Eugene Fama still swears by efficent markets

 FT carries a terrific interview with Eugene Fama, Nobel Laureate and author of the concept of "efficent markets". that idea that market prices capture all the information that is available, so they are right. Meaning, it's hard for investors to beat the market. The best thing to do for investors, therefore, is to simply invest in passive funds, that is, funds that mimic the broad market.

The fundamental inference has proved right over the past several decades:

The latest data from S&P Global, a company that produces financial benchmarks, indicates that less than 10 per cent of American stockpickers and under 20 per cent of British ones have beaten the market during the past decade. The numbers are similar elsewhere in the world, and get worse the longer the timeframe. This is a major reason why trillions of dollars keep gushing out of traditional, actively managed funds and into cheap, passively managed ones.

Why do people keep investing in mutual funds that manage funds actively? Well, every investor hopes he has found the 10 per cent of fund managers who outperform the market.

Fama concedes that sometimes market prices may not be right but that doesn't disprove the basic hypothesis. For the most part, it's hard to beat the market. Stock pickers who claim otherwise are plain wrong. Fama has a great quote for them:

I’d compare stock pickers to astrologers, but I don’t want to bad-mouth the astrologers.

Ukraine's push into Kursk: what exactly does it mean?

Ukraine stunned Russia- and the world- with its surprise thrust into Kursk close to the Northern part of Ukraine. The people of Ukraine exult in the fact that Ukraine has captured over 1000 sq kms of Russian territory in a matter of few days when it took more than a year for Russia to capture similar ground in Ukraine and at a much bigger cost in human lives.

Several interpretations of the move have been made. One, President Zelensky wants to use captured Russian territory as a bargaining chip in any future peace negotiations. Two, Ukraine wanted to assure the West that it retains its fighting capability and can put Russia on the back foot after more than a year of being on the defensive. Three, Ukraine hopes that its push into Kursk will force Russia to divert troops from the Donbas region and slow down Russia's year-long offensive in that region.

The Institute for the Study of War, based in Washington, offers a cautious view:

The Ukrainian incursion into Kursk Oblast and Russian offensive operations in eastern Ukraine are not in themselves decisive military operations that will win the war. Both Russian and Ukrainian forces lack the capability to conduct individual decisive war-winning operations and must instead conduct multiple successive operations with limited operational objectives that are far short of victory, but that in aggregate can achieve strategic objectives. It is too early to assess the outcomes and operational significance of the Ukrainian incursion into Russia and the ongoing Russian offensive effort in eastern Ukraine. The significance of these operations will not emerge in isolation, moreover, but they will matter in so far as they relate to a series of subsequent Russian and Ukrainian campaigns over time.

FT worries about whether the transfer of large number of troops from the East to the Kursk front will make it easier for Russia to make gains in the Donetsk region that is the focus of its efforts. Crucially, Ukraine has not yet succeeded in getting Russia to divert forces away from the Donetsk region and to Kursk:

Russian soldiers are still grinding their way through Ukrainian defences, capturing villages and towns and bringing Moscow closer to its stated goal of complete control of the Donetsk region in eastern Ukraine. On Monday, Russian troops appeared to have captured nearly all of the town of Niu-York, entered nearby Toretsk and were encroaching on the logistical hub of Pokrovsk. One Ukrainian artillery brigade commander in eastern Ukraine told the Financial Times that part of the reason for the Russian advance was Kyiv moving its scarce resources north.....

....Ukrainian soldiers and military analysts tracking the war said there had been no clear indication that Russia was moving a consequential amount of forces from the hottest area on the frontline in its east. “Despite the successes of the defenders in the Kursk region, the Russians have not yet transferred their troops en masse from here,” said Ukraine’s 47th Mechanised Brigade. “Its main strike force remains.”

The Economist, which has been for long hawkish on Russia's operations in Ukraine and a cheer-leader, for Ukraine offers a surprisingly downbeat assessment. It sees Ukraine's drive into Kursk as a desperate move to save the career of Ukraine's army chief, General Oleksandr Syrsky. It also sees worrying signs of Russia getting its response to the Kursk threat right:

The plan to invade part of Russia did not come from a happy place. In early July, General Syrsky, Ukraine’s newly appointed top commander, was under pressure. For months he had been grappling with a less-than-ideal inheritance from his predecessor, Valery Zaluzhny, and the army’s leadership was at odds with the president over mobilisation policies, leading to significant manpower shortages. In America Congress had delayed support. Avdiivka, a stronghold north of Donetsk, had consequently fallen. Front lines in the Donetsk region were crumbling, most especially around the logistical hub of Pokrovsk. Rumours circulated that General Syrsky was on the verge of being dismissed....

.....Evidence of an intensifying response inside Kursk is now clear. Ukrainian soldiers on the ground inside Russia say they are already beginning to see a different level of resistance. Losses are increasing. The Russians have reinforced with better trained units, including marines and special forces. They had studied the area.

Finally, Moon of Alabama, a military blog, offers the startling view that it was Britain, not the US, which knew about Ukraine's plans for Kursk and provided the necessary backing:

Britain, in a bipartisan move, wants to prolong the war in Ukraine. It suggested to and helped Ukraine to invade Russia even as it knew that this would interrupt peace talks in Qatar. It also promised to press its allies  for long range attack permission against Russia. But the U.S. and Germany are still blocking such attacks. Zelensky now complains that Britain failed to deliver on its promise.

The U.S., miffed about the British involvement in a likely useless Ukrainian attack on Russia, is leaking about the Ukrainian/Russian negotiations in Qatar. 

The above is largely based on the U.S. claims that it was not really involved in the planing of the Kursk incursion.

