Equitymaster

What Arun Jaitley can learn from marketers and real estate agents

Fostering Public Leadership - World Economic Forum - India Economic Summit 2010Vivek Kaul


I need to confess at the very start that I should have written this column a few days back. But more important things happened and this idea had to take a back seat. Nevertheless, as they say, it’s better late than never.
So, let’s start this column with two examples—one borrowed and one personal. The idea behind both the examples is to illustrate two concepts from behavioural economics—contrast effect and anchoring.
In the book The Paradox of Choice: Why More is Less, Barry Schwartz discusses an example of a high-end catalog seller, who was selling an automatic bread maker for $279. As he writes “Sometime later, the catalog seller began to offer a large capacity, deluxe version for $429. They didn’t sell too many of these expensive bread makers, but sales of the less expensive one almost doubled! With the expensive bread maker serving as anchor, the $279 machine had become a bargain.”
Essentially, there are two things that are happening here. The buyer first gets “anchored” on to high price of the deluxe version of bread maker which is priced at $429. After this the contrast effect takes over. The bread maker priced at $279 seems cheaper than the deluxe version and people end up buying it.
As John Allen Paulos writes in A Mathematician Plays the Stock Market “Most of us suffer from a common psychological failing. We credit and easily become attached to any number we hear. This tendency is called “anchoring effect.””
And once an individual is anchored on to a number, he then tends to compare it with other numbers that are thrown at him. Marketers exploit this very well. As Schwartz points out “When we see outdoor gas grills on the market for $8,000, it seems quite reasonable to buy one for $1,200. When a wristwatch that is no more accurate than one you can buy for $50 sells for $20,000, it seems reasonable to buy one for $2,000. Even if companies sell almost none of their highest-priced models, they can reap enormous benefits from producing such models because they help induce people to buy cheaper ( but still extremely expensive) ones.”
This was the borrowed example. Now let me discuss the personal example. Sometime in May 2006, I was suddenly asked to leave the apartment that I lived in because the landlord had not been paying the society charges for a very long time. And thus started the search for another apartment to rent. Affordable apartments in Central Mumbai tend to be in buildings that are not in best shape.
Given this, real estate agents use a trick where they try and exploit the contrast effect. The first few apartments that they show are in a really bad shape. After having done this they show an apartment which is slightly better than the ones shown earlier, but the rent is significantly higher.
The attractiveness of the apartment shown later is increased significantly by showing a few “run down” apartments earlier.
The idea behind sharing these two examples was to explain the idea of anchoring and contrast effect. I hope both these concepts are clear by now. Now let me move on to real issue that I want to talk about in this column.
On November 18, the finance minister Arun Jaitley said in a speech “Inflation, especially food inflation, has moderated in the last few months and global fuel prices have also come down. Therefore, if RBI, which is a highly professional organisation, in its wisdom decides to bring down the cost of capital, it will give a good fillip to the Indian economy.”
In simple English, Jaitley, as he has often done in the past, was asking the Reserve Bank of India (RBI) to cut the repo rate. Repo rate is the interest rate at which RBI lends to banks. The idea is essentially that at lower interest rates, people will borrow and spend more, and companies will invest and expand. This will lead to faster economic growth. While this sounds good in theory, as I had argued a few days back, it isn’t as simple it is made out to be.
One argument offered by those asking the RBI to cut interest rates is that inflation as measured by the consumer price index has fallen to 5.52% in October 2014. It was at 6.46 % in September 2014 and 10.17% in October 2013.
Nevertheless, is inflation really low? Or are Jaitley and others like him who have been demanding an interest rate cut just becoming victims of anchoring and the contrast effect?
The inflation figure of greater than 10% which had been prevalent over the last few years is anchored into their minds. And in comparison to that an inflation of 5.52% does sound low. Hence, the contrast effect is at work here.
Further, it is worth remembering that this so called low inflation has been prevalent only for a few months. Chances are that food prices might start rising again. The government has forecast that the output of kharif crops will be much lower than last year and this might start pushing food prices upwards all over again. Also, recent data showsthat vegetable and cereal prices have started rising again because of the delayed monsoon.
Central banks of developed countries typically tend to have an inflation target of 2%. In the recent past they have been unable to meet even that number. Large parts of the world might now be heading towards deflationary scenario, where prices will fall.
In October, the consumer price inflation in China stood at 1.6%, well below the targeted 3.5%. Also, in January earlier this year the Report of the Expert Committee to Revise and Strengthen the Monetary Policy Framework set up by RBI had recommended that the Indian central bank should set an inflation target of 4%, with a band of +/- 2 per cent around it .
The committee had said “transition path to the target zone should be graduated to bringing down inflation from the current level of 10 per cent to 8 per cent over a period not exceeding the next 12 months and 6 per cent over a period not exceeding the next 24 month period before formally adopting the recommended target of 4 per cent inflation with a band of +/- 2 per cent.”
Once, these factors are taken into account, the latest inflation number of 5.52% as measured by the consumer price index, isn’t really low, even though it seems to be low in comparison to the very high inflation that had prevailed earlier. But as explained this is more because of anchoring and the contrast effect at work.
Also, as I had written earlier, more than anything people still haven’t come around to the idea of low inflation, given that inflationary expectations(or the expectations that consumers have of what future inflation is likely to be) continue to remain on the high side.
As per the Reserve Bank of India’s Inflation Expectations Survey of Households: September – 2014, the inflationary expectations over the next three months and one year are at 14.6 percent and 16 percent. In March 2014, the numbers were at 12.9 percent and 15.3 percent. Hence, inflationary expectations have risen since the beginning of this financial year.
If inflationary expectations are to come down, then low inflation needs to be prevail for some time. Just a few months of low inflation is not enough. As RBI governor Raghuram Rajan had said in a speech in February this year “ the best way for the central bank to generate growth in the long run is for it to bring down inflation…Put differently, in order to generate sustainable growth, we have to fight inflation first.”
Rajan is trying to do just that, and it’s best that Jaitley allows him to do that, instead of demanding a cut in interest rates every now and then.

