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

The extortionate privilege of the dollar

3D chrome Dollar symbolVivek Kaul

On May 31, 2014, the total outstanding debt of the United States government stood at $17.52 trillion. The debt outstanding has gone up by $7.5 trillion, since the start of the financial crisis in September 2008. On September 30, 2008, the total debt outstanding had stood at $10.02 trillion.
In a normal situation as a country or an institution borrows more, the interest that investors demand tends to go up, as with more borrowing the chance of a default goes up. And given this increase in risk, a higher rate of interest needs to be offered to the investors.
But what has happened in the United States is exactly the opposite.
In September 2008, the average rate of interest that the United States government paid on its outstanding debt was 4.18%. In May 2014, this had fallen to 2.42%.
When the financial crisis broke out money started flowing into the United States, instead of flowing out of it. This was ironical given that the United States was the epicentre of the crisis. A lot of this money was invested in treasury bonds. The United States government issues treasury bonds to finance its fiscal deficit.
As Eswar S Prasad writes in The Dollar Trap—How the US Dollar Tightened Its Grip on Global Finance “From September to December 2008, U.S. securities markets had net capital inflows (inflows minus outflows) of half a trillion dollars…This was more than three times the total net inflows into U.S. securities markets in the first eight months of the year. The inflows largely went into government debt securities issued by the U.S. Treasury[i.e. treasury bonds].”
This trend has more or less continued since then. Money has continued to flow into treasury bonds, despite the fact that the outstanding debt of the United States has gone up at an astonishing pace. Between September 2008 and May 2014, the outstanding debt of the United States government went up by 75%.
The huge demand for treasury bonds has ensured that the American government can get away by paying a lower rate of interest on the bonds than it had in the past. In fact, foreign countries have continued to invest massive amounts of money into treasury bonds, as can be seen from the table.
foreign debt US
Between 2010 and 2012, the foreign countries bought around 43% of the debt issued by the United States government. In 2009, this number was slightly lower at 38.1%.
How do we explain this? As Prasad writes “The reason for this strange outcome is that the crisis has increased the demand for safe financial assets even as the supply of such assets from the rest of the world has shrunk, leaving the U.S. as the main provider.”
Large parts of Europe are in a worse situation than the United States and bonds of only countries like Austria, Germany, France, Netherlands etc, remain worth buying. But these bonds markets do not have the same kind of liquidity (being able to sell or buy a bond quickly) that the American bond market has. The same stands true for Japanese government bonds as well. “The stock of Japanese bonds is massive, but the amount of those bonds that are actively traded is small,” writes Prasad.
Also, there are not enough private sector securities being issued. Estimates made by the International Monetary Fund suggest that issuance of private sector securities globally fell from $3 trillion in 2007 to less than $750 billion in 2012. What has also not helped is the fact that things have changed in the United States as well. Before the crisis hit, bonds issued by the government sponsored enterprises Fannie Mae and Freddie Mac were considered as quasi government bonds. But after the financial mess these companies ended up in, they are no longer regarded as “equivalent to U.S. government debt in terms of safety”.
This explains one part of the puzzle. The foreign investors always have the option of keeping the dollars in their own vaults and not investing them in the United States. But the fact that they are investing means that they have faith that the American government will repay the money it has borrowed.
This “childlike faith of investors” goes against what history tells us. Most governments which end up with too much debt end up defaulting on it. Most countries which took part in the First World War and Second World War resorted to the printing press to pay off their huge debts. Between 1913 and 1950, inflation in France was greater than 13 percent per year, which means prices rose by a factor of 100. Germany had a rate of inflation of 17 percent, leading to prices rising by a factor of 300. The United States and Great Britain had a rate of inflation of around 3 percent per year. While that doesn’t sound much, even that led to prices rising by a factor of three1.
The inflation ensured that the value of the outstanding debt fell to very low levels. John Mauldin, an investment manager, explained this technique in a column he wrote in early 2011. If the Federal Reserve of the United States, the American central bank, printed so much money that the monetary base would go up to 9 quadrillion (one followed by fifteen zeroes) US dollars. In comparison to this the debt of $13 trillion (as it was the point of time the column was written) would be small change or around 0.14 percent of the monetary base
2.