Whatever the long-term significance of the Ukrainian move, there is little doubt that is at the moment a PR coup for Ukraine and a massive blow to President Putin. Ukraine crows that Putin's red lines for the West are just bluff;  Russia does not have the capacity to retaliate massively and Ukraine has in itself to hand Russia a military defeat.

Whether Putin can prove this narrative wrong or not may well determine not just the outcome of this conflict but Putin's own future. 

Remembering Harry Dexter White

The IMF's magazine, Finance & Development, carried this article and this one on one of the two men responsible for the creation of the IMF and the World Bank, known as the Bretton Woods twins after the conference at the site that led to their founding. The two articles are both authored by James Boughton, historian of the IMF. The man we are talking about is Harry Dexter White, then Chief Economist at the US Treasury. The other man was none other than John Maynard Keynes.

Keynes came to his meetings with White with idealistic fervour. He wanted a global central bank that would create an international currency as part of the post- War order. White would have none of it. Since the US was the primary global power and would be  mostly underwriting the expenses of the IMF/World Bank, he was clear that the US would call the shots. The IMF would be, not a central bank, but an entity that would promote global economic stability. And it was the US dollar that would serve as the reserve currency.

There were other differences between the two men. Keynes wanted Britain and the US to write up the charter for the IMF/World Bank. White wanted a large number of countries to be involved. Controversially, he wanted to involve the Soviet Union too in the effort. That hope was dashed by the Cold War. It was not until the dissolution of the Soviet Union in 1991 that White's vision was realised. White wanted to give all countries some say in the governance of the IMF through voting rights. Keynes had wanted the debtor countries, including the UK, to call the shots.  

The world economy, Boughton notes, evolved in ways that neither White nor Keynes could have imagined. The world economy grew much faster than they had expected after WW2. The IMF lacked the resources to cope with the demands made on it. White mooted the idea of a new asset for the purpose. This fructified much later as Special Drawing Rights (SDRs).

White and Keynes, however, agreed on the role of capital flows:

White and Keynes agreed that the IMF should discourage countries from being open to capital flows. The Fund’s charter specified that countries could borrow from the IMF only to finance trade deficits, not to counteract large capital outflows. It also authorized the IMF to require countries to impose capital controls when necessary. But the global economy changed as it grew. Because bank loans and international bonds became more widely used to finance trade between countries, the IMF eventually reversed course and began urging most countries to open their financial markets to foreign competition. Today, the IMF takes a more cautious approach, recognizing both the benefits of openness and the risks of volatility and loss of control.

White's career had an unfortunate end. During the Red Scare of the 1940s, White came under scrutiny for his meetings with Soviet officials during the creation of the Bretton Woods institutions. He was suspected of passing on documents to the Soviet Union.  

During the investigations of the McCarthy era, attacks on his motives ranged from the questionable to the bizarre. His meetings with Soviet officials around the time of Bretton Woods were interpreted as espionage. His efforts during the war to hold the Nationalist government in China accountable for hundreds of millions of dollars in U.S. financial aid were interpreted as an effort to undermine Chiang Kai-shek in favor of Mao Tse-tung

Three days after the hearings, in which White defended himself vigorously, White died of a heart attack. He was again vilified years later during the McCarthy hearings. He was now accused of being a Soviet spy. His reputation was tarnished. Mercifully, he was not around to witness his fall. 

Is Elon Musk making a big mistake?

Elon Musk, as is well known, has thrown his not inconsiderable weight behind Donald Trump. His recent interview with Trump was meant to boost the latter through access to a platform with a huge audience.

Musk's support is partly a matter of conviction: he genuinely believes that Trump is the best bet for the US. He backs Trumps' economic policies, as do many other business leaders in the US.

But if Musk thinks that he can benefit from a Trump presidency or if he believes that Trump will dance to his tune, he may well be mistaken, says this article in the Economist. 

The article makes the point that in the interview, it was clearly Trump who was calling the shots. It goes on to cite a recent book that shows how many business leaders' attempts at gaining from backing particular presidents did not work out:

John D. Rockefeller ignored Washington as he built Standard Oil into a vast monopoly in the late 1800s. But when antitrust fervour rose in the 1890s he sought to squash it by backing William McKinley, a president he thought he had in his pocket. McKinley was assassinated in 1901. His replacement was Theodore Roosevelt, a man Standard Oil had unwisely recommended as McKinley’s vice-president because he was too much trouble as governor of New York. Thus began the Progressive Era, and the eventual dismantling of Rockefeller’s monopoly

......Lee Iacocca, who ran Ford and then Chrysler, was a master White House manoeuvrer. He helped persuade Richard Nixon to protect the car industry from Ralph Nader’s safety onslaught. He won loan guarantees for Chrysler from Jimmy Carter in the 1970s. But though he liked Ronald Reagan personally, he rejected the then-president’s free-market tilt and tried (unsuccessfully) to get more government support for his business.

The regulatory state is much bigger than it was earlier. No business leader can afford to seriously antagonise the state, however big he may be. If Musk's bet does not work out, he can pay heavily for it. But even if it does, Musk may not have it his own way- as the history of businessmen's relationship with presidents clearly indicates.

Starbucks CEO ouster: board too deserves scrutiny

The board of directors has ousted its CEO, Laxman Narasimhan, and installed a replacement. I read this detailed story about what brought about the CEO's fall- and, more interestingly- about how the board of Starbucks engineered his ouster.

Narasimhan was removed in less than two years at the helm. The story dwells at great length- and with evident relish- on the behind-the-scenes action that followed his April announcement of poor sales performance at Starbucks and the 16 per cent drop in the stock price that followed the next day. The Chairman of the board held meetings with  a leading investor and set up a meeting with Brian Niccol, Narasimhan's successor. 