The article appeared originally on www.equitymaster.com on Nov 21, 2014

With Kisan Vikas Patra 2.0 now invest your black money with the government

indian rupees“If you can’t beat them, join them,” goes the old adage.
The government of India has done just that by relaunching the Kisan Vikas Patra (KVP). An investment in the newly launched KVP will double in 100 months. This means a return of 8.7% per year. It also comes with a lock-in of two and a half years.
There are no tax benefits, neither at the time of investment nor when the investment matures. Initially, the KVPs will be sold through post offices. But over a period of time the government plans to sell KVPs through some designated branches of public sector banks as well.
“The basic aim is to provide an investment opportunity to people who do not know where to invest and put their money into options like Ponzi schemes,” the finance minister Arun Jaitley said at the relaunch of the scheme.
A ponzi scheme is a fraudulent investment scheme in which money is repaid to old investors by using money being brought in by new investors. The scheme runs as long as the money being redeemed by the old investors is lower than the money being brought in by the new investors. The moment this reverses, the scheme collapses.
In the recent past, the country has seen a whole host of Ponzi schemes like Sahara, Saradha, Rose Valley etc. But how will the KVP stop people from investing in Ponzi schemes?
A major reason why people invested in Ponzi schemes over the last few years lies in the fact that real returns (i.e. nominal return minus the rate of inflation) on fixed income investments (like fixed deposits, post office savings schemes etc.) was negative over the last few years.
Between 2008 and 2013, both consumer price inflation and food inflation were greater than 10%, for large periods of time. In this scenario, the returns on offer on fixed income investments were lower than the rate of inflation.
Given this, individuals had to look at other modes of investment, in order to protect the purchasing power of their accumulated wealth. A lot of this money found its way into real estate and gold, which delivered good returns for most of that period. And some of it also found its way into Ponzi schemes, which promised a slightly higher rate of return than fixed deposits and other fixed income investments.
Inflation has fallen over the last few months, and after many years, the real return on fixed income investments is in the positive territory. This is, as true for KVPs, as it is for fixed deposits offered by public sector banks.
Take the case of a fixed deposit of less than Rs 1 crore with a tenure of one year to less than five years, offered by the State Bank of India. Such a deposit pays an interest of 8.75% per year, which is as good as the return of 8.7% per year offered by KVPs.
Further, the fixed deposit doesn’t come with a lock-in, unlike KVPs which have a lock-in of two and a half years. Also, those who have dealt with post offices on a regular basis will know that dealing with (even) public sector banks is relatively easier than dealing with a post office.
So, there is no basic case for investing in a KVP. Also, for those investing for the long term, instruments like PPF which are not taxed on maturity, remain a considerably better bet. Those comfortable with investing in debt mutual funds are also likely to get higher after tax returns in the long term, once indexation(or inflation in simple terms) is taken into account while calculating capital gains.
And as far as not investing in Ponzi schemes is concerned, the returns offered on KVP are not high enough to stop people from investing in Ponzi schemes.
The government also wants to increase savings by getting people to invest in this scheme. As Jaitley said at the launch “Over the last two three years, when economic growth slowed, our savings rate declined…So it is very necessary to encourage people to increase domestic savings.”
