Vivek Kaul’s Diary

How Low Interest Rates Have Hurt Economic Recovery

satyajit das
In the aftermath of the financial crisis that broke out in September 2008, after the investment bank Lehman Brothers went bust, central banks all across the Western world drove interest rates close to 0%.

This was referred to as the zero interest rate policy or ZIRP. The hope was that with ZIRP the interest rates on loans offered by banks would remain very low and in that environment people would borrow and spend more.

They would buy more cars…More homes…More TVs..

And this would ensure an economic recovery. QED.

But things did not turn out to be as simple as that. As Satyajit Das writes in his new book The Age of Stagnation—Why Perpetual Growth is Unattainable and the Global Economy is in Peril: “Low rates also discourage savings. But sometimes, in a complex cycle of cause and effect, they may perversely reduce consumption as lower returns force people to save more for future needs.”

And in fact low interest rates may also lead to lower consumption. How is that possible? As Das writes: “Citigroup equity strategist Robert Buckland has argued that low rates and QE reduce employment and economic activity, rather than increasing them. These policies encourage a shift from bonds into equities.”

Interestingly, those who have retired from work have had to shift their money into stocks because of low interest rates. As Das writes: “In October 2014 an American retiree with US$1 million invested in secure, two-year US government bonds would have earned US$3900 in annual interest, 92 percent less than the US$48,000 they would have received in 2007. The retired and savers in advanced economies were forced to purchase riskier securities or invest in dividend-paying stocks to earn a return.”

And these investors were looking for income from the investments they had made in stocks. As Das writes: “As investors are looking for income rather than capital growth, they force companies to increase dividends and undertake share buybacks. To meet these pressures, companies must boost cash flow and earnings, by shedding workers and reducing investments to cut costs. The process increases share prices and returns for shareholders of the company, but is bad for the overall economy.”

What does this mean? With interest rates on bank deposits and other fixed income investments at very low levels, people have moved their money to equity. These investors force companies to increase dividends and at the same time buyback its own shares. When a company buys back its own shares a lesser number of shares remain in the open market, pushing up the earnings per share. With fewer shares going around, it also increases the chances of a higher dividend per share.

Interestingly, with interest rates at such low levels, companies have been borrowing money to buy back their own shares. As Albert Edwards of Societe Generale wrote in a research note in November: “The primary driver for the rapid rise in bank lending…has been borrowing by US corporates and we all know they have been using the Fed’s free money not to invest in capacity expanding expenditures, but rather to buy back mountains of their own shares…Corporate debt borrowing at an $674bn annual rate [is] closing in rapidly on the all-time borrowing splurge of 2007!”

Also, in the pressure to boost earnings companies have had to fire people and at the same time reduce investments to cut costs. This has led to hire share prices but it has also led to a situation where employees have been fired from their existing jobs and new jobs haven’t been created. Any person who has been fired or is likely to be fired is unlikely to go out shopping, as the basic idea behind lower interest rates is.

This has an impact on consumption and economic growth. Hence, in a very perverse sort of way, low interest rates may have had a negative impact on consumption. And this has meant economic growth has not recovered as fast as it was expected to.

Also, the ZIRP has pushed up stock markets all over the developed world and in the process helped the rich become richer. As L Randall Wray writes in Why Minsky Matters—An introduction to the Work of a Maverick Economist: “According to a study by Pavlina Tcherneva, 95 percent of the benefits of the recovery from the global financial crisis have gone to the top 1 percent of the income distribution. Another study finds that the top one-thousandth (top 0.1 percent) of the U.S. population now owns fifth of all the wealth.”

The trouble is that the rich do not increase their consumption if they get richer. As Das writes: “Higher income households have a lower marginal propensity to consume, spending a lower portion of each incremental dollar of income than those with lower incomes. US households earning US $35,000 consume an amount from each additional dollar of income that is around three times that of a household with an income of US$200,000. Given that consumption constitutes around 60-70 percent of economic activity, concentration of income at the higher end limits growth in demand.”