A month after the April results, Satya Nadella,  Microsoft CEO, had left the board saying he was doing so with a heavy heart but while affirming full confidence in Narasimhan. The CEO had little inkling of his impending removal. Then, after everything was sewed up, came the "brutal" call from the Chairman to Narasimhan: he was out.

I must confess I read the story in some amazement. The way it is presented, we are supposed to applaud the cloak-and-dagger methods of the board in getting rid of a non-performing CEO. After going through the story carefully, however, I have a few questions:

• Where was the need for such secrecy? What if the board had conveyed to Narasimhan its discomfort with his performance and indicated to him that they might have to consider replacing him? Would the heavens have fallen? What is great about a board ambushing its CEO?
• The story says this is the third CEO change in three years. The same board had hailed Narasimhan as the "inspiring leader" Starbucks needed when it appointed him. What does this say about the board's judgement in selecting the CEO?
• The new CEO comes in with a package of $100 million, a huge increase over the package of $28 million offered to Narasimhan. What if the change does not work? Who would be accountable for the staggering package ? 
• The Chairman will cede her chair to Niccol, the new CEO, so that he is chair-cum-CEO. In governance terms, this is regressive. Separation of the two roles is considered the better option.

It may well be that Narasimhan had to go. But the board's own functioning needs to be put under the lens.That it's a star-studded board is all the more the reason to wonder about its functioning. 

Indian economy's hidden strengths

 An article in FT lists some not-so-obvious strengths of the Indian economy:

i. A leader in services, which positions it well to take advantage of the growing role of services in the global economy. In other words, missing the manufacturing bus may not be such a big loss.

ii.  A talented workforce: A large workforce in which one third of students choose a STEM degree. One might add: having such a large talent pool makes for intense competition for jobs. Whoever gets in would a high degree of competence.

iii. Entrepeneurial spirit: which makes possible Jugaad or innovation in various fields. India landed a spacecraft on the moon at a fraction of what it cost others.

iv. A large and vibrant capital market, which is crucial to raising capital and imposing market discipline on firms.

v. Resilience of the economy: being services driven makes for resilience as does a democratic system. Growth may be slower in other places but it is also steady.

Indians fret about having fallen behind in living standards. If one looks at a 75 year time frame, then the task in the initial decades for India was simply holding together as a nation: not many gave it a high chance of doing so. 

India has proved them wrong. That task accomplished, India turned its energies towards raising standards of living. We should be getting there by 2047. You have to ask yourself: how many large economies have done as well while preserving democracy? 

India must set realistic growth aspirations

The Indian economy has grown at 7 per cent p;us for three years since the pandemic and is poised for a fourth year of growth of around 7 per cent. There are many who think that if growth of 7 per cent is possible on the present basis, why not aim for even higher growth on the strength of "big bang" reforms? Why not aim at a growth rate of 8 or 9 per cent? 

India has grown at 8 per cent or 9 per cent in short spurts in the past. What we are looking at is a sustainable growth rate over the next 20 years or so until 1947 by when we hope to become a developed country, which means reaching a per capita income of $14,000 at today's prices (which is the lower end threshold of developed country status).

Leave us aside the political feasibility of the "big bang" reforms. What is the track record of growth across economies? Very few economies have grown at 7 per cent plus over 20 years. Fewer still have grown at 7 per cent after reaching Middle Income Country (MIC) status. Now, factor in the reality that the world economy is becoming less open than it was in the decades following WW2. If you take all this into account, it seems that a growth rate of 6.5 per cent (that is, a compounded annual growth rate) of 6.5 per cent over the next 20 years would be a considerable achievement. 

More on this in my last BS column, Don't count on a growth miracle.

Don’t count on a growth miracle 

In a volatile global landscape, sustained growth rate of more than 7 per cent is quite a challenge   

T T Ram Mohan

The recent Budget has assumed real gross domestic product (GDP) growth of 6.5 per cent for FY24-25. The latest Economic Survey forecasts growth of 6.5-7 per cent.  Would-be reformers in India are asking for more. They urge the government to do whatever it takes to boost GDP growth to 8, 9 or even 10 per cent. Aiming for a higher growth rate has become a sort of test of the government’s machismo.

The gratifying part of current growth aspirations is that there is a sense all around that a long-term growth rate of 6.5 per cent for India is achievable. Yet, few had forecast such an outcome, least of all after the Covid pandemic struck India in March 2020.

For years, commentators warned us  that a growth rate higher than 5-6 per cent would not be possible unless the government summoned the will to push through “second-generation” reforms. The slowdown in growth during the three years preceding the pandemic seemed to confirm these apprehensions. 

None of those reforms have happened. Yet, the economy grew at over 7 per cent for three years after the pandemic and is now poised for a fourth year of growth close to 7 per cent. 

In FY 2024, as the Economic Survey points out, the Indian economy returned to the pre-pandemic growth trajectory. This is an impressive feat. The US returned to the trajectory even earlier, then veered off and returned to the trajectory a second time. Europe is yet to get back to the pre-pandemic growth trajectory. China got back very quickly to the pre-pandemic trajectory but has since departed from it. India’s recovery appears more sure-footed. That is something to celebrate. 

High growth rates after the pandemic have been driven by rising capital expenditure at the Centre. Critics said such increases were unsustainable. They said such increases would happen at the expense of fiscal consolidation and would cause the public debt-to-gdp ratio to rise. Unless private investment picked up, growth would sputter. 

