Jaitley again asks for interest rate cuts, needs lessons in basic economics

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

It is fashionable in Delhi circles these days to ask for an an interest rate cut at a drop of a hat. The finance minister Arun Jaitley like his predecessor P Chidambaram likes to remind the Reserve Bank of India (RBI) now and then that the time is just right for a rate cut.
In an interview to
The Times of India late last week Jaitley 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.”
Before Jaitley, the senior columnist Prem Shankar Jha became the newest
interest-rate-wallah on the block and in a column in The Times of India held the RBI responsible for India’s slow economic growth over the last few years. As he wrote“[The] Indian economy is not on the road to recovery. The reason is the sustained high interest rate regime of the past four years. Industry has been begging for cuts in the cost of borrowing since March 2011… On August 5, RBI governor Raghuram Rajan surprised the country by announcing that he would not lower interest rates, because at 8% consumer price inflation was still too high.”
I guess Jha must have been among the few people surprised by Rajan’s decision given that among those who follow the workings of the Indian central bank closely, almost no one had expected Rajan to cut interest rates.
The premise on which
interest-rate-wallahs work is that at lower interest rates people will borrow and spend more, which will lead to economic growth. But the entire premise that low interest rates will lead to a pick up in consumption and hence, higher economic growth, doesn’t really hold. (As I have explained here). Jaitley believes that “expansion in real estate will take place significantly only if the interest rates come down a little.”
This is what the real estate companies also like to believe. But the basic point is that people are not buying homes because home prices have risen way above what they can afford. As I have explained in the past,
for an average Mumbaikar it currently takes around 34 years annual income to buy a home to live in. This is true for other cities as well, though the situation maybe a little better than that in Mumbai. So even a major cut in interest rates is not going to lead people buying homes to live in unless real estate prices fall. This is something that Arun Jaitley as the finance minister of this country needs to understand.
Having said that, those looking to move their black money around will always look at investing in real estate and for them the interest rates really don’t matter.
The other big reason offered is that companies can borrow at lower rates of interest. The idea being that lower interest rates might encourage companies to borrow and expand. Again it needs to be realized that companies don’t always decide to expand just because money is available at low interest rates, especially in difficult times as these.
Factors like ease of doing business and consumer demand play an important role.
As I have explained in the past, due to many years of high inflation consumer demand in India continues to remain subdued. And unless it starts to pick up, there is no real reason for companies to expand.
Also, it is worth remembering here that a some of the major business groups in India have already borrowed a lot of money and are having tough time paying interest on the debt they already have. Hence, where is the question of borrowing more?
The bigger question that
interest-rate-wallahs tend to ignore is how much control does the RBI really have over interest rates that banks pay their depositors and in turn charge their borrowers? Over the last few weeks, banks have cut interest rates on their fixed deposits. The list includes State Bank of India, Punjab National Bank and Central Bank of India. (You can read about here, here and here). The Indus Ind Bank also cut the interest it pays on its savings account to 4.5% from the earlier 5.5% for a daily balance of up to Rs 1 lakh, starting September 1, 2014.