And this explains why low interest rates through large parts of the Western world haven’t had the kind of impact that they were expected to. What this tells us is that there are no universal solutions to problems even though economists and politicians often sound very confident while offering them.

And this is something dear readers that you need to keep in mind the next time you hear a politician or an economist, talk about the economy, with great confidence. Economics is not an exact science.

Disclosure: Satyajit Das wrote the foreword to my book Easy Money: Evolution of Money from Robinson Crusoe to the First World War

The column appeared on the Vivek Kaul Diary on January 18, 2016

Dear Mr Modi who will sort out the mess at Food Corporation of India?

narendra_modi
Data released by the Petroleum Planning and Analysis Cell(PPAC) suggests that on January 13, 2016, the price of Indian basket of crude oil touched $27.32 per barrel. I expect the government to increase the excise duty on petrol and diesel soon, to capture the benefit of this ‘further’ fall in the price of oil.

If and when this happens this will be the eight such rise since November 2014. While the government has been quick to increase excise duty on petrol and diesel in order to shore up its finances, the same enthusiasm has been missing when it comes to controlling wasteful expenditure.

Let’s take the case of the Food Corporation of India(FCI). Last week the Supreme Court was hearing a case concerning the loaders at FCI and the exorbitant salaries they draw. As the judges reacted: “The report shows that in August 2014, 370 labourers received more than Rs 4 lakh in salary. Around 400 others got between Rs 2 lakh and 2.5 lakh in the same month…How is that possible?”

The judges were essentially referring to the Report of the High Level Committee on Reinventing the Role and Restructuring of Food Corporation of India (better known as the Shanta Kumar committee report). This report was released in January 2015.

In fact, as the Shanta Kumar committee report points out: “Some of the departmental labours (more than 300) have received wages (including arrears) even more than Rs 4 lakhs/per month in August 2014. This happens because of the incentive system in notified depots.”

Interestingly, even those who did not get paid Rs 4 lakh in August 2014, get paid quite a lot. The average salary of an FCI worker was Rs 79,588 per month between April and November 2014, which is seven to eight times higher than what a contract labourer gets paid. As can be seen from the following table the average salary of a worker has more than doubled between 2009 and 2014.

Financial yearAverage Salary
2009-1038459
2010-1153389
2011-1263763
2012-1371358
2013-1478549
April to Nov 201479588
Source: Shanta Kumar Committee Report

As the Shanta Kumar committee report points out: “FCI engages large number of workers (loaders) to get the job of loading/unloading done smoothly and in time. Currently there are roughly 16,000 departmental workers, about 26,000 workers that operate under Direct Payment System (DPS), some under no work no pay, and about one lakh contract workers. A departmental worker (loader) costs FCI about Rs 79,500/per month (Apri-Nov 2014 data) vis-a-vis DPS worker at Rs 26,000/permonth and contract labour costs about Rs 10,000/per month.”

There are a few points that need to be made here. First, is the fact that workers are paid different wages depending on how they are categorised, even though the do the same work. Hence, an FCI worker gets paid eight times that a contract worker gets paid. This is not fair.

The second point is why pay workers close to Rs 80,000 per month for loading and unloading stuff, when the same job can be carried out at the cost of Rs 10,000 or Rs 26,000 per month? This is a clear waste of money. The Supreme Court judges put the loss at Rs 1800 crore. This doesn’t sound much on its own, given the big numbers we are used to when we talk about the government.

But compare this with the plan outlay of the ministry of environment for 2015-2016, which is at Rs 1,446.60 crore. As the budget document points out: “The Plan outlay of Ministry of Environment, Forests & Climate Change is Rs 1,446.60 crore. An Amount of Rs 758.16 crore is allocated for Ecology and Environment which, inter alia, includes Rs 63.14 crore Conservation of Natural Resources and Ecosystems, and Rs 213.05 crore for Research and Development, Rs 100 crore for National Coastal Management Programme and Rs 76.10 crore for Environmental Monitoring and Governance.  Rs 150 crore has been provisioned for National Adaptation Fund for Climate Change.”
The point being there are better ways of spending money than paying an FCI worker Rs 79,500 per month.