They have been proved wrong on these counts as well. The central government’s capital expenditure as a proportion of gdp has doubled from 1.7 per cent in FY20 to 3.4 per cent in FY25. Yet, the gross fiscal deficit is projected to rise from 4.6 per cent to merely 4.9 per cent of GDP.   The total public debt –to-gdp ratio fell from FY21 to FY23 and rose marginally in FY24. Growth remains robust without the desired rise in private investment. Public investment-led growth has turned out to be more sustainable than analysts had thought. 

The reforms brigade now clamours for even higher gdp growth driven by further reforms- more fiscal consolidation, more privatisation, more labour reforms, more free trade. The clamour appears disconnected from reality. It is not just that the “second-generation” reforms have proved to be politically infeasible for nearly two decades and look even more remote in today’s setting. It is that growth miracles – growth of over 7 per cent for long periods- are rare for a Middle Income Country (MIC) and will become rarer still in the emerging global economic environment. 

That is the stark message from the World Bank’s World Development Report (WDR), 2024. The report focuses on the difficulties nations face in breaking out of the “Middle Income Trap”, that is, those with annual income per capita ranging from $1,136 to $13,845. India is now a lower MIC. It seeks to join the ranks of higher income countries by 2047 by growing at least 7 per cent for the next two decades. That would mean replicating the record of South Korea, which has the finest record of breaking out of the “Middle Income Trap”. 

The WDR pours cold water on such ambitions not only for India but for other aspirants as well. It states bluntly, “Given the changes in the global economy since the time that Korea was a middle-income economy, it would be fair to conclude that it would be a miracle if today’s middle-income economies manage to do in 50 years what Korea did in just 25”. 

 

The WDR report makes a point well known to students of economics from the Solow growth model:  Increases in investment can drive growth only up to a point. Thereafter, growth happens through increases in productivity. For productivity to grow, nations can induct technologies from elsewhere or they can innovate themselves. These steps are far more difficult than the initial one of simply raising the level of investment in the economy. That’s why becoming a MIC is easier than growing from that point into a high-income country. 

 

Growth in the MICs has already shown signs of slowing. Average annual income growth in these countries slipped by nearly one-third in the first two decades of this century—from 5 per cent in the 2000s to 3.5 per cent in the 2010s. Today, MICs face a whole set of adverse conditions: geopolitical tensions and fragmentation in the world economy, higher debt servicing obligations, and the costs of climate change.

The WDR 2024 report complements the findings of a study carried out by   the World Bank in 2008 under the leadership of Nobel Laureate Michael Spence.  That study that showed that growth of over 7 per cent for over 25 years from any starting point, not just from a MIC starting point, is a tall order- only 13 economies had been able to do so. Of these, nearly half were small economies. 

The economies that had grown rapidly had had the benefit of a post- WW2 world environment that was substantially open to free trade. 

If India can manage to sustain growth of 6.5 per cent over two decades starting from a MIC status in the bleakest international environment in two decades, it would be quite a feat. Those who would aim higher think that fixing several things in the Indian economy will automatically translate into a higher growth rate. 

They are mistaken. We have to reckon with serious constraints to growth and stability that emanate from outside. The sharp rise in geopolitical tensions in recent weeks and the sell-offs in financial markets in the past week only serve to reinforce this point. The Economic Survey’s conservatism about the growth rate for FY 24-25 may turn out to have been well-founded.  

Monetary policy: Is the status quo justified?

The RBI decided to maintain the policy rate at 6.5 per cent in its Monetary Policy Statement of August 2024.

The growth forecast for FY 24-25 remains 7.2 per cent. The inflation forecast remains 4.5 per cent. What is the case for cutting the policy rate and for not cutting the rate?

i. The case for cutting the policy rate

• With inflation projected at 4.5 per cent, the real rate is 2 per cent. This is too high. A real rate of 1.0 per cent is the "neutral rate", that is, where inflation is stable and growth is maximised. So, there is adequate scope for cutting the policy rate. The problem is that the RBI's estimate of the neutral rate has changed. In FY 22, the neutral rate was estimated at 08-1 per cent. More recently, it estimates the neutral rate at 1.4-1.9 per cent. If you accept the upper end as the estimate, the present neutral rate of 2 per cent seems okay

ii. The case against cutting the policy rate:

• The neutral rate argument apart, the RBI governor has said repeatedly that the RBI wishes to move the inflation rate down to 4 per cent. Food inflation remains elevated. Cutting the policy rate at this point would thus not serve the objective of meeting the inflation target of 4 per cent.
• India's growth rate of 7.2 per cent is pretty impressive in what is the bleakest world economic environment in the past two decades. Even if growth falls to 7 per cent, that would be good enough. It is incorrect to suppose that cutting the policy rate can enhance the growth rate. Why risk higher inflation when the growth rate does not have much chance of accelerating?
• The rupee is pushing close to Rs 84 to the dollar. A cut in the rate would make it difficult for the RBI to contain the rupee below Rs 84, beyond which it does not wish to see the rupee depreciate. The stance could change if the Fed and European banks cut their rates down the road. But a rate cut at this point would be imprudent in relation to maintain stability in the rupee exchange rate.

I would add one more point to the case against cutting the policy rate: geopolitical tensions. There has been an escalation in the situation in both Ukraine and Gaza. Neither conflict has thus far affected the global economy significantly. But we don't quite know when "managed escalation"- the game that NATO and Russia and Israel and Iran and its proxies have been playing- will get out of hand. 

As I write, Israel is bracing for a massive retalisation from Iran and its Lebanese ally, Hezbollah. If a regional war breaks out, oil prices could shoot up and render all macroeconomic estimates meaningless. Better to err on the side of caution in these troubled times- especially when gdp growth is over 7 per cent.

