US's planned attack on Syria

Ok, if the Syrian government did launch chemical weapon attacks on its people, it deserves an international response. But here is a simple question: why is the US not willing to wait for the formal report of the UN inspectors, which, it appears, will be available in just four days' time. Note that the visit of the UN inspectors had the concurrence of the Syrian government. As usual, one must turn to Atimes for a dispassionate analysis of the unfolding situation.

In an companion piece, M K Bhadrakumar, the former Indian diplomat, argues that an American attack on Syria provides just the right argument for Iran to go ahead with its plans to acquire nuclear weapons.He also outlines the rationale for an attack that falls well short of being an all-out war:

In sum, the plan behind the "limited" attack is to degrade the Syrian armed forces. The political objective is clear. The Obama administration insists that it is not "regime change''. What it means is that the US and its allies would hope that coming under immense pressure of death and destruction, the Syrian armed forces might begin, finally, to begin to question President Bashar al-Assad's leadership quality, which, in turn, could lead to a coup against him that will not be a "regime change" and yet a sufficient-enough "regime change''.

A return to capital controls?

The government has repeatedly ruled out imposition of capital controls, other than the limited ones imposed thus far. But, the buffeting of emerging economies caused by the impending reversal of QE in the US does raise the question: should emerging economies start think of capital controls by way of putting the brakes on both large inflows and outflows? As an article in FT points out, simply having a floating exchange rate problem does not provide insurance against volatile flows:

In an excellent new paper presented at Jackson Hole, however, Professor Hélène Rey of the London Business School argued that a global cycle in credit and capital flows – driven by the US Federal Reserve’s monetary policy – means that even a floating exchange rate does not give a country control over its own destiny. The trilemma is, in truth, a dilemma. The choice is this: impose capital controls or let the Fed run your economy....... She recommended targeted capital controls, tough bank regulation, and domestic policy to cool off credit booms.

If emerging markets are not to be at the mercy of the Fed and if they are to avoid capital controls, then we need a substantive reform in the international financial system: a move towards an international reserve other than the dollar. This proposal, while talked of for years, has gone nowhere. So, it would be prudent for emerging economies to have counter-cyclical checks on capital flows in order to damp down excesses. If there can be counter-cyclical capital requirements for banks, why not counter-cyclical controls on capital flows?

Does falling rupee point to economic mismanagement?

There is renewed talk of a 1991-like crisis following the steep fall in the rupee in recent days. It's good that Kaushik Basu of the World Bank has joined D Subbarao and others in quashing such speculation, much of it coming from ill-informed corporate chieftains.

Many points have been made by way of dispelling such talk- notably, the fact that forex reserves are now worth 7 months imports (instead of a couple of weeks in 1991), India's low external debt, a vastly improved private sector. But, perhaps, the most compelling point to make is that one of the root causes of the 1991 crisis, a fixed exchange rate, is now missing. A floating rate is an automatic adjustment mechanism in the face of a widening current account deficit. When the current account deficit widens, the currency depreciates; exports should go up, imports should go down (although how much depends on elasticities of exports and imports) and the deficit gets bridged as a result.

This self-correcting process can come unstuck for two reasons: one, inflation rises as a result of depreication and renders domestic goods uncompetitive; two, as the current account deficit widens and inflation rises, foreigners lose confidence in the economy and decide to fee, so it becomes difficult to finance the current account deficit. This could cause the currency to go into free fall. Now, let's apply these principles to the current Indian situation.

It should be clear that it's okay if the rupee depreciates as long as there is orderly depreciation. How much should the rupee depreciate? Here, it's useful to go by the real effective exchange rate (reer). This is the exchange rate after factoring in inflation rate differentials between a given country and its trading partners. The reer of the rupee, weighted by trade with respect to 36 currencies, had depreciated by just 3% in June over the previous year. Over 2005-13, the depreciation was 6%. These are both well within the RBI's comfort zone of an annual variation of reer of 5%. If we factor in weak global trade, then certainly a case existed for a fall in the rupee before the recent decline to Rs 65 (and bounce-back to 63).

A second reason for rupee depreciation is that the Fed is poised to taper off quantitative easing. This will mean a reversal of the flows that came in flooding post the 2007 financial crisis. All emerging market currencies are getting beaten as a result; India is no exception.

Thirdly, as the RBI has indicated in its latest annual report, there is evidence that some of the decline in the rupee is on account of speculative trades- non-deliverable forwards (NDF)- being carried out by MNC banks in the overseas markets. They seem to have been selling short overseas and buying forward here.

