians and central bankers do, in this day and age. The reason for this lies in the fact that during Nero’s time Rome used gold and silver coins as money. As Sehgal writes: “Nero was unable to affect uniformly his entire currency at once. When he issued a new batch of debased coins[i.e. coins with lower metal content] there were still high-grade coins{i.e. the coins that had been issued earlier and had a higher amount of metal content in them] in circulation. The value of these high-grade coins would appreciate, yet it would take time for them to be hoarded and removed from circulation.” They would be hoarded because they had more metal in them than the new coins.
But with paper money there are no such problems. When a central bank issues more paper money it “adjusts the overall money supply” and “affects the value of all notes simultaneously”. “Today it’s still common practice for central banks to adjust the supply of money to abet political goals,” writes Sehgal.
Take the case of Bank of Japan—the Japanese central bank is mandated to print 80 trillion yen annually so that it can create some inflation in Japan and get people to spend money (as explained above) and in the process create some economic growth. The idea also is to drive down the value of the yen against other currencies so that Japanese exports pick up. A paper money system gives the government and the central bank this kind of flexibility. This is something that would not be easily possible in a metallic based system. In order to flood the financial system with more gold or more silver, more gold or silver would be required. Unlike paper money, metallic money cannot be created out of thin air.
Also, history has shown that debasement of currency leads to inflation as more and more money chases the same amount of goods and services. And inflation benefits borrowers as they repay money they had borrowed with money that is less valuable than it was before. Further, governments run by politicians are themselves big borrowers. Hence, inflation ends up benefiting governments as well.
It is much easier to create inflation with a paper money system than with metal based currencies. In fact, a few years back I spoke to Russell Napier of CLSA who made a very interesting point: “The history of the paper currency system, or the fiat currency system is really the history of democracy… Within the metal currency, there was very limited ability for elected governments to manipulate that currency. And I know this is why people with savings and people with money like the gold standard. They like it because it reduces the ability of politicians to play around with the quantity of money. But we have to remember that most people don’t have savings. They don’t have capital. And that’s why we got the paper currency in the first place. It was to allow the democracies. Democracy will always turn toward paper currency and unless you see the destruction of democracy in the developed world, and I do not see that, we will stay with paper currencies and not return to metallic currencies or metallic based currencies.”
And this best explains why politicians love paper money.