In fact, one of the rare occasions in history when a country did not default on its debt either by simply stopping to repay it or through inflation, was when Great Britain repaid its debt in the 19th century. The country had borrowed a lot to finance its war with the American revolutionaries and then the many wars with France in the Napoleonic era. The public debt of Great Britain was close to 100 percent of the GDP in the early 1770s. It rose to 200 percent of the GDP by the 1810s. It would take a century of budget surpluses run by the government for the level of debt to come down to a more manageable level of 30 percent of GDP. Budget surplus is a situation where the revenues of a government are greater than its expenditure3.
The point being that countries more often than not default on their debt once it gets to unmanageable levels. But foreign investors in treasury bonds who now own around $5.95 trillion worth of treasury bonds, did not seem to believe so, at least during the period 2009-2012. Why was that the case? One reason stems from the fact nearly $4.97 trillion worth of treasury bonds are intra-governmental holdings. These are investments made by various arms of the government in treasury bonds. This primarily includes social security trust funds. Over and above this around $4.5 trillion worth of treasury bonds are held by pension funds, mutual funds, financial institutions, state and local governments and households.
Hence, any hint of a default by the U.S. government is not going to go well with these set of investors. Also, a significant portion of this money belongs to retired people and those close to retirement. As Prasad puts it “Domestic holders of Treasury debt are potent voting and lobbying blocs. Older voters tend to have a high propensity to vote. Moreover, many of them live in crucial swing states like Florida and have a disproportionate bearing on the outcomes of U.S. presidential elections. Insurance companies as well as state and local governments would be clearly unhappy about an erosion of the value of their holdings. These groups have a lot of clout in Washington.”
Nevertheless, the United States government may decide to default on the part of its outstanding debt owned by the foreigners. There are two reasons why it is unlikely to do this, the foreign investors felt.
The United States government puts out a lot of data regarding the ownership of its treasury bonds. “But that information is based on surveys and other reporting tools, rather on registration of ownership or other direct tracking of bonds’ final ownership. The lack of definitive information about ultimate ownership of Treasury securities makes it technically very difficult for the U.S. government to selectively default on the portion of debt owned by foreigners,” writes Prasad.
Over and above this, the U.S. government is not legally allowed to discriminate between investors.
This explains to a large extent why foreign investors kept investing money in treasury bonds. But that changed in 2013. In 2013, the foreign countries bought only 19.6% of the treasury bonds sold in comparison to 43% they had bought between 2010 and 2012.
So, have the foreign financiers of America’s budget deficit started to get worried. As Adam Smith wrote in
The Wealth of Nations “When national debts have once been accumulated to a certain degree, there is scarce, I believe, a single instance of their having been fairly and completely paid. The liberation of the public revenue, if it has been brought about at all, has always been brought about by a bankruptcy; sometimes by an avowed one, but always by a real one, though frequently by a pretended payment [i.e., payment in an inflated or depreciated monetary unit].”
Have foreign countries investing in treasury bonds come around to this conclusion? Or what happened in 2013, will be reversed in 2014? There are no easy answers to these questions.
For a country like China which holds treasury bonds worth $1.27 trillion it doesn’t make sense to wake up one day and start selling these bonds. This will lead to falling prices and will hurt China also with the value of its foreign exchange reserves going down. As James Rickards writes in
The Death of Money “Chinese leaders realize that they have overinvested in U.S. -dollar-denominated assets[which includes the treasury bonds]l they also know they cannot divest those assets quickly.”
It is easy to see that the United States government has gone overboard when it comes to borrowing, but whether that will lead to foreign investors staying away from treasury bonds in the future, remains difficult to predict. As Prasad puts it “It is possible that we are on a sandpile that is just a few grains away from collapse. The dollar trap might one day end in a dollar crash. For all its logical allure, however, this scenario is not easy to lay out in a convincing way.”
Author Satyajit Das summarizes the situation well when he says “Former French Finance Minister Valery Giscard d’Estaing used the term “
exorbitant privilege” to describe American advantages deriving from the role of the dollar as a reserve currency and its central role in global trade. That privilege now is “extortionate.”” This extortionate privilege comes from the fact that “if not the dollar, and if not U.S. treasury debt, then what?” As things stand now, there is really not alternative to the dollar. The collapse of the dollar would also mean the collapse of the international financial system as it stands today. As James Rickards writes in The Death of Money “If confidence in the dollar is lost, no other currency stands to take its place as the world’s reserve currency…If it fails, the entire system fails with it, since the dollar and the system are one and the same.”