Which part of the above can be said to constitute economic mismanagement? The current account deficit has grown wider for a number of reasons. Slowing global trade (no fault of the government); a fall in mineral exports because of a Supreme Court ban on mining in certain places (not much the government can do in the short-run); an increase in coal imports (partly because Coal India cannot expand mining because of environmental and forest area issues); and an increase in gold imports, thanks partly to sustained high inflation. Now, you could blame the government for some of the inflation because it did not contain the fiscal deficit in time. But much of the inflation is food-driven and there is not much the government can do about this either in the short-run (especially in so far as it relates to non-cereal food items).

In short, the government-bashing and talk of 'policy paralysis' we have seen are, in my view, overdone. Certainly, the government needs to do what it can to expedite clearances and see projects through to completion. But issues such as environmental clearance and land acquisition involve questions of trade-off between growth and equity that cannot be resolved in a hurry.

What does the new RBI governor need to do in this messy situation? The RBI must reverse the moves to tighten liquidity in recent weeks (some of this has just happened) and then try to ease interest rates. Further fiscal austerity must be avoided. A focus on fiscal and monetary policy to support growth plus Re depreciation plus a gradual revival in economic growth is what we must bank on.

More in my article in the Hindu, A new note on Mint Street.

Funds exiting the US too!

Everybody understands that emerging market currencies, including the Indian rupee, have tumbled largely in response to the expectation that the Fed will taper off quantitative easing (QE)in the months to come. With QE, the Fed buys long-term US securities; this increases money supply in the US, not all of which can be absorbed within the US. Much of it has been spilling into emerging markets. When QE is tapered off (that is, withdrawn gradually), US money supply will fall, bond yields will rise, thus pulling funds out of emerging markets back into the US.

So far, so good. But if US funds are heading back into the US, foreign funds, notably from China and Japan, are leaving the US, as an article in the FT points out. Foreigners have turned net sellers of US securities. Chinese and Japanese funds are exiting the US:

Net sales of long term securities in June came to $66.9bn. This is the biggest sell-off since August 2007 when foreigners sold $72.9bn of such securities as the credit crunch provided the curtain raiser for the financial crisis.

The focus of the sell off in June was primarily in the bond market where cumulative net sales of Treasuries and government agency bonds amounted to $95.2bn in the three months to the end of June. But equities were hit too. Net sales by foreigners of $25.5bn amounted to the second biggest disposal of the past 35 years, after the record sale of $39bn in August 2007.

Why are China and Japan exiting the US? Because they want to boost domestic consumption. This means a fall in saving and hence a fall in surpluses that can be exported to the US. If the Fed is tapering off QE and big investors in US securities, such as China and Japan, are exiting, then we should see a significant rise in bond yields in the US. That bodes ill for investment in emerging markets, especially emerging market bonds.

The Dawn on the LOC killings

In contrast to the jingoistic voices heard in the Indian media, particularly TV, the Dawn's edit on the subject is a model of restraint and sobriety:

In fact, the ‘peace process’ is not really there; India cannot put aside the 2008 Mumbai attacks and Pakistan has failed to rein in the militants. The latter are well-armed and well-funded and some of them have brought the two nuclear-armed neighbours to the verge of war twice since 9/11. Here lies the test for the two sides: will Islamabad and New Delhi hand the militants a diplomatic win by shying away from peace? On this point the two sides must be clear. 

....The 2003 ceasefire agreement has largely held but can be further reinforced and made durable given that there has been an increase in LoC tensions since January. And although the level of infiltration into India-held Kashmir has gone down considerably, Pakistan must make it a priority to cripple all attempts made by militants to sabotage peace efforts between the two countries.

Now you know why I am such a great admirer of the Dawn. I hope some day I will get a chance to go to Pakistan. If I do, I will make it a point to visit the office of the Dawn and tell the journalists there how much I have respected and admired their writings over the years. 

Bhagwati on Bhagwati versus Sen

Jagdish Bhagwati is at his polemical best in his piece in today's Business Standard. He points out the differences between himself and Sen, of course, but the the juicy bits are about the dirt that Sen's detractors (including the BJP) have dug up on Sen following his declaration that he didn't think Narendra Modi was PM material:

Having dragged himself into the political maelstrom, Mr. Sen now faces predictably gutter politics, as (I am told) lascivious photos of his actress daughter are now circulating on the internet. His appointment of himself as the Chancellor of the new Nalanda University and of an unknown academic as the Vice Chancellor at an astonishingly high salary has led to accusations of corruption. In fact, the former President of India Abdul Kalam  had written a letter saying, among other distressed complaints, that these functionaries would have to reside in Nalanda, which letter was suppressed and has now been released under the Freedom of Information Act. It now seems also as if Mr. Sen asked for and accepted a million dollars from BJP Finance Minister Yashwant Sinha for his new NGO, whereas I have not asked for a Rupee or received any financing from the BJP I am supposed by Mr. Sen’s media friends to be supporting. As Alexander Pope wrote, everything seems yellow to the jaundiced eye.