Budget 2024-25: what is in it for AP and Bihar?

In the run up to the budget, there was talk of AP and Bihar exacting a huge price from the central government for the support extended by the ruling parties of those states to the NDA government. All sorts of figures were mentioned- one report in the media said that AP had demanded Rs 1 lakh crore.

How much exactly is the central government dishing out?

It is impossible to make out precise allocations from the budgetary papers on expenditure. All we have are indications thrown out in the budget speech.

AP gets Rs 15,000 crore in the form of a soft loan arranged by the centre from multilateral agencies. That is hardly a "cost" to the centre. The budget speech mentions a few other things:

i. Financing and early completion of the Polavaram Irrigation Project, 

ii. Funds will be provided for essential infrastructure such as water, power, railways and roads in Kopparthy node on the Vishakhapatnam-Chennai Industrial Corridor and Orvakal node on Hyderabad-Bengaluru Industrial Corridor.   

iii. Grants for backward regions of Rayalaseema, Prakasam and North Coastal Andhra, as stated in the Act, will also be provided.

I have not been able to make out the specific allocations for these projects. 

For Bihar, the budget lists various projects in the railways, power and floods and irrigation amounting to about Rs 59,000 crore but there is no mention of the time frame. Also, some of these could be projects planned by the Centre in the normal course.

 

Budget 2024-25- Job creation thrust

The budget is seen as having an almost unprecented focus on job creation through subsidies and incentives. Will these work? Here are a few thoughts.

A few weeks before the budget, the RBI put out data that showed that the economy had created about 9 crore jobs in 9 years or about a crore a year in industry and services. The Economic Survey for 2023-24 says the economy needs to create about 8 million jobs every year. So where is the problem? Are industry and services generating jobs more of the unskilled variety so that educated unemployment is the issue? What explains the budget's almost unprecedented focus on job creation through subsidies and incentives?

There are three schemes in the budget for boosting job creation. The first is a payment of up to Rs 15,000 for those entering the workforce in the formal sector. This is a sort of top-up to the wages they will be paid. It can't lead to job creation, it only rewards those who manage to get jobs. 

The second is employment-linked incentives to the employer as well as the first-time employee in manufacturing. It will be by way of a payment towards the EPFO contributions of the two parties. To the extent that it reduces the burden on the employer, it will help job creation. It is expected to benefit 3 million youth.

The third is for all sectors and will reimburse to employers up to Rs 3000 per month for two years towards their EPFO contribution to employees. This is expected to create 5 million new jobs.

At the margin, the second and third schemes lower the cost of an employee in all sectors. They may, perhaps, help in businesses where the labour cost as a proportion of sales is relatively high. 

Then we have the Internship scheme for 1 crore youth at 500 top companies over five years. The government will provide Rs 5000 as stipend and the companies will have to bear 10% of the internship cost and the cost of training. As many have pointed out, this means each company will have to give internships to 4000 youths. What happens if they don't oblige? 

Monitoring and enforcement at private companies is a huge challenge. The government has a number of schemes that it implements through banks- Jan Dhan Yojana, Jan Awas etc. It is the public sector banks that bear the brunt. Private companies get away with doing very little. The same is likely to happen with the job creation schemes. We need to track exactly how many additional jobs are created through these schemes. The finance ministry has said that all these schemes are not mandatory, they are only intended to nudge companies, so we mustn't expect a great deal from the private sector.

If the idea is create jobs on a crash basis, filling vancies in government is a better idea. If unemployed youth are to be provided help until they can find a job, a direct transfer seems more sensible- give every educated unemployed youth a monthly allowance. 

What exactly is the government spending on employment generation? The budget speech mentions expenditure of Rs 2 lakh crore over five years or about Rs 40,000 crore in each year. For FY 24-25, the specific increase in expenditure on account of employment generation is a little less than Rs 10,000 crore. 

Pre budget musings

 Outlook Business carries an interview with me on the coming budget.

Artificial intelligence yet to make an economic impact

It's common to hear about how AI is going to transform the world and lead us to undreamt of riches. Economists are sceptical. A common view in the US is that AI will, at most, help sustain productivity growth at 2 per cent, it's not going to cause any acceleration. But that doesn't stop the industry types from gushing about AI.

What we can confidently say now is that AI has so far not had any significant impact. And that seems to be because the adoption of AI by industry is quite weak. Meaning to say, businesses have not incorporated AI into their practices in ways that can transform the businesses, as an article in the Economist points out.

I will content myself with reproducing a few points: 

Official statistics agencies pose AI-related questions to firms of all varieties, and in a wider range of industries than Microsoft and LinkedIn do. America’s Census Bureau produces the best estimates. It finds only 5% of businesses have used ai in the past fortnight..... Even in San Francisco many techies admit, when pressed, that they do not fork out $20 a month for the best version of Chatgpt.

Concerns about data security, biased algorithms and hallucinations are slowing the roll-out. McDonald’s, a fast-food chain, recently canned a trial that used ai to take customers’ drive-through orders after the system started making errors, such as adding $222-worth of chicken nuggets to one diner’s bill. A consultant says that some of his clients are struck by “pilotitis”, an affliction whereby too many small ai projects make it hard to identify where to invest. Other firms are holding off on big projects because ai is developing so fast, meaning it is easy to splash out on tech that will soon be out of date.

We hear often about AI displacing a range of jobs. This hasn't happened either:

Using American data on employment by occupation, we focus on white-collar workers, who range from back-office support to copywriters. Such roles are thought to be vulnerable to ai, which is becoming better at tasks that involve logical reasoning and creativity. Despite this, the share of employment in white-collar professions is a percentage point higher than before the pandemic..