The latest RBI annual report points out that “the household financial saving rate remained low during 2013-14, increasing only marginally to 7.2 per cent of GDP in 2013-14 from 7.1 per cent of GDP in 2012-13 and 7.0 per cent of GDP in 2011-12…the household financial saving rate [has] dipped sharply from 12 per cent in 2009-10.”
Household financial savings is essentially the money invested by individuals in fixed deposits, small savings scheme, mutual funds, shares, insurance etc. It has come down from 12% of the GDP in 2009-10 to 7.2% in 2013-14. A major reason for the fall has been the high inflation that has prevailed since 2008. The return on offer on KVPs is similar to other forms of fixed-income investments available in the market and there is no reason that it should lead to higher financial savings.
So that brings us to the question, why did the government launch KVPs then? Before we understand that, here are a few more features of the scheme. The KVPs as mentioned earlier come with a lock-in of two and a half years. They come in denominations of Rs 1000,Rs 5,000, Rs 10,000 and Rs 50,000 and there is no upper limit to the number of KVP certificates that can be bought. Hence, there is no limit to the amount of money that can be invested in the scheme.
As far as fulfilling know your customer requirements are concerned, the gazette notifications states that the individual buying the KYC will have to provide proof of name and residence. No PAN card details will have to be provided.
And here comes the clincher—the KVP will be a bearer instrument, which will not carry the name of the investor. Jaitley stated this at the event to relaunch the KVP. “So people with currency can invest in this,” Jaitley said. “This will be a bearer instrument just like currency and easy to encash,” he added.
So what does this really mean? There are some basic know your customer norms that need to be followed. But the KVP certificate will not carry any name on it, and that essentially makes it an anonymous instrument, once it has been issued.
With this move, the government is hoping that the KVPs will be used to launder black money. In fact, this was precisely the reason the scheme was discontinued in November 2011, a recent report in the Business Standard points out.
Black money over the years has gone into gold and real estate, where it isn’t productive enough. If it finds its way into the coffers of the government, it can be used more productively, or so the government would like to believe.
It would also lead to higher financial savings and in the process lower interest rates. The government will benefit because it will be able to finance the fiscal deficit at lower interest rates. Fiscal deficit is the difference between what a government earns and what it spends and is financed through borrowing.
The fact that the relaunched KVP is a bearer instrument, without the name of the investor and without any need to provide an identity proof, makes it ideal to invest black money in.
As R Jagannathan writes on Firstpost.com “Since it is a bearer certificate without limit, KVPs are likely to be more popular with the better off than just the poor…Rs 1 crore invested in KVPs of the face value of Rs 50,000 each will involve the creation of only 200 certificates. Not a very big pile and very portable for black money holders.” In fact, given the fact that it is a bearer instrument, KVPs can almost be used as a currency as well.
In the old days when the government wanted to access the black money in the country, it used to launch income tax amnesty schemes, where individuals could pay a one time tax on their accumulated black money and escape punishment. In its current form, the KVP looks more like a quasi-amnesty scheme. In fact, it is even better given that no tax needs to be paid on it.
It would have been a good idea to demand the PAN number from those investors who buy KVPs of Rs 1 lakh or more. Nevertheless, the question is, should a government which has strong views on “black money” actually be launching a scheme, which makes it convenient for people to invest black money and that too with the government?