(Vivek Kaul is the author of the Easy Money trilogy. He can be reached at [email protected])

The article appeared originally in the July 2014 issue of the Wealth Insight magazine

1T. Piketty, Capital in the Twenty-First Century(Cambridge, Massachusetts and London: The Belknap Press of Harvard University Press, 2014)

2 Mauldin, J. 2011. Inflation and Hyperinflation. March 10. Available at http://www.mauldineconomics.com/frontlinethoughts/inflation-and-hyperinflation, Downloaded on June 23, 2012

3T. Piketty, Capital in the Twenty-First Century(Cambridge, Massachusetts and London: The Belknap Press of Harvard University Press, 2014)

Of financial inequality and the financial crisis

thomas piketty

Thomas Piketty, a French economist, has taken the world by storm. His book Capital in the Twenty-First Century has been the second bestselling book on Amazon.com for a while now. Originally written in French, the book was translated into English and released a few months back in the United States.
Piketty’s Capital is not like some of the recent popular books in economics like Freakonomics or The Undercover Economist. It is a book running into 577 pages (if we ignore the notes running into nearly 80 pages) and is not exactly a bedtime read.
My idea is not to summarize the book in this column. That would be doing grave injustice to the book. Nevertheless I wanted to discuss an important point that the book makes.
A major but not so well discussed reason behind the financial crisis was the increasing inequality in the United States. Piketty discusses this in great detail in Capital.
The top 10% of the American population earned a little more than 50% of the national income on the eve of the financial crisis and then again in the early 2010s. In fact, if we look at income without capital gains, the top 10% earned more than 46% of the national income in 2010, which is already significantly higher than the income level attained in 2007, before the financial crisis started. The trend continued in 2011-2012 as well. In 1976, the top 10% of households earned around 33% of the national income.
The situation becomes even more grim when we look at the top 1% of the population. The top 1% of the households accounted for only 7.9% of total American wealth in 1976. This would grow to 23.5% of the income by 2007. This was because the incomes of those in the top echelons was growing at a much faster rate. The rate of growth of income for the period for those in the top 1% was at 4.4% per year. The remaining 99% grew at 0.6% per year.
A major reason for this inequality has been the pace at which the salaries of the top management of American companies have gone up. As Piketty writes“We’ve gone from a society of rentiers to a society of managers…Top managers[who Piketty calls supermanagers] have the power to set their own remuneration…or by corporate compensation committees whose members usually earn comparable salaries…in some cases without limit and in many cases without any clear relation to their individual productivity, which in any case is very difficult to estimate in a large organization.” This phenomenon was seen mainly in the United States, writes Piketty. But it was seen to a lesser extent in Great Britain and other English speaking developed countries in both the financial as well as non financial sectors.
In fact, Piketty even calls this phenomenon of senior managers being paid very high salaries as a form of “meritocratic extremism” or the need of modern societies, in particular the American society, to reward certain individuals deemed to be as “winners”. Interestingly, research shows that these winners got paid for luck more often than not. It shows that salaries went up most rapidly when sales and profits went up due to external reasons.
The solution to this increasing inequality of income was to some extent more education. But that is something that would take serious implementation and at the same time results wouldn’t have come overnight. How does a politician who has to go back to the electorate every few years deal with this? He needs to plan and think for the long run. But at the same time he needs to ensure that his voters keep electing him. If the voters don’t keep electing him in the short run there is nothing much he can do to improve things in the long run.