Bhagwati is scathing about those who contend that there are no basic differences between him and Sen:

Many argue that there are none (no differences). Montek Ahluwalia and Kaushik Basu from GOI have said so: but they are both bureaucrats and no one expects them to offer sincere opinions. Some also fall victim to the cultural tradition of obfuscation implied by Asti Nasti. Others feel uncomfortable challenging celebrities and are into the 'Sashtanga Pranam' mode which requires pretending that both sides are saying the same thing and are therefore both are right.
Surprisingly, the Finance Minister Mr. Chidambaram, who is a brilliant man with a gift for writing (I once released his book of essays written while he was out of power and said that he wrote so well that one wished that he was more often out of power!), has fallen victim to this fallacy. He is seduced by his cleaver phrasing, saying that Bhagwati has a passion for growth whereas Sen has compassion for the poor. But that is precisely where he goes wrong and where we must focus to put Mr. Sen in his place, which is certainly not on a pedestal.

I doubt that Basu, who is now Chief Economist at World Bank and was Chair professor at Cornell,  will like being labelled a 'bureaucrat'!

Indians on a house purchasing spree in UK

The Indian economy may be experiencing a severe downturn but that isn't hurting the money-bags. Wealthy Indians are buying up houses in Mayfair, an exclusive neighbourhood of London, the Economist reports, paying up to $5400 a square foot (Rs 33 lakhs). That would translate into a cool Rs 65 crore for a 2000 sq foot house. Not a big deal, considering that housing doesn't come cheap in India either and the prices in Mumbai would not be much lower:

Last year almost a quarter of the houses and flats that sold in Mayfair were bought—for up to £3,500 ($5,400) per square foot—by Indians, according to Peter Wetherell, an estate agent, making them the second biggest buyers after Britons. Russians and other Europeans, whose lust for prime London property is more often blamed for pushing up prices, were responsible for a similar proportion between them.

Early in the morning, St James’s Park resembles Lodi Gardens in Delhi or the Hanging Gardens in Mumbai, such is the procession of well-heeled Indians perambulating around it. They are overwatched from the Mall by the lavish quarters of a family of ex-India industrialists, the Hinduja brothers—bought from the queen and renovated at an estimated cost of £50m.

The Economist worries that while the Indian rich may be investing in property in the UK, they don't seem to be much interested in investing in business nor is trade with UK picking up. 

State is the primary driver of innovation

Everybody associates innovation with private entrepreneurship if not individual genius; the state is the great stifler of innovation. Rubbish, says a recent book reviewed in the FT by Martin Wolf.

It is known, but not widely recognised, that most of the great innovations of our time have come out of public funded research at private institutions, notably universities. The book goes further and contends that public institutions themselves have driven research in a big way :

Mazzucato notes that “75 per cent of the new molecular entities [approved by the Food and Drug Administration between 1993 and 2004] trace their research ... to publicly funded National Institutes of Health (NIH) labs in the US”. The UK’s Medical Research Council discovered monoclonal antibodies, which are the foundation of biotechnology. Such discoveries are then handed cheaply to private companies that reap huge profits.

A perhaps even more potent example is the information and communications revolution. The US National Science Foundation funded the algorithm that drove Google’s search engine. Early funding for Apple came from the US government’s Small Business Investment Company. Moreover, “All the technologies which make the iPhone ‘smart’ are also state-funded ... the internet, wireless networks, the global positioning system, microelectronics, touchscreen displays and the latest voice-activated SIRI personal assistant.” Apple put this together, brilliantly. But it was gathering the fruit of seven decades of state-supported innovation.

This book, needs to be read with Chinese economist Justin Lin's book, which argued that industrial policy or targeting of particular sectors by the state, has played a key role in growth. What emerges is a different view of the state from what we have been asked to believe in recent years: the state as the primary engine rather than mere facilitator or provider of law and order and defence.

Wolf's conclusion is worth quoting and worth remembering the next time somebody brays about 'rolling back the state':

The failure to recognise the role of the government in driving innovation may well be the greatest threat to rising prosperity.