The column originally appeared on The Daily Reckoning on April 16, 2015

15 April, 2015

George Soros’ theory of reflexivity explains the rut in public sector banks

Public sector banks continue to remain in a big mess. In a recent research note Crisil Research points out: “ Asset quality remained under pressure with gross non performing assets rising by 45 bps[basis points] to 5% of advances because of continuing stress across sectors such as infrastructure, construction and iron and steel. Also, restructured assets for public sector banks as a proportion of advances increased by 70-100 bps to around 7-8% as of December 2014.” One basis point is one hundredth of a percentage.
What this means in simple English is that for every Rs 100 given by Indian public sector banks as a loan(a loan is an asset for a bank) nearly Rs 12- 13(Rs 5 worth of non performing assets plus Rs 7-8 worth of restructured loans) is in shaky territory.
The borrower has either stopped repaying the loan or the loan has been restructured, where the borrower has been allowed easier terms to repay the loan (which also entails some loss for the bank) by increasing the tenure of the loan or lowering the interest rate. Crisil Research expects gross non-performing assets to remain at the current high levels, during the period January to March 2015, results for which will soon start coming out.
The question is how did the Indian public sector banks end up in this state? The simple answer as explained above is that they gave loans to borrowers who are no longer repaying them. The next question is whether the due diligence carried out by banks was adequate? This is where things get interesting.
A major portion of the loans which are now not being repaid were given out during the period 2002 and 2008. This was the period when the stock market in India was in the midst of a huge rally. The economy was also doing well.
This had created a massive “feel good” factor which ensured that corporates where willing to borrow and banks were willing to lend. Between end December 2001 and end December 2007, the lending by banks went up at a rapid rate of 26.8% per year. To give a sense of comparison, the lending by banks between December 2007 and December 2014 went up at the rate of 16.8% per year, which is significantly lower. If we consider a much shorter period between December 2011 and December 2014, the lending by banks went up by just 13.4% per year.
What this clearly tells us is that the growth in bank lending between December 2001 and December 2007 happened at a very rapid rate. This rapid rise was a reflection of the era of “easy money” that existed during that period due to the stock market and the Indian economy both going from strength to strength.
And this is where things started to get messy. Before we go any further it is important to understand, the theory of reflexivity proposed by hedge fund manager George Soros.
As Soros writes in The New Paradigm for Financial Markets: “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.” Reflexivity refers to circular relationships between cause and effect
Typically, the price of a stock is expected to reflect the underlying earnings potential of a company (or the kind of money that the company is expected to make in the days to come) or what analysts like to refer to as fundamentals of a company. What Soros implies through the theory of reflexivity is that the stock price of a company also impacts its earnings potential. Or to put it simply stock prices can have an impact on the fundamentals of a company.
In the feel good and easy money era that prevailed between 2001 and 2007, the stock prices of companies rallied at a rapid rate. This gave the companies the confidence to borrow a lot of money from banks, in the hope of expanding and earning much more money. But they bit more than they could chew and a few years down the line the interest that they paid on their outstanding debt was a major part of their total expenses. This had an impact on their profits. Hence, the stock price of a company ended up having an impact on its earnings.
As companies started defaulting on their interest payments and loan repayments, banks started becoming a part of this mess as well. They had to write off loans as well as restructure them. This has now led to a situation where the stressed assets of public sector banks are now close to 12-13%. In this way, a rapidly rising stock market ended up having an impact on the performance of banks. Also, in many cases the public sector banks were forced to lend to crony capitalists by politicians.
“High GNPAs will restrict growth in net interest income to 5-7% year on year, in spite of lowering of deposit rates by some of the banks,” points out Crisil.
To conclude, the bad habits are usually picked up during good times. And that is precisely what happened to public sector banks in India.

The column originally appeared on The Daily Reckoning on April 15, 2015

15 April, 2015

Indian firms are not creating enough jobs and the reason is restrictive labour laws

Vivek Kaul

Arvind Panagariya, the vice chairman of the NITI Ayog, recently said that Indian companies do not invest in industries which have the potential to employ a lot of people or what economists refer to as labour-intensive sectors. “Here is my charge to you: if I look around, none of you invest in industries, in sectors that would generate lots of employment; all of you just run away from hiring purpose,” Panagariya said.
Every month more than a million Indians are entering the workforce. As Panagariya put it: “Every year, 12 million enter the labour force. What is your plan for the country so that more people are employed? We really need to think. You know the ground conditions; why you are not investing in sectors which are more labour-intensive such as food processing, electronic assembly, leather products.”
The question that Panagariya was asking is why do Indian businesses shy away from investing in labour intensive sectors? This has led to a situation where the growth in labour force in India has been much faster than the rate at which jobs are being created.
As the latest Economic Survey points out: “Regardless of which data source is used, it seems clear that employment growth is lagging behind growth in the labour force. For example, according to the Census, between 2001 and 2011, labor force growth was 2.23 percent (male and female combined). This is lower than most estimates of employment growth in this decade of closer to 1.4 percent. Creating more rapid employment opportunities is clearly a major policy challenge.”
This slow growth in jobs has happened despite the Indian economy growing at a very fast rate for most of the period between 2001 and 2011. One obvious reason as Panagariya explained is the reluctance of Indian businesses to invest in sectors that are labour intensive. And there are reasons for the same.