The article originally appeared on www.equitymaster.com on Nov 20, 2014

Yen carry trade from Japan will drive the Sensex higher

Japan World Markets

Vivek Kaul 

John Brooks in his brilliant book Business Adventures writes “The road to Hell is paved with good intentions!” One country on which this sentence applies the most is Japan. The country has been trying to come out of a bad economic scenario for two decades and it only keeps getting worse for them, despite the effort of its politicians and its central bank.
In the previous column, I wrote about how the prevailing economic scenario in Japan will ensure that they will continue with the “easy money” policy in the days to come, by printing money and maintaining low interest rates in the process.
But it looks like the situation just got worse for them. The Japanese economy contracted at an annual rate of 1.6% during the period July-September 2014. This after having contracted at an annual rate of 7.1% in April-June 2014. Two consecutive quarters of economic contraction constitute a recession.
Shinzo Abe was elected the prime minister of Japan in December 2012. His immediate priority was to create some inflation in Japan in order to get consumer spending going again. The Bank of Japan cooperated with Abe on this, and decided to print as much money as would be required to get inflation to 2%. This policy came to be referred as “Abenomics”.
In April 2013, the Bank of Japan decided to print $1.4 trillion and use it to buy bonds, and hence, pump that money into the financial system. The size of the Japanese economy is around $5 trillion. Hence, as a proportion of the size of Japan’s economy, this money printing effort was twice the size of the Federal Reserve’s third round of money printing, more commonly referred to as the third round of quantitative easing or QE-III.
Sometime in April this year, the Abe government decided to increase the sales tax from 5% to 8%. The idea again was to raise prices, by introducing a tax, and get people to start spending again. Nevertheless, this backfired big time and the economy has now contracted for two consecutive quarters. Elaine Kurtenbach writing for the Huffington Post points out “Housing investment plunged 24 percent from the same quarter a year ago, while corporate capital investment sank 0.9 percent. Consumer spending, which accounts for about two-thirds of the economy, edged up just 0.4 percent.”
Towards the end of October 2014, the Bank of Japan decided to print $800 billion more because the inflation wasn’t rising as the central bank expected it to. Now with the economy contracting again, there will be calls for more money printing and economic stimulus. In fact, after GDP contraction number came out, Etsuro Honda, an architect of Abenomics, told the Wall Street Journal that it was “absolutely necessary to take countermeasures.”
While the “easy money” policy run by the Japanese government and the central bank hasn’t managed to create much inflation, it has led to the depreciation of the yen against the dollar and other currencies.
In early November 2012, before Shinzo Abe took over as the prime minister of Japan, one dollar was worth 79.4 yen. Since then, the yen has constantly fallen against the dollar and as I write this on the evening of November 18, it is worth around 117 to a dollar.
Interestingly, some inflation that has been created is primarily because of yen losing value against the dollar. This has made imports expensive. The consumer price inflation(excluding fresh foods) for the month of September 2014 came in at 3%. Once adjusted for the sales tax increase in April, this number fell to a six month low of 1%, still much below the Bank of Japan’s targeted 2% inflation.
Analysts believe that the yen will keep losing value against the dollar in the time to come. John Mauldin wrote in a recent column titled The Last Argument of Central Bankers “The yen is already down 40% in buying power against a number of currencies, and another 40-50% reduction in buying power in the coming years is likely, in my opinion.”
Albert Edwards of Societe Generale is a little more direct than Mauldin and wrote in a recent research report titled Forecast timidity prevents anyone forecasting ¥145/$ by end March – so I will “The yen is set to…[crash] through multi-decade resistance – around ¥120. It seems entirely plausible to me that once we break ¥120, we could see a very quick ¥25 move to ¥145 [by March 2015].”