Will things change with more AI adoption? Will AI adoption happen on the scale projected? We don't know. 

India's banking sector going from strength to strength

Going through the RBI's latest Financial Stability Report (June 2024), one has to pinch oneself in disbelief. The turnaround in India's banking sector has surpassed all expectations. One key indicator: the ratio of gross NPAs to advances is 2.8 per cent, below the international benchmark of 3 per cent.

Even more surprising is the improvement in profitability, measured by return on assets, in 2023-24. Analysts had warned us that, with deposit costs rising, banks' margins would be squeezed. A greater focus on retail loans would result in higher bad loans and result in high provisions. Both these would dent banks'  returns in 2023-24. They have been proved wrong.

In my latest article in BS, I explain how this has happened:

 

FINGER ON THE PULSE

Banking sector continues to confound sceptics

It has shown remarkable resilience in the post-pandemic years despite challenges and warnings about instability

T T Ram Mohan

India’s banking sector continues to astonish. Its performance in 2023-24, revealed in the Financial Stability Report (FSR) of June 2024, is as much of a pleasant surprise as its turnaround in the preceding years.

The sector entered the first year of the Covid-19 pandemic, 2020-21, with a non-performing asset (NPA) level of 8.5 per cent of advances. Analysts warned that the improvement seen in the previous two years was in jeopardy. The chances were that NPAs would shoot up instead of declining. Vast amounts would again be needed to recapitalise public sector banks (PSBs). 

Later, as the Reserve Bank of India (RBI) announced various restructuring schemes, we were warned of the perils of “kicking the can down the road”. If you don’t recognise NPAs now, be prepared for higher NPAs to show up later, analysts said. It was better, they argued, to “bite the bullet” now. 

They were proved wrong.  Out-of-the-box thinking enabled the RBI to nudge the banking sector back to normalcy in the post-pandemic years despite the Ukraine shock and the shocks emanating from banking instability in the US and Europe. By 2022-23, NPAs had fallen to 3.9 per cent.

Fair enough, the analysts said. However,   sustaining the secular improvement in financial indicators of the previous years would be difficult in 2023-24.  Banks would face a liquidity crunch, with deposits failing to keep pace with growth in loans. The net interest margin would be squeezed and asset quality would suffer from the rapid build-up of loans. Returns were bound to fall. 

Wrong again, it turns out. Yes, banks’ liquidity at the margin was indeed stretched- the incremental credit-deposit ratio for all scheduled commercial banks was over 100 per cent, as the FSR points out. For private banks, the incremental credit-deposit ratio was nearly 120 per cent.  But banks seem to have had no difficulty in passing on the higher costs of deposits to their borrowers. The net interest margin (NIM) fell by only 1 basis point relative to the previous year (3.6 per cent compared to 3.7 per cent).  

How did banks manage to maintain NIM in the face of rising deposit rates? Well, they did so by maintaining a high rate of growth in high-yielding retail products, such as credit cards, personal loans, loans against property, and auto loans. The growth rate in these products in the past two years is a good 7 to 14 percentage points above aggregate loan growth rate of 15.4 per cent and 16.3 per cent in the years 2023-23 and 2023-24, respectively.

In what was predicted to be a challenging year for bank, the return on assets for banks as a whole increased from 1.1 per cent to 1.3 per cent. Apart from NIM staying high, several factors contributed to the improvement: A higher rate of loan growth, lower provisions, higher trading income, and higher fee income. The return on assets for PSBs is 0.9 per cent, pretty close to the figure of 1 per cent that is something of an international benchmark. We seem to be getting back to banking’s heady days of the early 2000s. 

Privatisation of PSBs, promised in successive budgets of the past, has been on hold. The privatisation of IDBI Bank, which was initiated in 2018, is yet to be completed. At a return on assets of 1 per cent, PSBs can generate enough capital through internal surpluses and from the market to sustain themselves. They will not pose large demands on the exchequer. The return to health of PSBs means that privatisation will likely lose its impetus. 

Banks have increased the share of retail and service sectors in total credit over the last two decades. Sustained growth in these sectors has so far not told on asset quality. Gross NPAs in retail loans declined from a high of 2.1 per cent in June 2022 to 1.2 per cent in March 2024. Unsecured retail lending has long been seen as a vulnerable area in retail loans. However, asset quality of unsecured retail lending too is showing improvement, with gross NPA ratio at 1.5 per cent compared to 1.6 per cent a year ago. 

It’s almost as if, after the infrastructure imbroglio of the early 2000s, banks can’t put a foot wrong now. Tighter regulation and supervision, an improvement in risk management at the bank level and better selection of leaders at PSBs through the Financial Services Institutions Bureau have all contributed to the improvement.

Can Indian banking keep going the way it has in the past few years? On the face of it, there seems to be little reason why it can’t. Banking is a play on the economy. The Indian economy looks set to grow at around 6.5 per cent over the long-term. The FSR thinks credit growth of 16-18 per cent can happen without seriously impacting asset quality.  

At the same time, competition for deposits will remain intense. Net financial saving, the FSR notes, has declined to 5.3 per cent of GDP during 2022-23 from an average of 8.0 per cent during 2013-2022. The RBI Annual Report shows that the share of deposits in gross financial savings has declined from a peak of 6.3 per cent in 2016-17 to 4 per cent in 2022-23. 

The crucial question, then, is whether retail loans can continue to drive bank revenues and profits as they have in the recent past. The FSR sounds a note of caution. It points out that household debt to GDP at 40 per cent in India is below that in emerging markets. However, in relation to GDP per capita, it is quite high.  Nevertheless, the record of the past five years suggests that we are still some distance away from the point where banks’ focus on retail loans may turn counter-productive. 