The labour laws in India remain very restrictive. In their book India’s Tryst with Destiny Jagdish Bhagwati and Panagariya recount a story told to them by the economist Ajay Shah. Shah, asked a leading Indian industrialist about why he did not enter the apparel sector, given that he was already backward integrated and made yarn and cloth. “The industrialist replied that with the low profit margins in apparel, this would be worth while only if he operated on the scale of 100,000 workers. But this would not be practical in view of India’s restrictive labour laws.”
Labour comes under the concurrent list of the Indian constitution i.e. both central and state governments can make laws on it. This has led to a situation where there are a surfeit of labour laws which companies need to follow. As Bhagwati and Panagariya write: “The ministry of labour lists as many as fifty-two independent Central government Acts in the area of labour. According to Amit Mitra (the finance minister of West Bengal and a former business lobbyist), there exist another 150 state-level laws in India. This count places the total number of labour laws in India at approximately 200. Compounding the confusion created by this multitude of laws is the fact that they are not entirely consistent with one another, leading a wit to remark that you cannot implement Indian labour laws 100 per cent without violating 20 per cent of them.”
This explains why Indian businessmen stay away from labour-intensive businesses. It also explains why Indian businesses start small and continue to remain small. As Bhagwati and Panagariya point out: “As the firm size rises from six regular workers towards 100, at no point between these two thresholds is the saving in manufacturing costs sufficiently large to pay for the extra cost of satisfying the laws”.
This means many firms that can grow bigger choose not to and in the process don’t create jobs that they would have otherwise. The textile sector is a very good example where most Indian firms continue to remain small. 92.4% of workers in this sector work with small firms which have forty-nine or less workers. Now compare this to China where large and medium firms make up around 87.7% of the employment in the apparel sector.
In fact, even Bangladesh has overtaken India in the textiles sector. As Mihir S. Sharma writes in Restart—The Last Chance for the Indian Economy: “Before the expansion of trade thanks to new international rules in the twenty-first century, India made $10 billion from textile exports, and Bangladesh $8 billion. Today India makes $12 billion—and Bangladesh $21 billion.”
So what happened here? The textile industry, explains Sharma, needs to turnaround big orders quickly and efficiently. “Really long assembly lines still matter in textiles: in some cases, 100 people can sequentially work to make a pair of trousers in least time. In Bangladesh, the average number of people in a factory is between 300 and 400; in the South Indian textiles hub of Tirupur, it’s around 50,” writes Sharma.
To allow Indian businesses to grow bigger, the government will have to prune down its long list of labour laws. But politically that remains a very difficult thing to do. Further, research shows that new and young businesses create the maximum jobs. As an OECD research paper points out: “SMEs (small and medium-sized enterprises) account for 60 to 70 per cent of jobs in most OECD countries, with a particularly large share in Italy and Japan, and a relatively smaller share in the United States. Throughout they also account for a disproportionately large share of new jobs, especially in those countries which have displayed a strong employment record, including the United States and the Netherlands. Some evidence points also to the importance of age, rather than size, in job creation: young firms generate more than their share of employment.”
This can only happen in India if the ease of doing business and starting a new business goes up in the years to come. To conclude, Mr Panagariya asked a question for which he already had the answer.

(Vivek Kaul is the author of the Easy Money trilogy. He tweets @kaul_vivek)