Also, it is not surprising that those making Rs79,500 per month or more, get cheaper contract labour to do their work. If I was earning Rs 4 lakh per month and was in a position to outsource my work to someone at the cost of Rs 10,000 per month, I would do the same thing.

As the Shanta Kumar committee report points out: “Some of the departmental labours (more than 300) have received wages (including arrears) even more than Rs 4 lakhs/per month in August 2014. This happens because of the incentive system in notified depots, and widely used proxy labour. This is a major aberration and must be fixed, either by de-notifying these depots, or handing them over to states or private sector on service contracts, and by fixing a maximum limit on the incentives per person that will not allow him to work for more than say 1.25 times the work agreed with him. These depots should be put on priority for mechanization so that reliance on departmental labour reduces.”

The Supreme Court judges have given the government a time of 10 days to respond on how this daylight robbery of the country can stop. “Labourers in FCI have an aggressive past. Officers have been murdered. There is a clique that is operating there and FCI has become a hen that lays golden eggs for them. The FCI is literally held to ransom by the labourers and their unions and there is something seriously wrong with it,” the Supreme Court judges said.

The prime minister Narendra Modi before he became the prime minister talked a lot about “minimum government maximum governance”. This is one area where the slogan can be put into practice. The loot of the nation by a few thousand workers of the FCI needs to stop. The money thus saved needs to be put to better use.

The question is will this stop? The trouble is that after being elected Modi has continued with the maximum government handed down to him. Any elected official (or for that matter even any individual) has limited time and mind-space to tackle things. This is even more true for this government, where the lack of ministerial talent is glaringly obvious and the government is run more and more by the prime minister’s office.

The prime minister’s office is busy with many things, propping up loss making units like Air India and MTNL, being among them. In this environment does it have the time and the mind-space to tackle the mess that FCI is in?

The column originally appeared in the Vivek Kaul’s Diary on Equitymaster

George Soros Has Got a Backache Again and This Time It’s Because of China

george-soros-quantum-fund
George Soros has got some of the biggest macro calls right over the years. How does he do it? If you were to get around to reading all the books that Soros has written over the years, you will come to realise that he follows something known as the theory of reflexivity to get in and out of financial markets.

Nevertheless, his son Robert, offers another explanation for his success in Michael Kaufman’s Soros: The Life and Times of a Messianic Billionaire. As Robert puts it “My father will sit down and give you theories to explain why he does this or that. But I remember seeing it as a kid and thinking, Jesus Christ, at least half of this is bullshit, I mean, you know the reason he changes his position in the market or whatever is because his back starts killing him. It has nothing to do with reason. He literally goes into a spasm, and it’s his early warning sign.”

Soros himself has had his doubts about how he makes money. As he writes in The New Paradigm for Financial Markets – The Credit Crisis of 2008 and What It Means: “To what extent my financial success was due to my philosophy is a moot question because the salient feature of my theory is that it does not yield any firm predictions. Running a hedge fund involves the constant exercise of judgement in a risky environment, and that can be very stressful. I used to suffer from backaches and other psychosomatic ailments, and I received as many useful signals from my backaches as from my theory. Nevertheless, I attributed great importance to my philosophy and particularly my theory of reflexivity.”

And from the looks of it, seems like George Soros has had a few backaches of late. This time his worries are coming from China. Speaking at an economic forum in Sri Lanka, Soros recently said: “When I look at the financial markets there is a serious challenge which reminds me of the crisis we had in 2008…Unfortunately China has a major adjustment problem and it has a lot of choices and it can actually transfer to the rest of the world its own problems by devaluing its currency and that is what China is doing.”