Many have commented on the remarkable resilience the Indian economy has displayed in the post-Covid years in the face of lacklustre global growth. The banking sector’s stability is a key factor underpinning that resilience. Our banking sector model drew scathing criticism from several quarters in the post-reform era. Its remarkable success in recent years should silence critics. 

RBI's growth optimism

Here is a telling quote from the RBI's Monthly Review of the economy which is in line with the upbeat assessment given by the RBI Governor recently. (Please see my previous post):V

There is increasing evidence that in the post-pandemic years, a trend upshift is taking shape, which is shifting India’s growth trajectory from the 2003-19 average of 7 per cent to the 2021-24 average of 8 per cent or even more, powered by domestic drivers.

The growth forecasts for the global economy are downbeat: global economic growth in the next five years will be below the average of the last two decades. Nevertheless, the RBI seems to suggest India can grow at 8 per cent plus on the strength of "domestic drivers". Does the RBI think the Indian economy can grow at 8 per cent even under conditions of weak global growth? Will that be on account of services exports? 

This does seem to be an altogether new appraisal of India's economic prospects. Economists have been telling us for long that an 8 per cent growth rate is out of the question without robust export growth, say, 15 per cent per annum.

There's one thing, though, that puzzles me. The Monthly Review projects growth of 7.6 per cent in 2024-25 but only 6.4 per cent in 2025-26. Will India move towards an 8 per cent trajectory thereafter or have we already move on to such a trajectory? The RBI may clarify.

 

 

A very important statement from the RBI Governor

The RBI Governor, Mr Shaktikanta Das, recently made a statement that hasn't got the attention it deserved. 

The Governor is quoted as saying:

India is at the threshold of a major structural shift in its growth trajectory, moving towards 8 per cent GDP growth in a sustained manner. We are moving towards an annual growth rate of 8 per cent.

This is by far the most optimistic official statement on the Indian economy in a long time. It is not clear what time frame the Governor has in mind for the growth rate of 8 per cent, whether it is a mediium-term forecast or a long-term forecast- the issue of the word "sustained" does suggest a fairly long time horizon.

The Chief Economic Advisor in the finance ministry has been talking of a sustained growth rate of 6.5 per cent. Many analysts have been talking of the potential for the Indian economy to grow at 8 per cent- provided various "big bang" reforms are carried out. What the RBI Governor is saying- if he has been quoted correctly in the media- is that, on present steam, the Indian economy is moving towards an 8 per cent trajectory. 

Any thoughts on this, anybody?

Unbounded optimism about AI

All of us have been reading about AI could turn into a Frankenstein monster and reduce humans to slaves.Economists have been sceptical about the boost to productivity from AI: the general view is that AI can at best sustain America's productivity growth at 2 per cent, which has been its long-term rate. It can't raise the productivity growth rate.

Along comes an article by computer scientist Ray Kurzweil that suggests that AI is about to open the doors to Paradise on earth in the years to come.  He says AI on the threshold of bring about  a transformation in three areas: energy, manufacturing and medicine.

The way to solve the world's energy problem is to rely on solar energy which is available in abundance. The challenge is to find photovoltaic materials that are inexpensive and increase the storage capacity of batteries. That is a chemistry problem- finding what combination of chemicals and materials will help address these issues. Kurzweil tells us how AI will crack this problem:

...AI can rapidly sift through billions of chemistries in simulation, and is already driving innovations in both photovoltaics and batteries. This is poised to accelerate dramatically. ... Once vastly smarter AGI finds fully optimal materials, photovoltaic megaproejcts will become viable and solar energy can be so abundant as to be almost free. 

Manufacturing will change as energy costs fall and also the costs of labour and raw materials. Robotics will reduce labour costs. It will also reduce raw material extraction costs. As for medicine, AI moleuclar biosimulations will reduce the costs implied in clinical trials and also make possible more effective drugs. We can produce medicines tailored to each individual patient. Away with disease! 

Kurzweil says longevity in the US and UK now grows by an extra six to seven weeks ever year. With AI, we may expect life expectancy to increase by 1 year annually. That means, in 30 years,life expectancy in Canada, for instance, will leap from 85 to 115!

Kurzweil's conclusion is breathaking: "This is AI's most transformative promise: longer, healthier lives unbounded by the scarcity and fraitly that have limited humanity since its beginnings. 

Makes me wonder: why on earth are economists fretting about long-term economic growth rates falling in the next ten years? 

Geopolitical risks shoot up: Russia's redline crossed

Two major conflicts have been going on for a while now, one in Ukraine and the other in Gaza. Neither has impacted the world economy in a major way except for a brief period in 2022 when oil prices rose above $100 a barrel.

But we just don't know how long it will remain that way. There has been progressive escalation in the conflict in Ukraine. It appears that a new and dangerous redline has been crossed. Ukraine sent ATACMS (Army Tactile Missile Systems) into Sevastopol in Russia's Crimean region a few days ago. Four were intercepted and one was blown up, it appears, and the debris fell on people holidaying on a beach, with an estimated five children among those killed. The ATACMS were provided by the US.

Quite recently, the Americans lifted an earlier restriction on American weapons being fired into Russia territory with the proviso that the weapons must be for military targets alone. The relaxation by America came following a broad offensive by Russia that threatened to overwhelm Ukraine's defenses in some parts. Ukraine contended that the only way to thwart the Russians was to disable the artillery and other batteries from which Ukrainian positions were being pounded. The Americans relented.

Whether the proviso was observed in the latest salvo is not clear. Some military analysts say that there is an airfield nearby but it is of little value, so the drones were intended for civilian targets. We don't know, for sure. Regardless, the loss of civilian losses has create fury across Russia and there's a demand for a punitive response.