The article originally appeared on Firspost on April 15, 2015

14 April, 2015

Why Modi’s dream of acche din will continue to remain a dream

Sushma Swaraj, the minister of external affairs, must be one unhappy woman these days. This, coming from the fact that prime minister Narendra Modi among other things is also India’s real minister of external affairs.
Modi is currently touring Germany, after having visited France. In an op-ed in the German daily Frankfurter Allgemeine Zeitung the prime minister wrote: “We have re-energised the Indian growth engine. The credibility of our economy has been restored. India is once again poised for rapid growth and development…It is the only emerging economy where growth rate is rising. The prospects are even better.”
Prime ministers need to say such “optimistic” things when they go on foreign visits. But things on the ground level in India are not very different than they have been in the past. Take corporate performance for one. In a research note released last week Crisil Research expects “India Inc.’s revenue growth to slip to a 7-quarter low of 2.5 per cent on a year-on-year (y-o-y) basis,” for the period between January to March 2015. This is less than half the growth of 5.4% seen in the period October to December 2014.
Crisil believes that the steel sector will see revenue declines of 10-11%. The petrochemicals industry will see a revenue decline of 20-22% on account of drop in global crude oil prices. “Growth for construction and capital goods sectors’ will continue to remain sluggish due to lower order backlog and slow project execution,” the research note points out.
The revenues of the automobile sector are expected to grow by around 6%. “While sales of cars and medium & heavy commercial vehicles have picked up, muted growth in international businesses and the two wheeler space will impact the topline.” The two wheeler companies are not expected to do well primarily because of the non-seasonal rains in large parts of the country which will impact the production of the rabi crop. This will dent farm incomes.
As Crisil Research points out: “Domestic consumption and export-oriented sectors are likely to outperform but, here too, sectors heavily dependent on rural consumption such as motorcycles, tractors, and FMCG have been facing severe pressure on volumes as unseasonal weather conditions and slow growth in crop prices have dented farm incomes.”
This will have an impact on the Fast Moving Consumer Goods(FMCG) sector as well. Crisil forecasts this sector to grow at 8-9% during the period January to March 2015. The sector had grown at close to 14% in between April and September 2014, the first half of the last financial year.
What this clearly tells us is that the performance of the Indian companies will remain weak during the period January to March 2015. What is interesting is that before Narendra Modi came to power, corporate performance had been relatively stronger than it is now. During the period April to June 2014 (the first quarter of the last financial year) the revenues had grown by 12.8%. In each of the three quarters before that, the revenues had grown at higher than 10%.
Since July 2014, the revenue growth started to fall and has continued to fall. Modi came to power on May 26, 2014. Corporate growth is a function of many factors and just blaming the Modi government for it is not fair. But the claim that Modi made in Germany that “ we have re-energised the Indian growth engine,” is not correct either. Without growth in company revenues, there is no way the overall Indian economic growth can be re-energised. Both are closely linked.
Further, if sustainable economic growth is to be created jobs need to be created to employ India’s burgeoning workforce. Sample this—Every year up till 2030, 13 million Indians will enter the workforce. This means more than a million Indians are entering the workforce every month. And if enough new jobs are created for them, economic growth will automatically happen.
But is that the case? Are enough jobs being created? The trouble on this front is that India does not have good data on employment. In fact, the latest economic survey makes this point: “The data on longer-term employment trends are difficult to interpret because of the bewildering multiplicity of data sources, methodology and coverage.”
Despite this, some broad inferences can be made by looking at data from multiple data sources. (I will spare you the details here. But anyone interested in the details can refer to Box 1.3 Employment Growth and Employment Elasticity: What is the Evidence? In Volume 1 of the Economic Survey).
As the Economic Survey points out: “Regardless of which data source is used, it seems clear that employment growth is lagging behind growth in the labour force. For example, according to the Census, between 2001 and 2011, labor force growth was 2.23 percent (male and female combined). This is lower than most estimates of employment growth in this decade of closer to 1.4 percent. Creating more rapid employment opportunities is clearly a major policy challenge.”
This is a major challenge for the Modi government and honestly it doesn’t seem to have done much on this front. Jobs are essentially created by small entrepreneurs as they grow big. The labour laws in India essentially ensure that most firms start small and continue to stay small. For this anomaly to be corrected, India’s labour laws need to be simplified. Nothing has happened on this front at the central level, since Narendra Modi came to power.
Over and above this, the entire process of starting and running a business in India is not easy. As per the Ease of Doing Business ranking India ranks 142 in a list of 189 countries. When it comes to the ease of starting a new business it comes in 158th. When it comes to enforcing contracts India comes in 186th out of 189 countries.
What this clearly tells us is that the entire Indian system works against an individual wanting to establish and run a business. What it also tells us is that in order to run a business in India you need to be well connected and that explains the surfeit of crony capitalists who do well in India.
If jobs are to be created the ease with which a business can be started and operated in India needs to be improved. Sadly, nothing much has happened on that front despite the so called dynamism of Narendra Modi. And unless this changes, the entire dream of acche din will continue to be just that.