All these cuts in interest rates have happened despite the RBI maintaining the repo rate at 8%. Repo rate is the interest rate at which the RBI lends to banks. So what has changed that has allowed these banks to cut the interest rates at which they borrow?
Let’s look at some numbers. As on October 3, 2014, over a period of one year, the loans given by banks rose by 9.87%. During the same period the deposits raised by banks rose by 11.54%. How was the situation one year back? As on October 4, 2013, over a period of one year, the loans given by banks had risen by 15.18%. During the same period the deposits had grown by 12.9%.
Hence, the rate of loan growth for banks has fallen much faster than the rate at which their deposit growth has fallen. Given this, it is not surprising that banks are cutting fixed deposit rates, given that their rate of loan growth is falling at a much faster rate.
As Henry Hazlitt writes in
Economics in One Lesson “Just as the supply and demand for any other commodity are equalized by price, so the supply of demand for capital are equalized by interest rates. The interest rate is merely a special name for the price of loaned capital. It is a price like any other.”
As Hazlitt further points out “If money is kept…in…banks…the banks are eager to lend and invest it. They cannot afford to have idle funds.”
Hence, given that the rate of loan growth is much slower than the rate of deposit growth, it is not surprising that banks are cutting interest rates on their fixed deposits. Given this, the impact that RBI’s repo rate has on interest rates is at best limited. It is more of a broad indicator from the RBI on which way it thinks interest rates are headed.
Further, it also needs to be remembered that financial savings in India have fallen dramatically over the last few years. 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 rate of return on offer on fixed income investments(like fixed deposits, post office savings schemes and various government run provident funds) has been lower than the rate of inflation. This led to people moving their money into investments like gold and real estate, where they expected to earn more. Hence, the money coming into fixed deposits slowed down leading to a situation where banks could not cut interest rates., given that their loan growth continued to be strong.
What also did not help was the fact that the borrowing requirements of the government of India kept growing over the years.
The RBI was not responsible for any of this. The only way to bring down interest rates is by ensuring that inflation continues to remain low in the months and the years to come. If this happens, then money flowing into fixed deposits will improve and that, in turn, will help banks to first cut interest rates they offer on their deposits and then on their loans.
The government needs to play an important part in the efforts to bring down inflation. In fact, it has been working on that front. In a recent research report analysts Abhay Laijawala and Abhishek Saraf of Deutsche Bank Market Research write that the “the government is firmly ‘walking the talk’ on fiscal consolidation” through a spate of “recent administrative moves on curbing food inflation (such as fast liquidation of surplus foodstock, modest single-digit hike in MSPs, an effort to eliminate fruits and vegetables from ambit of APMC etc.)”
This is very important given that once inflation remains low for an extended period of time, only then will inflationary expectations (or the expectations that consumers have of what future inflation is likely to be) be reined in. And consumer demand is likely to pick up after this.
The Reserve Bank of India’s Inflation Expectations Survey of Households: September – 2014 which was a survey of 4,933 urban households across 16 cities, and which captures the inflation expectations for the next three-month and the next one-year period. The median inflation 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.
To conclude, RBI seems to have become everyone’s favourite punching bag even though its impact on setting interest rates is rather limited. It is time that
interest-rate-wallhas like Jaitley and Jha come to terms with this.