This is precisely what happened in the United States. Politicians addressed the issue of inequality by making sure that easier credit was accessible to their voters. Raghuram Rajan, currently the governor of the Reserve Bank of India, explains this very well in his award winning book Fault Lines: How Hidden Fractures Still Threaten the World Economy: “Since the early 1980s, the most seductive answer has been easier credit. In some ways, it is the path of least resistance…Politicians love to have banks expand housing credit, for all credit achieves many goals at the same time. It pushes up house prices, making households feel wealthier, and allows them to finance more consumption. It creates more profits and jobs in the financial sector as well as in real estate brokerage and housing construction. And everything is safe—as safe as houses—at least for a while.”
Hence, the palliative proposed by politicians for the increasing income inequality in America was easy credit. As Michael Lewis writes in The Big Short – A True Story “How do you make poor people feel wealthy when wages are stagnant? You give them cheap loans.”
While, the government and the politicians worked towards making borrowing easier, there is another point that needs to be made here. As income levels stagnated at lower levels, a large section of the population had to resort to taking on debt and this contributed to the financial instability of the United States. As Piketty writes in Capital “One consequences of increasing inequality was virtual stagnation of the purchasing power of the lower and middle classes…which inevitably made it more likely that modest households would take on debt, especially since unscrupulous banks and financial intermediaries….eager to earn good yields on enormous savings injected into the system by the well-to-do, offered credit on increasingly generous terms.”
So, it worked both ways. The government made it easier to borrow and the people were more than willing to borrow. As author Satyajit Das puts it “Borrowing became a substitute for rising incomes.”
This wasn’t surprising given that the minimum wage in the United States when measured in terms of purchasing power reached its maximum level in 1969. At that point of time the wage stood at $1.60 an hour or $10.10 in 2013 dollars, taking into account the inflation between 1968 and 2013. At the beginning of 2013, it was at $7.25 an hour, lower than that in 1969, in purchasing power terms.
The easy money strategy that has been followed in the aftermath of the financial crisis has again worked led to increasing inequality. The American stock market has rallied by more than 150% in the last five years and this has benefited the richest Americans.
In the five year bull run, the stock market generated a paper wealth of more than $13.5 trillion. In fact, in 2013, the market value of listed stocks in the United States went up by $4 trillion. This benefited the top 10% of Americans who own 80% of the shares listed on stock exchanges.
A similar thing happened in the United Kingdom, where the Bank of England admitted in 2012 that its quantitative easing program boosted the value of stocks and bonds by 25% or about $970 billion. Almost 40% of these gains went to the richest 5% of the British households.
Interestingly, the salaries of CEOs in the United States have continued to go up, even after the financial crisis. If one considers the Fortune 500 companies, the average CEOs salary is 204 times that of their rank and file workers. This disparity has gone by 20% since 2009.
At the same time, the income of the median American household fell to $51,404 in February 2013. This was 5.6% lower than what it was in June 2009. Further, the average income of the poorest 20% of the Americans has fallen by 8% since 2009. Given this, more than 100 million Americans are receiving some form of support from the government.
In fact new research carried out by Emmanuel Saez and Thomas Piketty reveals that between 2009 and 2012, the top 1% of income earners in the United States enjoyed a real income growth of 31%. Income for the bottom 90% of the earners shrank.
The point being that the Western world does not seem to have learnt from its past mistakes. As George Akerlof and Paul Romer wrote in a research paper titled Looting: The Economic Un­derworld of Bankruptcy for Profit, “If we learn from experience, history need not repeat itself.”If only that were the case!