Edwards further writes that he expects “the key ¥120/$ support level to be broken soon and the lows of June 2007 (¥124) and Feb 2002 (¥135) to be rapidly taken out.” The note was written before the information that the Japanese economy had contracted during July-September 2014, came in.
This makes the Japanese yen a perfect currency for a “carry trade”. It can be borrowed at a very low rate of interest and is depreciating against the dollar. Before we go any further, it is important that we go back to the Japan of early 1990s.
The Bank of Japan had managed to burst bubbles in the Japanese stock and real estate market, by raising interest rates. This brought the economic growth to a standstill.
After bursting the bubbles by raising interest rates, the Bank of Japan had to start cutting interest rates and soon the rates were close to 0 percent. This meant that anyone looking to save money by investing in fixed-income investments (i.e., bonds or bank deposits) in Japan would have made next to nothing.
This led to the Japanese looking for returns outside Japan. Some housewife traders started staying up at night to trade in the European and the North American financial markets. They borrowed money in yen at very low interest rates, converted it into foreign currencies and invested in bonds and other fixed-income instruments giving higher rates of returns than what was available in Japan.
Over a period of time, these housewives came to be known as Mrs Watanabes and, at their peak, accounted for around 30 percent of the foreign exchange market in Tokyo, writes Satyajit Das in Extreme Money.
The trading strategy of the Mrs Watanabes came to be known as the yen-carry trade and was soon being adopted by some of the biggest financial institutions in the world. A lot of the money that came into the United States during the dot-com bubble came through the yen-carry trade.
It was called the carry trade because investors made the carry, that is, the difference between the returns they made on their investment (in bonds, or even in stocks, for that matter) and the interest they paid on their borrowings in yen.
The strategy worked as long as the yen did not appreciate against other currencies, primarily the US dollar. Let’s try and understand this in some detail. In January 1995, one dollar was worth around 100 yen. At this point of time one Mrs Watanabe decided to invest one million yen in a dollar-denominated asset paying a fixed interest rate of 5 percent per year.
She borrowed this money in yen at the rate of 1 percent per year. The first thing she needed to do was to convert her yen into dollars. At $1 = 100 yen, she got $10,000 for her million yen, assuming for the ease of calculating that there was no costs of conversion.
This was invested at an interest rate of 5%. At the end of one year, in January 1996, $10,000 had grown to $10,500. Mrs Watanabe decided to convert this money back into yen. At that point, one dollar was worth 106 yen.
She got around 1.11 million yen ($10,500 × 106) or a return of 11 percent. She also needed to pay the interest of 1 percent on the borrowed money. Hence, her overall return was 10 percent. Her 5 percent return in dollar terms had been converted into a 10 percent return in yen terms because the yen had lost value against the dollar.
But let’s say that instead of depreciating against the dollar, as the yen actually did, it instead appreciated. Let’s further assume that in January 1996 one dollar was worth 95.5 yen. At this rate, the $10,500 that Mrs Watanabe got at the end of the year would have been worth 1 million yen ($10,500 × 95.5) when converted back into yen.
Hence, Mrs Watanabe would have ended up with the same amount that she had started with. This would have meant an overall loss, given that she had to pay an interest of 1 percent on the money she had borrowed in yen.
The point is that the return on the carry trade starts to go down when the currency in which the money has been borrowed, starts to appreciate. Since its beginnings in the mid-1990s, the yen carry trade worked in most years up to mid-2007. In June 2007, one dollar was worth 122.6 yen on an average. After this, the value of the yen against the dollar started to go up over the next few years.
With the yen expected to depreciate further against the dollar, it will lead to big institutional investors increasing their yen carry trades in the days to come. This will mean money will be borrowed in yen, and invested in financial markets all over the world.
Some of this money will find its way into the stock and the bond market in India. Moral of the story: The easy money rally is set to continue. The only question is till when?
Stay tuned!