This an updated version of a column that appeared on Oct 22, 2014. You can read the original column here

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

Deregulating diesel prices: A good decision that will be tested when oil prices rise again

light-diesel-oil-250x250

Vivek Kaul

The government on Saturday announced the decision to deregulate diesel prices. “Henceforth—like petrol—the price of diesel will be linked to the market,” the finance minister Arun Jaitley said after a cabinet meeting. “Whatever the cost involved, that is what consumer will have to pay,” he added.
After this decision the price of diesel was reduced by around Rs 3.50 per litre (the cut would vary all around India given the different rates of taxes in different states). This was the first cut in the price of diesel since January 2009.
The proposal to allow oil marketing companies to decide the price of diesel was first made in 1997, when Inder Kumar Gujral was the prime minister. The price of petrol and diesel were finally deregulated in April 2002, under the regime of Atal Bihari Vajpayee.
But this decision was over turned in late 2004, around the time oil prices had touched $50 per barrel. In November 2004, Mani Shankar Aiyar, the then Petroleum Minister said “since January 1, 2004, government was dictating even petrol and diesel prices… We have been far more honest in saying the government will control prices of cooking and auto fuels.”
This led to the oil marketing companies having to sell oil products at a price at which they incurred under-recoveries. The government compensated a part of these under-recoveries. And due to this the government expenditure and in turn, the fiscal deficit went up. Fiscal deficit is the difference between what a government earns and what it spends.
In the last two financial years (i.e. 2012-2013 and 2013-2014) the total petroleum subsidy (subsidy for diesel, cooking gas and kerosene) amounted to Rs 1,82,359.9 crore. As an article in The Wall Street Journal points out “Around half of that was for diesel. Before diesel prices were freed, economists estimated that a $1 per barrel rise in the global price of oil would increase India’s subsidy bill by around $1 billion a year.”
As government expenditure in order to pay for the under-recoveries of the oil marketing companies went up over the years, so did its borrowing. When the government borrows more, it crowds out the other borrowers i.e. it leaves lesser on the table for the private borrowers to borrow. This, in turn, pushes up interest rates, as the other borrowers now need to compete harder.
The high interest rate scenario that has prevailed in India over the last five-six years has been because of this increased government borrowing. If diesel prices had continued to be deregulated this wouldn’t have happened.
Other than the high interest rates, there were several other things that happened. But before we get into that let’s see what the economist Henry Hazlitt writes in
Economics in One Lesson “We cannot hold the price of any commodity below its market level without in time bringing about two consequences. The first is to increase the demand for that commodity. Because the commodity is cheaper, people are tempted to buy, and can afford to buy, more of it…In addition to this production of that commodity is discouraged. Profit margins are reduced or wiped out. The marginal producers are driven out of business.”
The demand for diesel went up in the form of people buying more and more passenger cars that ran on diesel, given the substantial difference between the price of petrol and diesel. This led to the government of India indirectly subsidising car owners over the last few years. Hence, rich consumers ended up consuming more than their fair share of diesel.
As Hazlitt writes in this context: “Unless a subsidized commodity is completely rationed, it is those with the most purchasing power than can buy most of it. This means that they are being subsidized more than those with less purchasing power…What is forgotten is that subsidies are paid for by someone, and that no method has been discovered by which the community gets something for nothing.”
The move to dismantle diesel price deregulation also drove private marketers of oil (Reliance, Essar etc) out of business, as suggested by what Hazlitt had to say on the issue. The government owned oil marketing companies (Indian Oil, Bharat Petroleum, Hindustan Petroleum) were compensated by the government and the upstream oil companies (like ONGC, Oil India Ltd) for selling diesel at a lower price. There was no such compensation for the private oil marketers and hence, they had to shut down their business.
Once all these factors are taken into account the decision to deregulate diesel prices is a brilliant one even though it took a long time to come. Nevertheless, it will not lead to any major immediate benefits for the government. Since Narendra Modi took over as the prime minister of the country, the oil price has fallen dramatically.
As per the Petroleum Planning and Analysis Cell, the international crude oil price of Indian Basket as on October 17, 2014, stood at $ 85.06 per barrel. This price had stood at $108.05 per barrel on May 26, 2014, the day Modi took over as the prime minister.
Interestingly, during April to June 2014, the first quarter of this financial year, the under-recoveries of oil marketing companies on the sale of diesel, cooking gas and kerosene were at Rs 9,037 crore. This is much lower in comparison to the huge under-recoveries that these companies suffered over the last few years.
Also, since January 2013, the price of diesel has been raised by 50 paisa every month. This has led to the under-recoveries of oil marketing companies coming down significantly. Interestingly, for the fortnight starting October 16, 2014, the over-recovery on diesel stood at Rs 3.56 per litre. And that explains why the government was able to cut the price of diesel by around Rs 3.50 per litre.
What this tells us clearly is that there will be no immediate benefit on the fiscal front of diesel price deregulation to the government. Further, the real benefit of this reform will kick in only once oil prices start to rise. And it is at that point of time, the government of the day will have to resist any temptation to start controlling diesel prices, as has been the case in the past.
If it resists this temptation, the upstream oil companies (ONGC, Oil India) will also benefit because the government will not strip them of their profits to pay off the under-recoveries of the oil marketing companies. This explains why the share price of ONGC is up by more than 5% today.
Nevertheless, one immediate benefit of the diesel price cut will be a slightly lower inflation. On the flip side, this also means that if and when oil prices start to go up, the inflation will start reflecting a higher price of diesel more quickly than was the case in the past.
Another benefit of the deregulation will be that private marketers can now look to get back into the business. This is good news for the Indian consumer as it will mean more competition, which may lead to better services. In fact, one huge problem with the products sold by the public sector oil marketing companies is adulteration. Given the cheap price of kerosene, there is lot of adulteration of petrol and diesel. Private marketers can make in roads into the market by providing pure petrol and diesel, and hope to attract the attention of the consumer.
To conclude, there are a few immediate benefits of diesel price deregulation, but the real challenge and the benefit for the government will only come, once oil prices start to go up again.