Note: Not all data has been sourced from Thomas Piketty’s Capital in the Twenty-First Century. Some numbers have been sourced from Raghuram Rajan’s Fault Lines.

The article originally appeared in the June 2014 edition of the Wealth Insight magazine

(Vivek Kaul is the author of the Easy Money trilogy. He can be reached at [email protected]

India: The Siege Within

satyajit dasSatyajit Das  

India seems never to be able to fulfil its economic potential. The nation seems to be trapped in an Alice in Wonderland world where “the rule is, jam tomorrow and jam yesterday-but never jam today”.
India Shining…
India’s GDP rose by 43% between 2007 and 2012, slightly less that China which increased by 56% but much faster than developed economies which grew only 2%.
Economists rushed to out do each other in spruiking the India story. Forecasts of growth rates of 8.5% per annum or even higher became commonplace. Morgan Stanley, the US investment bank, predicted that India’s growth would reach 9-10%, outpacing China’s “pedestrian” 8% within three to five years.
In a report titled India: Better Off Than Most Others, Macquarie Capital, argued that India’s traditional weaknesses -low exports, a predominantly state-owned financial system lightly integrated to foreign markets, sluggish export growth because of bureaucracy and the large domestic agricultural sector producing only for domestic consumption- were now strengths underpinning growth.
Indian leaders moved between international forums, basking in their new found status and power. Indian businessman made trophy purchases of business overseas, usually financed by debt. At the World Economic Forum at Davos, representatives of the Indian government and business announced that India could grow in its sleep.
India’s economic hubris was exemplified by a marketing slogan, first popularised by the then-ruling Bharatiya Janata Party (“BJP”) for the 2004 Indian general elections – “India Shining”. After years without a good news story, the Indian media focused on the nation’s “greatnesses”, relying on extraneous facts. The fact that the market capitalization of State Bank of India surpassed that of Citigroup was cheered. The press celebrated the first Indian edition of Harper’s Bazaar which featured a crystal-studded cover, the introduction by Rolls-Royce of its new Phantom Coupe in India and the opening of a new BMW showroom in Delhi. More recently, the nation has found solace in its venture to send an unmanned spacecraft to Mars!
But in recent times, the unsound economic basis of India’s growth has increasingly been revealed. In late 2011, the government’s 12th five-year plan forecast growth of 9% between 2012 and 2017. By late 2013, India’s economic growth had slowed below 5% , high by the standards of developed countries but well below the levels required to maintain economic momentum and improve the living standards of its citizens.
Elements of the India Shining story remain intact –the demographics of a youthful population, the large domestic demand base and the high savings rate. Increasingly, India’s problems – poor public finances, weak international position, structurally flawed businesses, poor infrastructure, corruption and political atrophy- threaten to overwhelm its future prospects.
Instead of membership of the prestigious BRICS (Brazil, Russia, India, China, South Africa), the nation has become attained membership of the BIITS (Brazil, India, Indonesia, Thailand, South Africa), the acronym for the most vulnerable emerging economies.
Public Troubles
In recent years, India has consistently run a public sector deficit of 9-10% of GDP, including the state governments and off-balance-sheet items.
Confronted with the global financial crisis and the additional complication of a poor monsoon, India implemented successive aggressive stimulus packages from 2008 onwards to restore growth. The predictable result was a huge increase in the central government’s fiscal deficit.In fact, between April and October 2013, the government has already touched 84.4% of the annual fiscal deficit target of Rs 5,42,499 crore or 4.8% of the GDP. Interestingly, the finance minister P Chidambaram has reiterated time and again that the target set at the beginning of the year is a “red line” which will not be crossed.
It is unlikely that the government will be able to meet its budget deficit target, other than by adopting some cosmetic measures such as postponing the recognition of expenditure. In effect, it may delay payment of a portion of subsidies to the various oil marketing companies for the under-recoveries they face while selling diesel, cooking gas and kerosene at a subsidised price. At the same time, the Food Corporation of India will also not be immediately compensated for selling food grains at a subsidised price.
Indian government’s debt is around 70% of GDP. As the debt is denominated in rupees and sold domestically, India faces no immediate financing difficulty. Instead, the government’s heavy borrowing requirements crowds out private business.
Indian banks are significant purchasers of government bonds. The banks, generally majority state owned, are also forced to lend to Indian state enterprises and also politically well connected promoters. This limits the supply of credit to Indian businesses that are sometimes forced to borrow overseas, exposing them to currency risk. Given India’s deteriorating external position, the foreign debt is becoming increasingly problematic.
Foreign Troubles
Swiss bank Credit Suisse in its August 2013 report House of Debt -Revisited analysts estimated that the gross debt of ten Indian corporate groups for 2012-2013 stood at Rs 6,31,024.7 crore, having risen by 15% year on year. In fact, the interest coverage ratio of these groups stands at a low 1.4. The report drew attention to the fact that a significant proportion of corporate loans, estimated at 40-70%, are denominated in foreign currency, meaning thatthe sharp depreciation in the rupee will have added to the debt burden.