The article originally appeared on www.equitymaster.com on Nov 19, 2014

Is the stock market rally for real or will the bubble burst soon?

bubble

The BSE Sensex closed at 28,177 points on November 17, up by around half a percent from its last close. Its been good going for the Sensex, having rallied by 33.3% since the beginning of this year. This probably led to a reader asking me on Twitter whether the stock market rally was for real or would the bubble burst soon?
These are essentially two questions here. First, whether the current rally is a bubble? Second, how long will it last? These are not easy questions to answer. Also, instead of trying to figure out whether the current rally is a bubble or not, I will stick to answering the second question, that is, how long will the current rally last.
As I have written on a few occasions in the past, the current rally is being driven by foreign institutional investors (FIIs). The domestic institutional investors(DIIs) have had very little role to play in it. The FIIs have made a net investment of a little over Rs 68,000 crore since the beginning of the year. During the same period the DIIs have made net sales of Rs 32,468 crore.
This data makes it very clear who has been driving the market up. Given this, instead of trying to figure out whether the current market is a bubble or not, it makes more sense to figure out whether the FIIs will keep bringing in fresh money into the Indian stock market.
The foreign investors have been borrowing money at very low interest rates and investing it in financial markets all around the world. They have been able to do that because Western central banks have been printing money to maintain low interest rates.
The Federal Reserve of the United States (the American central bank) recently decided to stop printing money and almost at the same time, the Bank of Japan decided to increase it. The Japanese central bank will now print around 80 trillion yen per year. The central bank had been printing around 60-70 trillion yen since April 2013, when it got into the money printing party, big time.
Like other central banks it pumped this money into the financial system by buying bonds. Interestingly, the size of the balance sheet of the Bank of Japan stood at around 164.8 trillion yen in March 2013. Since then, it has increased dramatically and as of October 2014 stood at 286.8 trillion yen.
The Bank of Japan hopes that by printing money it will manage to create some inflation. Once people see the price of goods and services going up, they will go out and shop, in the hope of getting a better deal. Also, with all the money printed and pumped into the financial system, interest rates will continue to remain low. And at low interest rates people were more likely to borrow and spend. Once people start to shop, it will lead to economic growth. Japan has had very little economic growth over the last two decades.
The trouble is that the Japanese aren’t falling for this oft tried central bank formula. And there is a clear reason for it. James Rickards in his book The Death of Money explains the point using what Eisuke Sakakibara, a former deputy finance minister of Japan, said in a speech on May 31, 2013, in South Korea.
As Rickards writes “Sakakibara…pointed out that Japanese people are wealthy and have prospered personally despite decades of low nominal growth. He made the often-overlooked point that because of Japan’s declining population, real GDP per capita will grow faster than aggregate GDP. …Combined with the accumulated wealth of the Japanese people, this condition can result in well-to-do-society even in the face of nominal growth that would cause central bankers to flood the economy with money.”
The question to ask here is will the Japanese continue to print money? The answer is yes. The Japanese politicians are desperate to create some inflation and the central bank has decided to get into bed with them. Also, more than that the Japanese government spends much more than it earns and needs to be bailed out by the Bank of Japan.
As analyst John Mauldin wrote in a recent column titled The Last Argument of Central Banks “According to my friend Nouriel Roubini, in 2013 Japan’s total tax revenue fell to a 24-year low. Corporate tax receipts fell to a 50-year low. Japan now spends more than 200 yen for every 100 yen of tax revenue it receives. It is likely Japan will run an 8% fiscal deficit to GDP this year, but the Bank of Japan is currently monetizing at a rate of over 15% of GDP, thereby theoretically reducing the level of debt owed by government institutions other than the central bank.”
Fiscal deficit is the difference between what a government earns and what it spends.
What Mauldin basically means is that a part of the debt raised by the Japanese government is being repaid through the Bank of Japan printing money and lending it to the government. With all this money continuing to float around in the financial system, interest rates in Japan will continue to remain low.
This will allow large financial institutions to borrow money at low interest rates in Japan and invest it in financial markets all over the world, including India.
The European Central Bank (ECB) also seems to be in the mood to start quantitative easing (QE, i.e. printing money to buy bonds). As Mohamed A. El-Erian, Chief Economic Adviser at Allianz wrote in a recent column “In fact, ECB President Mario Draghi signaled a willingness to expand his institution’s balance sheet by a massive €1 trillion ($1.25 trillion).”
While the United States might have decided to stop printing money, Japan and the Euro Zone, want to take a shot at it. Interestingly, chances are that the United States might go back to money printing in the years to come. As Niels C. Jensen writes in The Absolute Return Letter for November 2014 “If my growth expectations are about correct, QE is far from over – at least not in some parts of the world, and it is even possible that the Fed[the Federal Reserve of the United States] will come creeping back after having distanced itself from QE recently.”
The Federal Reserve of the United States has been financing the American fiscal deficit by printing money and buying treasury bonds issued by the government. In mid September 2008, around the time the financial crisis started, the Fed held treasury bonds worth $479.8 billion dollars. Since then, the number has shot up dramatically and as on October 29, 2014, it stood at $2.46 trillion dollars.
The fiscal deficit of the United States government shot up in the aftermath of the financial crisis. It was financed by more than a little help from the Federal Reserve. Nevertheless, the fiscal deficit has now been brought down. As Mauldin points out “The 2014 government deficit will be only 2.8% of GDP (it last saw that level in April 2005), the first time in a long time it has been below nominal GDP.”
The bad news is that the fiscal deficit will start rising again in 2016. “It is projected to fall again next year before rising in 2016. For the United States, this represents a reprieve, allowing us some time to deal with potential future problems before government spending rises to a proportion of income that is impossible to manage without severe economic repercussions. Government spending on mandated social programs will rise more than 50%, from $2.1 trillion this year to $3.6 trillion in 2024, potentially blowing the deficit out of control,” writes Mauldin.
The Federal Reserve might have to start printing money again in order to finance the government fiscal deficit.
Moral of the story: There are enough reasons for the Western nations to continue printing money and ensuring low interest rates. This means, FIIs can continue to borrow money at low interest rates and invest it in financial markets all over the world, including India.
The easy money party hasn’t ended. The only condition here is that the current government should not create a negative environment like the previous one did.
To conclude, the difficult thing to predict is, until when will this easy money party continue. I don’t have any clue about it. Do you, dear reader?