The article originally appeared on www.FirstBiz.com on Oct 20, 2014

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

Why RBI killed the debt fund

RBI-Logo_8Vivek Kaul 
The Reserve Bank of India(RBI) is doing everything that it can do to stop the rupee from falling against the dollar. Yesterday it announced further measures on that front.
Each bank will now be allowed to borrow only upto 0.5% of its deposits from the RBI at the repo rate. Repo rate is the interest rate at which RBI lends to banks in the short term and it currently stands at 7.25%.
Sometime back the RBI had put an overall limit of Rs 75,000 crore, on the amount of money that banks could borrow from it, at the repo rate. This facility of banks borrowing from the RBI at the repo rate is referred to as the liquidity adjustment facility.
The limit of Rs 75,000 crore worked out to around 1% of total deposits of all banks. Now the borrowing limit has been set at an individual bank level. And each bank cannot borrow more than 0.5% of its deposits from the RBI at the repo rate. This move by the RBI is expected bring down the total quantum of funds available to all banks to Rs 37,000 crore, reports The Economic Times.
In another move the RBI tweaked the amount of money that banks need to maintain as a cash reserve ratio(CRR) on a daily basis. Banks currently need to maintain a CRR of 4% i.e. for every Rs 100 of deposits that the banks have, Rs 4 needs to set aside with the RBI.
Currently the banks need to maintain an average CRR of 4% over a reporting fortnight. On a daily basis this number may vary and can even dip under 4% on some days. So the banks need not maintain a CRR of Rs 4 with the RBI for every Rs 100 of deposits they have, on every day.
They are allowed to maintain a CRR of as low as Rs 2.80 (i.e. 70% of 4%) for every Rs 100 of deposits they have. Of course, this means that on other days, the banks will have to maintain a higher CRR, so as to average 4% over the reporting fortnight.
This gives the banks some amount of flexibility. Money put aside to maintain the CRR does not earn any interest. Hence, if on any given day if the bank is short of funds, it can always run down its CRR instead of borrowing money.
But the RBI has now taken away that flexibility. Effective from July 27, 2013, banks will be required to maintain a minimum daily CRR balance of 99 per cent of the requirement. This means that on any given day the banks need to maintain a CRR of Rs 3.96 (99% of 4%) for every Rs 100 of deposits they have. This number could have earlier fallen to Rs 2.80 for every Rs 100 of deposits. The Economic Times reports that this move is expected to suck out Rs 90,000 crore from the financial system.
With so much money being sucked out of the financial system the idea is to make rupee scarce and hence help increase its value against the dollar. As I write this the rupee is worth 59.24 to a dollar. It had closed at 59.76 to a dollar yesterday. So RBI’s moves have had some impact in the short term, or the chances are that the rupee might have crossed 60 to a dollar again today.
But there are side effects to this as well. Banks can now borrow only a limited amount of money from the RBI under the liquidity adjustment facility at the repo rate of 7.25%. If they have to borrow money beyond that they need to borrow it at the marginal standing facility rate which is at 10.25%. This is three hundred basis points(one basis point is equal to one hundredth of a percentage) higher than the repo rate at 10.25%. Given that, the banks can borrow only a limited amount of money from the RBI at the repo rate. Hence, the marginal standing facility rate has effectively become the repo rate.
As Pratip Chaudhuri, chairman of State Bank of India told Business Standard “Effectively, the repo rate becomes the marginal standing facility rate, and we have to adjust to this new rate regime. The steps show the central bank wants to stabilise the rupee.”