Intelligence on targets is obtained through American satellites. The programming of the missiles is done by American technicians. The Ukrainian contribution, military analysts say, is to press the button. So it wil be hard for the US to disclaim responsibility. 

Russia summoned the American ambassador and conveyed to her that retaliatory measures would follow. There's now speculation on what these measures would entail. One conjecture is that Russia would declare the Black Sea a ' no fly' zone which means American reconnaisance satellites entering the area would be taken out. That would be an act of war. Others suggest the Russians will arm a range of parties - Iran, North Korea, etc- in ways not done earlier. Yet others say Putin will first take the issue to the UN Security Council and prepare the ground for a Russian response.

Whatever the response, it's clear that we now have a significant escalation. Why the financial markets, including our own, have not taken notice is a a mystery. It's hard to see how the global economy will remain unaffected for much longer. 

Why government should be careful in calling in management consultants

 I re-read this year-old interview with economist, Mariana Mazzucato, and I thought should post it  here.

Mazzucato is an economist who thinks the government is a force for good and that the good that governments do has been obscured by the rise of neo-liberal ideas.  She has co-authored a book, The Big Con, which contends that governments harm themselves by hiring big consulting firms to work for them. We have the usual problems, lack of genuine expertise in the firms and conflicts of interest. 

But the real problem, Mazzucato, contends is that it takes interesting work in government away from civil servants and is hence demotivating to them. The answer to finding expertise is to pay civil servants better and to give them challenging assignments,not oursourcing the work of government to consultants.

Here is an excerpt from the interview for those who can't access the interview:

For the past decade, she has waged a sometimes lonely battle to rehabilitate the state’s reputation as an economic motor. Her new book, The Big Con, written with Rosie Collington, argues that consultancies are hobbling governments’ ability to perform that role. In her office, holding a Diet Coke, she says: “For me, the big wake-up call was Brexit [preparations], because [the consultants] were everywhere.” In 2019-20, the British government spent nearly £1bn on strategy and other consultants — to the despair of some MPs. Mazzucato and Collington also widen their critique to include the Big Four accounting firms, such as Deloitte, and outsourcing companies, which carry out chunks of the state’s core functions.

Banks don't have to fear fintech

For some years now, we have been hearing about the fintech threat to banks, including large banks. It was said that these banks would use the internet or mobile to gather deposits and make loans. Thereby, they would dispense with the need for expensive brick and mortar branches. Moreover, they would provide a vastly superior customer experience- lightning fast transactions, bill payments and shopping that would work far more smoothly than anything the big bank had to offer.

Nothing of the sort has happened thus far, as this article makes clear in the case of the UK. (The UK experience is not unique; fintechs have not unseated banks anywhere). Very few fintechs make money, most of them are burning investor cash in garnerning customers. The three leading fintech ventures in the UK have been Revolut, Monzo and Starling. Ten years  after they started off - and ten years is a long time- only Starling  has turned a profit in the year ended March 2023. The other two hope to make profit in the next accounting year.

These three fintechs may have brought in a decent number of customers but they customers use them only to put through transactions on which the banks make a fee. The fintechs have yet to register a meaningful presence in the core banking functions, namely, making deposits and loans. People are not ready to place their savings in a meanginful way with the fintechs- one sure sign: the fintechs have a very low share of salary accounts. Large banks with their brick and mortar visibility inspire more confidence than fintechs. 

If you cannot take care of the funding side, you can't do much on the lending side either. Without low cost deposits, there is little competitive edge to lending. The ones they can lend to are customers whom the traditional banks won't entertain, that is, high-risk customers. Some fintechs claim to have cracked the problem with analytics and stuff but their high level of non-performing assets tells its own story. 

Finally, banks have not been idle in the face of the supposed fintech threat. They have invested hugely in technology and improvements in the customer interface. Some have got into collaboration with fintechs whereby the banks get the benefit of fancy technology and the fintechs collect a decent fee. 

The bottomline: the threatened disruption of the banking industry has not happened at all. If I were a depositor, I would go with a large bank for a simple reason: I know the authorities will not allow it to fail, so my money is safe. With a fintech, I have no such assurance. If the price I have to pay is that it takes more four seconds more to put through a transaction, I can live with that. 

Sceptical voices about AI's impact on economic growth

Will AI transform growth prospects for the world and usher in an era of greater abundance? That is what business executives and management consultants would have us believe. But serious economists are sceptical. Let me cite a few:

Daren Acemoglu of MIT cited here:

The professor ...... anticipates AI will boost GDP growth by only 0.93 percent to 1.16 percent over the next decade.

But even that figure may be too optimistic, he argues, because productivity estimates come from automating "easy tasks" – future tasks may be more complicated and less amenable to automation. He therefore contends there will be a more modest increase in TFP and GDP in the next ten years – on the order of 0.53 percent and 0.90 percent, respectively.

Nobel Laureate David Romer of NYU quoted here:

We’ve benefited from scaling up compute and ingesting a whole lot of data.... ....Scaling up compute is pretty easy. It’s just more machines, more chips. But what’s going to happen is we’re not going to have enough data. 

Charles I Jones of Stanford in a paper at the Jackson Hole Symposium last year:

*Automation has been ongoing for 200 years — stable growth ◦

*Steam engine, electricity, internal combustion, semiconductors ◦

*Maybe A.I. is the latest great idea that will allow 2% growth to be sustained a bit longer

Jones notes that long-term productivity growth in the US has been stable at 2 per cent. He reckons AI will help maintain that rate at best and prevent it from falling.