The article originally appeared on www.equitymaster.com on Nov 18, 2014

Raghuram Rajan won’t cut interest rates even in Hindi

ARTS RAJANAt a recent function, Raghuram Rajan, the governor of the Reserve Bank of India (RBI), spoke in Hindi. The joke going around in the social media after that was that even in Hindi, Dr Rajan refused to cut the repo rate. Repo rate is the interest rate at which the RBI lends to banks. Nevertheless, four pieces of data that came out last week, will increase the pressure on Rajan to cut the repo rate. These four pieces of data are as follows:

  1. Inflation as measured by the consumer price index fell to 5.52% in October 2014. It was at 6.46 % in September 2014 and 10.17% in October 2013. 

  2. Inflation as measured by wholesale price index fell to 1.77%. It was at 2.38 % in September 2014 and 7.24% in October 2013. 

  3. The index of industrial production, which is a measure of the industrial activity within the country, grew by 2.5% in September 2014, in comparison to September 2013. The IIP for August 2014 was only 0.4% higher in comparison to August 2013. Interestingly, some economists believe that this marginal recovery in the IIP will not hold for October 2014. The reason for this lies in the fact that indicators of industrial activity like car sales, bank loan growth etc., have slowed down in October 2014. 

  4. The bank loan growth for a period of one year ending October 31, 2014, stood at 11.2%. This had stood at 16.4%, for the period of one year ending November 1, 2013. The loan growth year to date stands at 4.6%. It was at 7.6% last year.

These four data points have got the Delhi based economic experts and industry lobbyists brushing up their economic theory again. “It is time that the RBI started to cut interest rates,” we are being told. Chandrajit Banerjee, the director general of the Confederation of Indian Industries, a business lobby said “This provides sufficient room to the RBI to review its prolonged pause in policy rates and move towards policy easing in its forthcoming monetary policy especially as investment and consumption demand are yet to show visible signs of a pick-up.” This was a sentiment echoed by A Didar Singh as well. Singh is the secretary general of Federation of Indian Chambers of Commerce and Industry (FICCI), which is another industry lobby. As he put it “The inflationary expectations are fairly tamed and we see no immediate upside risks with regard to prices. Given that, it is important to reiterate that demand remains subdued. The consumer durables segment reported negative growth for the fourth consecutive month in September. It is imperative that all levers are used to pep up demand.” The idea here is simple. If the RBI cuts the repo rate, banks will cut the interest rates they charge on their loans as well. If that were to happen, people would borrow and spend more, and businesses would borrow and invest more. And this will lead to faster economic growth. Economics 101. QED. Banerjee and Singh are not the only ones asking for an interest rate cut. Sometime back industrialist Anand Mahindra had said that “It might be time for the RBI to think of a rate cut…The need of the hour has changed and its time to start to look to support growth.” Sunil Mittal, chief of Bharti Airtel, also suggested the same when he told CNBC TV 18 that the finance minister Arun Jaitley “had spoken for the nation,” when had asked for an interest rate cut. In an interview to The Times of India in late October Jaitley had said “Currently, interest rates are a disincentive. Now that inflation seems to be stabilizing somewhat, the time seems to have come to moderate the interest rates.” While all this sounds good in theory, things are not as simple as the businessmen and the politicians are making it out to be. It is worth recounting here what Rajan had said in a speech in February 2014: “But what about industrialists who tell us to cut rates? I have yet to meet an industrialist who does not want lower rates, whatever the level of rates.” And what about the politicians? Alan Greenspan, the former chairman of the Federal Reserve of the United States, recounts in his book The Map and the Territory that in his more than 18 years as the Chairman of the Federal Reserve, he did not receive a single request from the US Congress urging the Fed to tighten money supply and thus not run an easy money policy. In simple English, what Greenspan means is that the American politicians always wanted lower interest rates. The Indians ones aren’t much different on that front. Nonetheless, the question is will lower interest rates help in reviving consumption and investment? Let’s tackle the issues one by one. Let’s say an individual wants to buy a car. He borrows Rs 4 lakh to be repaid over a period of five years at a rate of interest of 10.5%. The EMI on this works out to Rs 8,598. Let’s say the RBI cuts the interest rate and as a result the interest rate on the car loan falls to 10%. The EMI now works out to Rs 8,499 or around Rs 100 lower. Now will an individual go out and buy a car because the EMI is Rs 100 lower? Even if interest rates fall by 200 basis points (one basis point is one hundredth of a percentage) to 8.5%, the EMI will come down by only around Rs 400. For two wheeler and consumer durables loans, the differences are even smaller. Hence, suggesting that lower interest rates lead to higher consumption isn’t really correct. The real estate experts think that cutting interest rates will help revive the sector. The basic problem with the real estate sector is that prices have gone totally out of whack and a cut in interest rates is not going to have any significant impact. What about corporate investment? As Rajan had asked in his speech “Will a lower policy interest rate today give him more incentive to invest? We at the RBI think not…We don’t believe the primary factor holding back investment today is high interest rates.” So what is holding back investment? The answers are provided in a recent report titled “Will a rate cut spur investments?Not really“, brought out by Crisil Research. As the report points out “Investment growth, particularly private corporate investment, plummeted in the fiscals 2013 and 2014, despite low real interest rates. During this time, the policy rate in real terms – repo rate minus retail inflation – has been negative, and real lending rates averaged 2.4%. This is significantly lower than the 7.4% seen in the pre-crisis years (2004-2008). Yet investment growth dropped to 0.3%, down from an average 16.2% seen in the pre-crisis years.” The accompanying chart makes for an interesting read. 