Over the years, the Chinese yuan has been largely pegged against the American dollar. The People’s Bank of China, the Chinese central bank, has ensured that the value of the yuan has fluctuated in a fixed range around the dollar. This has been primarily done in order to take away the currency risk that the Chinese exporters may have otherwise faced.

In a world where so many things have changed in the aftermath of the financial crisis which started in September 2008, the value of the Chinese yuan against the dollar has been one of the few constants.

Over the last few months, the value of the Chinese yuan against the dollar has gradually been allowed to fall. In August 2015, the People’s Bank of China pushed the value of the dollar against the yuan, from 6.2 to around 6.37. In November 2015, one dollar was worth around 6.31 yuan. By the end of the year, one dollar was worth 6.48 yuan, with the yuan gradually depreciating against the dollar.

In the new year, the yuan has depreciated further against the dollar and one dollar is now worth around 6.58 yuan. So what is happening here? It is first important to understand how the People’s Bank of China has over the years maintained the value of the yuan against the dollar.

When Chinese exporters bring back dollars to China or when investors want to bring dollars into China, the Chinese central bank buys these dollars. They buy these dollars by selling yuan. This ensures that at any given point of time there is no scarcity of yuan and there are enough yuan in the market, in order to ensure that the value of the yuan is largely fixed against the dollar.

Where does the People’s Bank get the yuan from? It can simply create them out of thin air, by printing them or creating them digitally.

The situation has reversed in the recent past. Money is now leaving China. Hence, the total amount of dollars leaving China is now higher than the dollars entering it. And this has created a problem for the Chinese central bank. Between July and September 2015, the net capital outflows reached $221 billion. “[This] occurred for the sixth straight quarter and reached a new record of $221 billion,” wrote Jason Daw and Wei Yao of Societe Generale in a recent research note.

The fact that more dollars are now leaving China than entering it, changes the entire situation. When investors and others, decide to take their money out of China, what do they do? They sell their yuan and buy dollars. This pushes up the demand for dollars. In a normal foreign exchange market this would mean that the dollar would appreciate against the yuan, and the yuan would depreciate against the dollar.

But remember that the Chinese foreign exchange market is rigged. The People’s Bank of China likes to maintain a steady value of the yuan against the dollar. What does the Chinese central bank do when more dollars are leaving China? In order to ensure that there is no scarcity of dollars in the market, it buys yuan and sells dollars. This is exactly the opposite what it has been doing all these years, when more dollars where entering China than leaving it.

The trouble is that China cannot create dollars out of thin air, only the Federal Reserve of the United States can do that. China does not have an endless supply of dollars. The foreign exchange reserves of China as of December 2015 stood at $3.33 trillion. In December 2015, the foreign exchange reserves fell by $107.9 billion. They had fallen by $87.2 billion in November. In fact, between December 2014 and December 2015, the Chinese foreign exchange reserves have fallen by a huge $557 billion, in the process of defending the value of the yuan against the dollar.

While, China has the largest foreign exchange reserves in the world, it is worth asking what portion of these reserves are liquid? The Chinese central bank has invested these reserves in financial securities all over the world. As of October 2015, $1.25 trillion was invested in US government treasuries.

The question is how quickly can these investments be sold in order to defend the value of the yuan against the dollar? As economist Ajay Shah wrote in a recent column in the Business Standard: “For a few months, reserves have declined by a bit less than $100 billion a month. We may think that, with $3 trillion of reserves, the authorities can handle this scale of outflow for 30 months. Things might be a bit worse. Questions are being raised about the liquidity of the reserves portfolio. There are only a few global asset classes where the Chinese government can easily dispose of $100 billion of assets per month. A lot of the reserves portfolio might not be in these liquid asset classes.”