All this suggests an environment of “tight liquidity” in the Indian financial system. What this also means is that instead of borrowing from the RBI at a significantly higher 10.25%, the banks may sell out on the government bonds they have invested in, whenever they need hard cash.
When many banks and financial institutions sell bonds at the same time, bond prices fall. When bond prices fall, the return or yield, for those who bought the bonds at lower prices, goes up. This is because the amount of interest that is paid on these bonds by the government continues to be the same.
And that is precisely what happened today. The return on the 10 year Indian government bond has risen by a whopping 33 basis points to 8.5%. Returns on other bonds have also jumped.
Debt mutual funds which invest in various kinds of bonds have been severely impacted by the recent moves of the RBI. Since bond prices have fallen, debt mutual funds which invest in these bonds have faced significant losses.
In fact, the data for the kind of losses that debt mutual funds will face today, will only become available by late evening. But their performance has been disastrous over the last one month. And things should be no different today.
Many debt funds have lost as much as 5% over the last one month. And these are funds which give investors a return of 8-10% over a period of one year. So RBI has effectively killed the debt fund investors in India.
But then there was nothing else that it could really do. The RBI has been trying to manage one side of the rupee dollar equation. It has been trying to make rupee scarce by sucking it out of the financial system.
The other thing that it could possibly do is to sell dollars and buy rupees. This will lead to there being enough dollars in the market and thus the rupee will not lose value against the dollar. The trouble is that the RBI has only so many dollars and it cannot create them out of thin air (which it can do with rupees). As the following graph tells us very clearly, India does not have enough foreign exchange reserves in comparison to its imports.
import
The ratio of foreign exchange reserves divided by imports is a little over six. What this means is that India’s total foreign exchange reserves as of now are good enough to pay for imports of around a little over six months. This is a precarious situation to be in and was only last seen in the 1990s, as is clear from the graph.
The government may be clamping down on gold imports but there are other imports it really doesn’t have much control on. “The commodity intensity of imports is high,” write analysts of Nomura Financial Advisory and Securities in a report titled India: Turbulent Times Ahead. This is because India imports a lot of coal, oil, gas, fertilizer and edible oil. And there is no way that the government can clamp down on the import of these commodities, which are an everyday necessity. Given this, India will continue to need a lot of dollars to import these commodities.
Hence, RBI is not in a situation to sell dollars to control the value of the rupee. So, it has had to resort to taking steps that make the rupee scarce in the financial system.
The trouble is that this has severe negative repercussions on other fronts. Debt fund investors are now reeling under heavy losses. Also, the return on the 10 year bonds has gone up. This means that other borrowers will have to pay higher interest on their loans. Lending to the government is deemed to be the safest form of lending. Given this, returns on other loans need to be higher than the return on lending to the government, to compensate for the greater amount of risk. And this means higher interest rates.
The finance minister P Chidambaram has been calling for lower interest rates to revive economic growth. But he is not going to get them any time soon. The mess is getting messier.
The article originally appeared on www.firstpost.com on July 24, 2013

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

Yesterday, once more! Western central banks are fuelling real estate bubbles again