The column originally appeared on The Daily Reckoning on Apr 14, 2015

14 April, 2015

Central banks are now printing money to repay themselves

In a recent report titled Debt and (not much) deleveraging the McKinsey Global Institute found that between 2007 and the second quarter of 2014, the total global debt had grown by $57 trillion. The total global debt as of the second quarter of 2014 stood at $199 trillion or 286% of the global GDP.
Government debt constituted a significant portion of this. The total government debt all around the world had stood at $33 trillion as of 2007. It has since jumped to $58 trillion, a jump of $25 trillion, at the rate of 9.3% per year.
What is interesting is that a lot of this government debt is owed to central banks. “Today, the central banks of the United States, the United Kingdom, and Japan hold 16, 24, and 22 percent, respectively, of government bonds outstanding in their countries,” the McKinsey report points out. Governments borrow money by selling bonds.
In the aftermath of the financial crisis that broke out in September 2008, central banks in developed countries started printing money. The idea was to flood the financial system with a lot of money and drive down interest rates. At lower interest rates more people were expected to borrow and spend. This would benefit businesses and in turn the overall economy.
In order to pump the printed money into the financial system the central banks bought both government as well as private sector bonds. And that is how they have ended up with massive holdings of government bonds on their balance sheets.
The central banks of the United States as well as the United Kingdom have stopped printing money and buying bonds. Nevertheless, central banks of a few other countries continue to print money and buy government bonds.
The Bank of Japan is mandated to buy 80 trillion yen worth of government bonds every year against 50 trillion yen. Starting in January 2015, the European Central Bank has also decided to buy up to €720 billion of government bonds in a year. So, in that sense central banks continue to accumulate bonds at a rapid rate.
A central bank gets paid interest by the government on the government bonds that it has in its kitty. This interest that a central bank gets paid is a part of the profit that it makes. The profit is remitted back to the government. Hence, what this means is that the government is basically paying interest to itself on its debt.
“In a sense, this debt is merely an accounting entry, representing a claim by one part of the government on another. Moreover, all interest payments on this debt typically are remitted to the national treasury, so the government is effectively paying itself,” the McKinsey report points out.
If the money that governments owe to their central banks is not taken into account, things start to look a little different. The government debt to GDP ratio in the United States falls from 89% to 67%. In the United Kingdom the number similarly falls from 92% to 63%. In case of Japan, the drop is huge—from 234% to 94%.
What these numbers also tell us is that central banks are printing money to repay themselves. How did this astonishing situation arise? Take the case of Bank of Japan. The Japanese central bank prints money and buys government bonds directly from the government. This helps the government finance its increased expenditure. A part of this expenditure is also repaying the bonds which are maturing. A part of the maturing bonds are held by Bank of Japan. Money is fungible, and hence that means that the Bank of Japan is printing money to repay itself.
This is a weird situation. As John Truman Wolfe writes in Crisis by Design, The Untold Story of the Global Financial Coup, a book published in mid-2010: “How bizarre is it that instead of simply printing the money themselves, governments ‘chose’ to borrow it from their respective central bank. The United States is currently $16 trillion in debt—and the debt is growing at the rate of $49,000 a second! Last year’s interest on the debt here was $454,000,000,000—Why borrow money from the Fed ([which] simply creates it out of thin air by making a book entry and clicking a mouse) when the government could simply print its own without borrowing it and paying interest on it.”
It is now being said that this situation can be set right given that the debt owed to central banks is ultimately an accounting entry. As the McKinsey report points out: “Whether central banks could cancel their government debt holdings is unclear… Another option that has been suggested is to replace the government debt on the central bank’s balance sheet with a zero-coupon perpetual bond.”
A perpetual bond would mean that the government will have to never repay the bond, at the same time it won’t have to pay any interest on it given the zero coupon. While this sounds fancy, this would still mean a default by the government. Governments defaulting on their debt has happened regularly in the past. “Today’s rich European nations, including England and France, defaulted repeatedly from the 14th to the 18th centuries (France did it eight times). Latin American economies defaulted repeatedly in the 20th century, and Argentina has done it once in the 21st. The most recent sovereign debt restructuring was in 2012 in Greece,” the McKinsey report points out.
And any default or a semblance of a default won’t go down well with financial markets all over the world. “Any such move could create backlash in the markets and, in some countries, by policy makers.”
A financial market backlash would mean that bond yields will go up, which in turn will push up interest rates. This is something that the governments of the Western economies can ill-afford at this point of time. Any move up in interest rates will have a negative impact on the economies, which are floundering at this point of time.
Given this, even though it is just an accounting entry, getting out of central bank debt won’t be so easy for western governments.

(Vivek Kaul is the author of the Easy Money trilogy. He tweets @kaul_vivek)

The column originally appeared on Firstpost on Apr 13, 2015