Given this, China does not have an endless supply of dollars and cannot constantly keep defending the yuan against the dollar. This explains why it has gone slow in defending the yuan against the dollar, in the recent past, and allowed its currency to depreciate against the dollar.

The question is why is all this worrying the world at large, Soros included? A weaker Chinese yuan will make Chinese exports more competitive. This will mean a headache for other export oriented economies like Japan, Taiwan, South Korea, Germany, and so on. They will also have to push the value of their currencies down against the dollar. Hence, the global currency war which has been on a for a while, will continue. Further, a weaker yuan might lead to China exporting further deflation (lower prices) all over the world.

But what is more worrying is the fact that residents and non-residents are primarily the ones withdrawing their money out of China. The non-residents withdrew $82 billion during the period July to September 2015. The residents withdrew $67 billion, after having withdrawn $102 billion between March and June 2015.

When any economy is in trouble it is the locals who start to withdraw money first. This is clearly happening in China. And that has got the world worried. Also, China is a major consumer of commodities and any economic slowdown in China, will lead to a fall in commodity demand. This isn’t good news for many commodity exporting countries in particular and global economic growth in general.

The column originally appeared on the Vivek Kaul’s Diary on January 13, 2016

Of Jaitley, Fiscal Deficit and a 19th Century French Economist

Fostering Public Leadership - World Economic Forum - India Economic Summit 2010
Lawyers who become politicians are extremely eloquent speakers. But do they ‘really’ mean what they say? Or is it just something that sounds good at a given point of time, like a film dialogue?

The finance minister Arun Jaitley in his maiden budget speech in July 2014 had said: “We need to introduce fiscal prudence that will lead to fiscal consolidation and discipline. Fiscal prudence to me is of paramount importance because of considerations of inter-generational equity. We cannot leave behind a legacy of debt for our future generations. We cannot go on spending today which would be financed by taxation at a future date.”

Most governments spend more than what they earn. In order to bridge the gap, they borrow money by selling governments bonds. These bonds are repaid in the years to come. If the government borrows more today, the more it has to repay in the years to come.

This repayment is carried out of the money the government earns from taxing the future generations. This means that the benefits of borrowing are received by one generation but the debt is repaid by another. And this is why Jaitley talked about “considerations of inter-generational equity”. Or so it seemed.

The only way of respecting inter-generational equity is to borrow less today, so that the future generations don’t have to repay it, in the days to come. Borrowing less is only possible if the government is spending less today.

In his July 2014 budget speech Jaitley had talked about precisely this. He had said: “Difficult, as it may appear, I have decided to accept this target as a challenge. One fails only when one stops trying. My Road map for fiscal consolidation is a fiscal deficit of 3.6 per cent [of the gross domestic product (GDP)] for 2015-16 and 3 per cent for 2016-17.”

Fiscal deficit is the difference between what a government earns and what it spends. This difference is made up through borrowing money by selling government bonds. Hence, a lower fiscal deficit means lower borrowing and in the process the “considerations of inter-generational” equity is take into account.

In the budget speech Jaitley made in February 2015, the considerations of inter-generational equity took a slight backseat. He postponed the achievement of the fiscal deficit target of 3% of the GDP for 2016-2017, by a year.

As he said on that occasion: “Rushing into, or insisting on, a pre-set time-table for fiscal consolidation pro-cyclically would, in my opinion, not be pro-growth.  With the economy improving, the pressure for accelerated fiscal consolidation too has decreased.  In these circumstances, I will complete the journey to a fiscal deficit of 3% in 3 years, rather than the two years envisaged previously.  Thus, for the next three years, my targets are: 3.9%, for 2015-16; 3.5% for 2016-17; and, 3.0% for 2017-18.  The additional fiscal space will go towards funding infrastructure investment.”

What the government had set out to achieve in a period of two financial years, Jaitley said would now be achieved in three years. This was in February 2015, when the budget for the current financial year 2015-2016 was presented.