bubble


Vivek Kaul
 

A major reason behind the financial crisis that started in late 2008 was the fact that the Western countries had built many more homes than were required to house their populations. Once the home prices started crashing what followed was an economic catastrophe from which the world is still trying to come out.
Ironically the solution that central banks came up with for mitigating the negative effects of the financial crisis was to get home prices up and running again. This was done by printing money and pumping it into the financial system and ensure that the interest rates remain at very low levels. The hope was that at low interest rates people will borrow money and buy homes. 
Initially people stayed away but gradually they seem to be getting back to borrowing and home prices in Western countries are up and running again. 
As Albert Edwards of Societe Generale writes in a report titled 
If UK Chancellor George Osborne is a moron, Fitch’s Charlene Chu is a heroine “Young people today haven’t got a chance of buying a house at a reasonable price, even with rock bottom interest rates. The Nationwide Building Society data shows that the average first time buyer in London is paying over 50% of their take home pay in mortgage payments – and that is when interest rates are close to zero!…The OECD has recently identified UK house prices as between 20-30% too high (depending on whether you compare prices with rents or incomes – link). To be sure the UK is nowhere near the most expensive, with some of the usual suspects such as Canada, Australia and New Zealand even worse.”
Home prices in the United States have also been rising steadily since the beginning of 2012. The S&P Case-Shiller 20-City Home Price Index has risen by 13.4% since the beginning of 2012. Even with this price rise, home prices in the United States are still 25% lower than the peak they achieved in April 2006. 
Real estate prices in Western countries should not be rising at such high rates. They have huge amounts of land to build all the homes that they need. Hence, real estate prices in a country like America, which is not really short of land have rarely risen at a very fast pace. Housing prices in America had remained flat for a large part of the 20th century. Prices rose on an average at the rate of 0.4% per year (adjusted for inflation) for the period between 1890 and 2004. In fact in many parts of the country the pries had actually gone down.
For smaller countries like the United Kingdom land may be an issue, but the population density is not very high. The United Kingdom has around 255 people living per square kilometre. In comparison, Japan has 337 people living per square kilometre and India has 367. So there is enough land going around given the population. 
But more than these reasons the biggest reason why home prices should not be rising at the rates that they are is simply because the home ownership rates in these countries are very high. In June 2004, at the peak of the real estate boom, 69.2% of US households owned their own homes, up from 64% in 1995. Home ownership in the United Kingdom peaked in 2001 at 69%. Since then home ownership rates have fallen. In the United States, it has fallen to around 65%. In the United Kingdom it is at 64%. 
Even with the falling home ownership rates a major part of the population in these countries owns the homes that they stay in. The falling home ownership rate in the aftermath of the financial crisis only means one thing and that is that there were many more homes built than required. And a lot of homes were bought not to live in, but for speculation. 
The governments and central banks are now trying to get the speculation going again. In the United States this is important because home equity loans were responsible for a lot of consumption. Home equity is the difference between the market price of a house and the home loan outstanding on it. Banks give a loan on this home equity. 
Charles R Morris writing in 
The Trillion Dollar Meltdown: Easy Money, High Rollers, And the Great Credit Crash explains this phenomenon: “Consumer spending jumped from a 1990s average of about 67% of GDP to 72% of GDP in early 2007. As Martin Feldstein, a former chairman of the Council of Economic Advisers, has pointed out, that increase was financed primarily by the withdrawal of $9 trillion in home equity.”