In an environment of booming stock markets between 2005 and 2008, foreign currency convertible bonds (FCBs) provided companies with low cost debt. However, the toxic combination of falls in share prices and a fall in the value of the rupee (in which the shares are denominated) means that the FCBs will not convert and need to be repaid. The repayment in foreign currency will crystallise large currency losses. In addition, refinancing the FCBs will result in much higher borrowing costs, which will significantly affect the profitability of Indian corporations.
Bank Troubles
Slowing growth, tighter credit and other economic problems have increased corporate defaults to the highest level in 10 years resulting in bad loans. Non performing loans are now above 3.6% of bank assets, a sharp increase over the last year.
The real level of bad debts is probably higher, because of the significant number of “restructured” loans, which many suspect are merely non-performing loans which have been extended with more generous terms to avoid formal recognition as bad debts.
The problem is greatest for government owned banks, which constitute 75% of the banking system. The bad loans are concentrated in sectors such as power, aviation, infrastructure, real estate and telecommunications.
The common element is that these industries are characterised by government involvement and which have suffered from erratic government policy or wholesale interference. In electricity, state owned utilities have accumulated losses of $14 billion, in part because low government mandated rates dictated by political considerations do not cover the cost of generation.
While many Indian companies are financially sound, with strong earnings and healthy balance-sheets, there are significant levels of loans to politically sponsored “promoters”, who are over indebted and have limited access to new capital without a willingness to dilute down the backers stakes, which is often not acceptable except in extremis.
The pressures are likely to increase over time as the economic slowdown bites.
The Indian government has already moved to recapitalise state owned banks to ensure their capital position. In the process, the budget deficit and the government borrowing requirements have come under increasing pressure.
We have no Infrastructure Today
India is plagued by inadequate infrastructure. In critical sectors like power, transport and utilities, there are significant shortages. Poor investment and slow government decision making has hindered development.
Political pressure to keep utility costs low has impeded investment. In the electricity sector, state-owned utilities that purchase power from producers and sell to residential users have incurred large losses. State governments are unwilling to raise retail consumer rates despite increases in the price that power producers charge the utilities.
Electricity generators cannot obtain sufficient coal from the state-owned mining monopoly Coal India, which has been unable to increase production to match the demands of new power plants. Some electricity producers have been forced to invest overseas to assure access to coal.
Increasingly, the structural problems and poor history of projects has made foreign investors cautious, creating a shortage of foreign capital for investment in infrastructure.
While its workforce is young and growing, there is a shortage of skills. In a dysfunctional public education system 40% of students do not complete school. The workforce is 40% illiterate. India’s overall adult literacy rate is 66% compared to 93% for China.
Some universities, especially the 16 Indian Institutes of Technology, are world class. But their limited capacity means that are significant shortages. Some estimates forecast a shortage of 200,000 engineers, 400,000 other graduates and 150,000 vocationally trained workers, such as builders, electricians and plumbers, in the coming years. In contrast, there are 60-100 million underemployed or surplus low skilled workers in agriculture.
Political Atrophy
Political paralysis is a major impediment to economic development. Successive governments of every political persuasion have failed to undertake meaningful reforms, necessary to foster growth, employment and development.
Required changes in land and property laws have not been made. Problems in acquiring land are a factor in 70% of delayed infrastructure projects. Reform of tax laws, including introduction of a direct sales tax correcting cumbersome difference between individual states, have not been completed. Changes to mining and mineral development regulations to allow proper, environmentally controlled exploitation of India’s mineral wealth have not been made.
Other crucial areas remains unaddressed – rationalising unwieldy and economically distorted subsidies, implementing economic pricing of utilities, promoting foreign investment in key sectors or reforming agriculture, especially the wasteful and inefficient logistics system for transporting produce to market. Reform of labour markets and privatisation of key sectors has not been progressed.
The lack of progress on reforms remains a barrier to international investment.
Corruption remains a problem. As current RBI Governor Raghuram Rajan told a business audience a few years ago “too many people have gotten too rich based on their proximity to the government”.
The current governing Congress led coalition and the BJP led opposition are weak, both crippled by corruption scandals. All parties are dominated by political monarchies or by geriatric politicians who cannot or will not embrace change.
India’s fabled democracy is increasingly ossified, where a complete inability to make hard decisions or undertake reforms makes government futile if profitable for some.