After 6 years, real repro rate (adjusted for CPI inflation) turns positive

Source: RBI, Central Statistical Office, CRISIL Research Note: Nominal repo rate at the fiscal year-end minus average CPI inflaction , F= Forecast

As Crisil Research points out “During fiscals 2013 and 2014, when investment growth slumped to 0.3% per year, the real repo rate was still minus 2.1%, while the real lending rate was only +2.8%. Only in June 2014, for the first time in six years, did the real repo rate turned mildly positive.” So companies were borrowing and investing at higher “real” interest rates earlier but they are not doing that now. Why is that the case? This is primarily because the expected rate of return on investments has fallen “because of high policy uncertainty, slowing domestic and external demand, and rising input costs driven by persistently elevated inflation.” “The rate of return on investments – as proxied by return on assets (RoA) of around 10,000 non-financial companies as per CMIE Prowess database – have fallen sharply to 2.8% in fiscal 2013 and 2014 from 5.9% in the pre-crisis years,” Crisil Research points out. Moral of the story: Corporates invest when it is profitable to invest, and not simply because interest rates are low. Indeed, the other factors that are likely to revive investment are in the hands of the government and not RBI. Hence, a cut in interest rates is neither going to revive consumer demand nor corporate investments. Having said that, high food inflation has been a big factor behind high inflation. And the RBI really cannot control that. Also, food inflation has come down considerably in the recent past. So why not just cut interest rates? Rajan explained it very well in his February speech where he said “They say the real problem is food inflation, how do you expect to bring it down through the policy rate? The simple answer to such critics is that core CPI inflation, which excludes food and energy, has also been very high, reflecting the high inflation in services. Bringing that down is centrally within the RBI’s ambit.” Further, food prices might start rising again. The government has forecast that the output of kharif crops will be much lower than last year and this might start pushing food prices upwards all over again. Also, recent data showsthat vegetable and cereal prices have started rising again because of the delayed monsoon. To conclude, despite falling inflation, the inflationary expectations (or the expectations that consumers have of what future inflation is likely to be) are on the higher side. As per the Reserve Bank of India’s Inflation Expectations Survey of Households: September – 2014, the inflationary expectations over the next three months and one year are at 14.6 percent and 16 percent. In March 2014, the numbers were at 12.9 percent and 15.3 percent. Hence, inflationary expectations have risen since the beginning of this financial year. And for inflationary expectations to come down, low inflation needs to stay for a considerable period of time. As Rajan said “A more important source of our influence today, therefore, is expectations. If people believe we are serious about inflation, and their expectations of inflation start coming down, inflation will also come down…Sooner or later, the public always understands what the central bank is doing, whether for the good or for the bad. And if the public starts expecting that inflation will stay low, the central bank can cut interest rates significantly, thus encouraging demand and growth.” If inflationary expectations are controlled only then will consumer demand revive and that in turn, will lead to revival of corporate investments as well. Given this, it would be surprising to see Rajan start cutting the repo rate any time soon. The article originally appeared on www.equitymaster.com on Nov 17, 2014

Vivek is a writer who has worked at senior positions with the Daily News and Analysis (DNA) and The Economic Times, in the past. He has just finished writing a trilogy on the history of money and the financial crisis. The series is titled Easy Money. His writing has also appeared in The Times of India, Business Standard, Business Today, The Hindu and The Hindu Business Line.