Feldstein’s study was carried out for the period between 1997 and 2006. A study carried out by Alan Greenspan estimated that in the 2000s, home equity withdrawals financed 3% of all personal consumption. But this was a low estimate. Home equity supplied more than 6% of the disposable personal income of Americans between 2000-2007, another study pointed out. In fact, by the first quarter of 2006, home equity extraction made up for nearly 10% of disposable personal income of Americans. 
And all this consumption in turn created economic growth. If home prices keep going up, more home equity will be created and people can borrow against that. Also as home prices go up, people feel wealthier and tend to spend more, which helps economic growth. 
Governments are trying to encourage banks to give out loans so that people can buy homes. George Osborne, the British chancellor of the exchequer (the Indian equivalent of the finance minister) has come up with a “help to buy” scheme. In this the government will guarantee up to 20% of the home loan to encourage lending to borrowers with small savings. As Edwards writes “This means that if a borrower defaults on a loan, the taxpayer will be liable for a proportion of the losses.”
Criticism for this scheme has come in from various fronts. Andrew Bridgen, senior economist for Fathom Consulting, a forecasting firm run by former Bank of England economists, said: “Help to Buy is a reckless scheme that uses public money to incentivise the banks to lend precisely to those individuals who should not be offered credit. Had we been asked to design a policy that would guarantee maximum damage to the UK’s long-term growth prospects and its fragile credit rating, this would be it.” (As Edwards quotes in his report)
This is precisely what happened in the United States as well in the run up to the financial crisis, wher
e the government nudged banks and other financial institutions to lend to people who were in no position to repay the loan.
Central banks can afford to keep interest rates low primarily because of the policy of inflation targeting that they follow. There mandate is to maintain the rate of inflation at a certain rate and do everything required for that. Increasing real estate prices do not get captured in the rate of consumer price inflation, which central banks tend to use for inflation targeting. 
In fact inflation targeting was one of the reasons behind the global real estate bubble of the 2000s. As Stephen D King writes in 
When Money Runs Out – The End of Western Affluence “Take, for example, inflation targeting in the UK. In the early years of the new millennium, inflation had a tendency to drop too low, thanks to the deflationary effects on manufactured goods prices of low-cost producers in China and elsewhere in the emerging world. To keep inflation close to target, the Bank of England loosened monetary policy with the intention of delivering higher ‘domestically generated’ inflation…The inflation target was hit only by allowing domestic imbalances to arise: too much consumption, too much consumer indebtedness, too much leverage within the financial system and too little policy-making wisdom.” 
The same thing seems to be happening right now. With inflation rates too low the central banks have been maintaining low interest rates, so that people consume more and that in turn hopefully creates some inflation. But that in turn means doing the same things that led to the financial crisis. 
Governments and central banks pushing up real estate prices does help in the short term and translates into some sort of economic growth. But it does have serious long term repercussions as we have seen over the last few years. As Edwards writes “What makes me genuinely 
really angry is that burdening our children with more debt (on top of their student loans) to buy ridiculously expensive houses is seen as a solution to the problem of excessively expensive housing…First time buyers need cheaper homes not greater availably of debt to inflate house prices even further. This is madness.”
To conclude, let me quote economist Robert J Shiller from 
The Subprime Solution: How Today’s Global Financial Crisis Happened, and What to Do about It “The idea that public policy should be aimed at…preventing a collapse in home prices from ever happening, is an error of the first magnitude. In the short run a sudden drop in home prices may indeed disrupt the economy, producing undesirable systemic effects. But, in the long run, the home-price drops are clearly a good thing.” 