Insecure India
In the title of his 1990 book A Million Mutinies, writer V.S. Naipaul pithily captured India’s internal political disputes. Today, about a third to a half of India is affected by the Naxalites, a violent Maoist insurgency which has been active for over the 50 years.
The threat of religious conflict between Hindus and Muslims is ever present. The Chief Minister of Gujarat, a likely candidate for future Prime Minister, remains under a cloud for his alleged involvement in sectarian violence.
Ongoing border disputes with Pakistan and China and the instability of AfPak (Afghanistan and Pakistan), which will be compounded by the US withdrawal, dictates large defence expenditure diverting resources away from other parts of the economy. This is compounded by regional competition with China for influence requiring the capability to project military power into the Indian Ocean and also South East Asia.
The Great Pretender
In the 1980s, Indian sociologist Ashis Nandy observed that “in India the choice could never be between chaos and stability, but between manageable and unmanageable chaos”. Today, a deteriorating global environment, deep-seated structural problems and lack of crucial reforms exacerbated by corruption, threatens to make condition unmanageable, more quickly than most assume.
Indian leaders have been urging businesses and investors to “trust them”. But the country and its elite seems unable to face the truth and undertake fundamental long term changes.

The column originally appeared in the Business Today, edition dated January 6, 2014

Satyajit Das is author of Extreme Money: The Masters of the Universe and the Cult of Risk (2011)

(As told to Vivek Kaul) 

Five years after Lehman Brothers went bust, the same mistakes are being made

A logo of Lehman Brothers is seen outside its Asia headquarters in TokyoVivek Kaul 
Graham Greene’s fascinating book The End of an Affair starts with these lines: “A story has no beginning or end: arbitrarily one chooses that moment of experience from which to look back or from which to look ahead.”
If the current financial crisis were a story (which it is) its beginning would be on September 15, 2008, when Lehman Brothers, the smallest of the big investment banks on Wall Street, went bust. It was the largest bankruptcy in the history of the world. Lehman Brothers started a crisis, from which the world is still trying to recover.
While the American government and the Federal Reserve(the American central bank) let Lehman Brothers go under, the got together to save AIG, one of the largest insurance companies in the world, a day later. This was followed by a spate of other rescues in the United States as well as Europe. These rescues cost the governments around the world a lot of money. As Mark Blyth writes in Austerity – The History of a Dangerous Idea “The cost of bailing, recapitalizing, and otherwise saving the global banking system has been depending on…how you count it, between 3 and 13 trillion dollars. Most of that has ended up on the balance sheets of governments as they absorb the costs of the bust.”
It’s been five years since Lehman Brothers went bust. Hence, enough time has elapsed since the financial criss started, to analyse, if any lessons have been learnt. One of the major reasons for the financial crisis was the fact that governments across the Western world ran easy money policies, starting from the turn of the century. Loans were available at low interest rates.
People went on a borrowing binge to build and buy homes and this led to huge real estate bubbles in different parts of the world. Take the case of Spain. Spain ended up building many more homes than it could sell. Estimates suggest that even though Spain forms only 12 percent of the GDP of the European Union (EU) it built nearly 30 percent of all the homes in the EU since 2000. The country has as many unsold homes as the United States of America which is many times bigger than Spain.
Along similar lines, by the time the Irish finished with buying and selling houses to each other, the home ownership in the country had gone up to 87%, which was the highest anywhere in the world. A similar thing happened in the United States, though not on a similar scale.
Housing prices in America had already started to fall before Lehman Brothers went bust. After that the fall accelerated. As per the Case-Shiller Composite-20 City Home Price Index, housing prices in America had risen by 76% between mid of 2001 and mid of 2006. The first time the real estate prices came down was in January 2007, when the Case-Shiller Composite-20 City Home Price Index suggested that housing prices had fallen by a minuscule 0.05% between January 2006 and January 2007. This fall came nearly two and half years after the Federal Reserve started raising interest rates to control the rise in price of real estate.
The fall gradually accentuated and by the end of December 2007, housing prices had fallen by 9.1% over a one year period. The fall continued. And by December 2008, a couple of months after Lehman went bust, housing prices, had fallen by 25.5%, over a period of three years. The real estate bubble had burst and the massacre had started. Similar stories were repeated in other parts of the Western world. Soon, western economies entered into a recession.
Governments around the world started tackling this by throwing money at the problem. The hope was that by printing money and putting it into the financial system, the interest rates would continue to remain low. At lower interest rates people would borrow and spend more, and this in turn would lead to economic growth coming back.