In the recent past, there have been news-reports as well as statements which suggest that the government will again postpone, the fiscal deficit targets it had set for itself. “I am not particularly worried about the fiscal deficit target,” Jaitley said in early December.

A Reuters news-report quotes a senior finance ministry official as saying that the “the minister[i.e. Jaitley] has been advised to increase its fiscal deficit target to 3.7 or 3.9 per cent of gross domestic product (GDP) from 3.5 per cent.” “The economy is still suffering from slack demand…It needs a conducive fiscal and monetary policy,” the official added.

The industrial as well as consumer demand are seeing slow-growth and hence the government should be spending more, and in the process incurring a higher expenditure and a higher fiscal deficit. The higher government expenditure will push up economic growth. This is what the senior finance ministry official meant.

This is something Jaitley has also said recently: “Public investment has been stepped up in the last year and it will continue to remain stepped up… When you fight a global slowdown, public investment has to lead the way.”

In a year when the government will have to incur significantly extra expenditure to implement the recommendations of the Seventh Pay Commission, implement one rank one pension for the armed forces and pay pending, fertilizer and food subsidies, where is the money for public investment going to come from?

It is worth recounting here what the French economist Frédéric Bastiat had said in his 1874 book That Which is Seen, and That Which is Not Seen. “In the department of economy, an act, a habit, an institution, a law, gives birth not only to an effect, but to a series of effects. Of these effects, the first only is immediate; it manifests itself simultaneously with its cause–it is seen. The others unfold in succession—they are not seen. It is well for us if they are foreseen.”

When we talk about the government abandoning the fiscal deficit target and spending more, this is precisely how things are playing out. The immediate effect or that which is seen is that higher government expenditure will create economic growth in an environment where industrial and consumer demand growth continues to remain slow. This is the effect that is being ‘seen’.

But there are other effects which are not being seen. The entire issue about inter-generational equity that Jaitley had talked about in his July 2014, seems to have taken a backseat.

Let’s go back a few years in order to understand this point. In 2008-2009, the government spent 51% of what it earned in paying interest on its existing debt and repaying the debt that was maturing. In the aftermath of the financial crisis that started in September 2008, the government increased its expenditure and its fiscal deficit. When the government talked about increased government spending it was only in the context of economic growth. This effect was seen.

Nevertheless, increased government spending meant more borrowing. In 2015-2016, the government will spend around 60% of what it earns in paying interest on existing debt and repaying the debt that matures. The higher borrowing of 2008-2009 and the years that followed is now having an impact. This was the effect which was unseen or wasn’t foreseen in 2008-2009, when the government decided to spend more. This is what Jaitley meant when he talked about considerations of inter-generational equity.

When one government borrows more it leaves a problem for another government in years to come. Also, as more money goes towards debt servicing it leaves little money for other things, unless more money is borrowed.

Further, the government doesn’t have any separate access to borrowings. As economist M Govinda Rao wrote in a recent column in The Financial Express: “This year, the Union government’s deficit is set at 3.9%, and with the states together having a deficit of about 2.2%, the aggregate fiscal deficit of the government works out to 6.1%. It is reported that 21 distribution companies are likely to join the UDAY scheme and the deficit on that account could be about 1%.” If we were to add all this the real fiscal deficit of the government would come at 7.1% of the GDP. The household financial savings in 2014-2015 stood at 7.5% of GDP.

This means that if the government borrows more it will automatically lead to higher interest rates for everyone else who wants to borrow. When the finance minister talks about public investment and not being bothered about a higher fiscal deficit, these points also need to be ‘seen’. Currently, they are not being seen.

As Bastiat put it: “Between a good and a bad economist this constitutes the whole difference—the one takes account of the visible effect; the other takes account both of the effects which are seen and also of those which it is necessary to foresee.”

Of course, politicians are in the business of winning elections not in the business of foreseeing or in the business of practicing good economics.

The column originally appeared on The Daily Reckoning on January 12, 2016