The article originally appeared on www.firstpost.com on July 10, 2013
(Vivek Kaul is a writer. He tweets @kaul_vivek) 

 

It's just another manic Monday for the Indian rupee

 rupeeVivek Kaul  
The Indian rupee crashed to an all time low level, crossing 61 to a dollar, this morning. As I write this one dollar is worth around Rs 61.2. On Friday when the foreign exchange market closed one dollar was worth Rs 60.24.
The rupee has crashed in response to return on the 10 year American treasury bond spiking to 2.73% on Friday i.e. July 5, 2013. This was an increase of 21 basis points (one basis point is equal to one hundredth of a percentage) in comparison to the return on Wednesday i.e. July 3, 2013. The bond market was closed on July 4, 2013, the American independence day.
A 10 year treasury bond is a bond issued by the American government to finance its fiscal deficit i.e. the difference between what it earns and what it spends. These bonds can be bought and sold in the open market. This buying and selling impacts the price of these bonds and hence their overall return.
The return on the 10 year American treasury bond spiked in response to better than expected jobs data. American businesses added 1,95,000 jobs in June, 2013, which was better than what the market expected. This faster than expected recovery in the job market is being taken as a signal that the American economy is finally getting back on track.
Since the start of the financial crisis in late 2008, the Federal Reserve of United States, the American central bank, has been printing dollars and pumping them into the financial system. This is to ensure that there are enough dollars going around in the financial system, so that interest rates continue to stay low. At low interest rates people are likely to borrow and spend more. Consumer spending makes up for around 71-72% of the American gross domestic product. Hence, an increase in consumer spending is very important for the American economy to keep growing.
The Federal Reserve prints dollars and pumps them into the financial system by buying bonds worth $85 billion every month. This includes government bonds and mortgage backed securities. On June 19,2013, Ben Bernanke, the Chairman of the Federal Reserve of United States, had said that if the American economy kept improving, the Federal Reserve would go slow on money printing in the time to come. He had said that it was possible that the Fed could stop money printing to buy bonds by the middle of next year.
The jobs data has come out better than expected. This is a signal to the bond market that the Federal Reserve will start going slow on money printing sooner rather than later. Several estimates now suggest that the Federal Reserve will start going slow on money printing as soon as September this year.
As and when the Federal Reserve goes slow on money printing the interest rates are likely to go up, as the financial system will have lesser amount of dollars going around. This is likely to push interest rates up. Bond prices are inversely related to interest rates. So as interest rates will go up, bond prices will fall, leading to losses for investors.
But markets don’t wait for things to happen. They start discounting likely happenings in advance.
Given this, the bond market investors are selling out on American government bonds to limit their losses. This has led to bond prices falling. Even when bond prices fall, the interest paid on these bonds continues to remain the same. This means a higher return for the investors who buy the bonds that are being sold.
So this has pushed the return on the 10 year American treasury bond to 2.73%. On May 1, 2013, the return on the 10 year American treasury bond was 1.66%.
An increase in return on government bonds pushes up interest rates on all other loans. This is because lending to the government is deemed to the safest, and hence the return on other loans has to be greater than that, to compensate for the higher risk involved.
As mentioned above, in the aftermath of the financial crisis, the Federal Reserve started to print money, in order to get the American economy up and running again. The trouble was that the average American was just coming out of a huge borrowing binge and was not ready to borrow again, so soon.
But the financial system was slush with money available at very low interest rates. This led to large institutional investors indulging in what came to be known as the dollar carry trade. Money was borrowed in dollars at low interest rates and invested in financial assets all over the world. The difference in return between what the investor makes and the interest he pays on his dollar borrowing, is referred to as the carry.
With interest rates in the United States going up, as returns on government bonds up, the carry made on the dollar carry trade has been on its way down. The arbitrage that investors were indulging in by borrowing in dollars and investing those dollars all across the world with a prospect of making higher returns is no longer as viable as it used to be.
A lot of this money came into the Indian stock market as well as the bond market. In case of the bond market the amount of return that can made is limited. Hence, carry trade investors who had invested in Indian bonds have been selling out. Between May end and now, foreign investors have sold out around $6 billion worth of Indian bonds.
When they sell out on these bonds, the investors are paid in rupees. In order to repatriate these rupees abroad they need to convert them into dollars. Hence they sell rupees to buy dollars. When they sell rupees there is a surfeit of rupees in the market and not enough dollars going around. In this scenario, the rupee tends to fall in value against the dollar.
And that’s what has happened in the morning today when the rupee crossed 61 to a dollar. As the rupee loses value against the dollar, foreign investors face a higher amount of currency risk, leading to more of them selling out. This puts further pressure on the rupee. ( you can read more about it here).
The pressure on the rupee will continue in the days to come. If American bond yields keep going up, more foreign investors will sell out of India and this will lead to the rupee continuing to lose value against the dollar. Over and above that there are several home grown issues that will ensure that the rupee will keep depreciating against the dollar. (You can read more about it here) This is not the last manic Monday we have seen as far as the rupee is concerned.

 PS: In the time that it took me to write this piece, the rupee recovered against the dollar. One dollar is now worth around Rs 60.99. Looks like the RBI has intervened to sell dollars and buy rupees.
The article originally appeared on www.firstpost.com on July 8,2013.
 (Vivek Kaul is a writer. He tweets @kaul_vivek)