Hence, the idea was to cure a problem, which primarily happened on account of excess borrowing, by encouraging more borrowing. The question is where did this thinking come from? In order to understand this we need to go back a little in history.
As Nobel Prize winning economist Robert Lucas said in a speech he gave in January 2003, as the president of the American Economic Association: “Macroeconomics was born as a distinct field in the 1940s, as a part of the intellectual response to the Great Depression. The term then referred to the body of knowledge and expertise that we hoped would prevent the recurrence of economic disaster.”
Given this, the economic thinking on the Great Depression has had a great impact on American economists as well as central bankers. This is also true about economists across Europe to some extent.
In 1963, Milton Friedman along with Anna J. Schwartz, wrote 
A Monetary History of United States, 1867-1960, which also had a revisionist history of the Great Depression. What Friedman and Schwartz basically argued was that the Federal Reserve System ensured that what was just a stock market crash in October 1929, became the Great Depression.
Between 1929 and 1933, more than 7,500 banks with deposits amounting to nearly $5.7 billion went bankrupt. This according to Friedman and Schwartz led to the total amount of currency in circulation and demand deposits at banks, plunging by a one third.
With banks going bankrupt, the depositors money was either stuck or totally gone. Under this situation, they cut down on their expenditure further, to try and build their savings again. This converted what was basically a stock market crash, into the Great Depression.
If the Federal Reserve had pumped more money into the banking system at that point of time, enough confidence would have been created among the depositors who had lost their money and the Great Depression could have been avoided.
This thinking on the Great Depression came to dominate the American economic establishment over the years. Friedman believed that the Great Depression had happened because the American government and the Federal Reserve system of the day had let the banks fail and that had led to a massive contraction in money supply, which in turn had led to an environment of falling prices and finally, the Great Depression.
Hence, it was no surprise that when the Dow Jones Industrial Average, America’s premier stock market index, had a freak crash in October 1987, and fell by 22.6% in a single day, Alan Greenspan, who had just taken over as the Chairman of the Federal Reserve of United States, flooded the financial system with money.
After this, he kept flooding the system with money by cutting interest rates, at the slightest hint of trouble. This led to a situation where investors started to believe that come what may, Greenspan and the Federal Reserve would come to the rescue. This increased their appetite for risk, finally led to the dotcom and the real estate bubbles in the United States.
In fact, such has been Friedman’s influence on the prevailing economic thinking that Ben Bernanke, who would take over as the Chairman of the Federal Reserve, after Greenspan, said the following at a conference to mark the ninetieth birthday celebrations of Friedman in 2002. “I would like to say to Milton and Anna: Regarding the Great Depression. You’re right, we did it. We’re very sorry. But thanks to you, we won’t do it again.”
At that point of time, Bernanke was a member of the board of governors of the Federal Reserve System and hence, the use of the word “we”. What Bernanke was effectively saying was that in the days and years to come, at the slightest sign of trouble, the Federal Reserve of United States would flood the financial system with money.
And that is precisely what Bernanke and the American government did once the financial crisis broke out in September 2008. The Bank of England, the British central bank, followed. And so did the European Central Bank in the time to come. Recently, the Bank of Japan decided to join them as well.
Central banks around the world have been on a money printing spree since the start of the financial crisis in late 2008. Between then and early February 2013, the Federal Reserve of United States has expanded its balance sheet by 220%. The Bank of England has done even better at 350%. The European Central Bank came to the money printing party a little late in the day and has expanded its balance sheet by around 98%. The Bank of Japan has been rather subdued in its money printing efforts and has expanded its balance sheet only by 30% over the four year period. But during the course of 2013, the Bank of Japan has made it clear that it will print as much money as will be required to get the Japanese economy up and running again.
The trouble is that people in the Western world are not interested in borrowing money again. Hence, the little economic recovery that has happened has been very slow. The Japanese economist Richard Koo calls the current state of affairs in the United States as well as Europe as a balance sheet recession. The situation is very similar to as it was in Japan in 1990 when the stock market bubble as well as the real estate bubble burst.
Hence, Koo concludes that the Western economies including the United States may well be headed towards a Japan like lost decade. In a balance sheet recession a large portion of the private sector, which includes both individuals and businesses, minimise their debt. When a bubble that has been financed by raising more and more debt collapses, the asset prices collapse but the liabilities do not change.
In the American and the European context what this means is that people had taken on huge loans to buy homes in the hope that prices would continue to go up for perpetuity. But that was not to be. Once the bubble burst, the housing prices crashed. This meant that the asset (i.e. homes) that people had bought by taking on loans lost value, but the value of the loans continued to remain the same.
Hence, people needed to repair their individual balance sheets by increasing savings and paying down debt. This act of deleveraging or reducing debt has brought down aggregate demand and throws the economy in a balance sheet recession.
While the citizens may not be borrowing, this hasn’t stopped the financial institutions and the speculators from borrowing at close to zero percent interest rates and investing that money in various parts of the world. And that, in turn, has led to other asset bubbles all over the world.
These bubbles have benefited the rich. 
As The Economist points out “THE recovery belongs to the rich. It seemed ominous in 2007 when the share of national income flowing to America’s top 1% of earners reached 18.3%: the highest since just before the crash of 1929. But whereas the Depression kicked off a long era of even income growth the rich have done much better this time round. New data assembled by Emmanuel Saez, of the University of California, Berkeley, and Thomas Piketty, of the Paris School of Economics, reveal that the top 1% enjoyed real income growth of 31% between 2009 and 2012, compared with growth of less than 1% for the bottom 99%. Income actually shrank for the bottom 90% of earner.”
Once these bubbles start to burst, the world will go through another round of pain. Satyajit Das explains the situation beautifully 
in a recent column for the Financial Times, where he quotes the Irish author Samuel Beckett “Ever tried. Ever failed. No matter. Try Again. Fail again. Fail better.”
To conclude, there are many lessons that history offers us. But its up to us whether we learn from it or not. As the German philosopher Georg Engel once said “What experience and history teach is this – that nations and governments have never learned anything from history, or acted on principles deduced from it”
And why should this time be any different?
The article originally appeared on www.firstpost.com on September 16, 2013
(Vivek Kaul is a writer. He tweets @kaul_vivek)