Nobel for Economics

FT has two interesting articles on this year's Nobel for Economics, one by John  Kay and the other by Tim Harford (of Undercover Economist fame). They make a point that many others have made, that two of Nobel Laureates, Eugene Fama and Robert Shiller, got the award for holding rather contradictory views. Fama propounded the theory that markets are efficient, that is, securities prices reflect all available information. Shiller contended that markets are prone to bubbles and that volatility in stock prices exceeds what can be ascribed to new information.

Who is right? Well, in a way, I suppose both are. Markets tend towards efficiency; the fact that they deviate from efficiency often or even for long periods does not refute Fama's basic postulate. As Harford points out, one big outcome has to been to discredit stock analysts and stock pickers in general. It's far better in terms of returns and far more cost effective simply to invest in a basket that mimics the market.

The popular view is that the sub-prime crisis arose from the belief in market efficiency and that this belief underlies the crisis. Harford makes an interesting point: true believers in market efficiency would have wondered how safe (AAA securities) could yield such high returns and would have stayed away from these.

I guess the point about the crisis is that the banks ventured into activities that are more the preserve the capital markets; poor regulation allowed them to do so. Capital markets may not be efficient at all times but that does not diminish their role. Banks too have their traditional role but they must be careful not to stray away from it and involve themselves heavily in capital markets.

The Nobel:how the news is given out and what makes it great

Nobel Laureate Peter Higgs chose to disappear on a holiday without his mobile to evade the media frenzy that follows the announcement. He must have been pretty sure he would win- and, of course, he was heavily tipped to.

How the news is given and how it is received is a story in itself- and it's well told here. Often, people are disbelieving: how could they be sure it's not a hoax? Sometimes, there is a stunned silence. At other times, people just want to be by themselves to digest the enormity of it all. Those tipped to win will be more than a little tense on the given day - if it's a Tuesday, it's Chemistry, Wednesdays are for the Physics prize-and Economics the following Monday. These prizes are announced by the permanent secretary to the Royal Academy of Sciences of Sweden. Peace, medicine, literature- these are left to others.

FT has a good article on why the Nobel remains the most sought after and respected, despite attempts by other endowments to outdo the Nobel in terms of money.

America Inc rules again

American firms have muscled their way back into nine of the top ten slots amongst global firms in terms of market cap. In 2009, only the US had only three firms in the list. Post-crisis, it seemed the US was headed for a decline. For the nth time, the US is to prove the naysayers wrong. The US economy is recovering better than Europe and it's emerging markets that are slipping up of late.

The Economist gives the reasons why America's renewed ascendance in the business world:

A perky stockmarket is partly responsible. The euro crisis has killed off any hope that more firms from the euro zone might scale the rankings: the currency block has just four firms in the top 50 (see article).
Two deeper factors are also at play, though. First, America’s mix of resilience and renewal. Three of its nine biggest firms have their roots in a 16-year period in the late 19th century—Exxon, General Electric and Johnson & Johnson. Their durability reflects their powerful corporate cultures. But the country still does creative destruction, too. IBM and Intel have slid down the rankings to be replaced by Apple and Google. Chevron, an energy firm, has gone from a laggard to a world-beater. Success has been anything but parochial. Six of the nine biggest firms sell more abroad than at home.

Second, the old rule that buying shares in state firms is investment suicide has reasserted itself. The world’s ten biggest state firms in 2009 have lost $2.2 trillion of value, or 60%, from their peaks. Lower commodity prices are only partly to blame. Investors now award most state firms stingier valuations than their private peers. Gazprom is worth three times its profits, versus Exxon’s multiple of 11. And although emerging economies have slowed, nimble private firms are doing fine. In 2007 investors gorged on shares in PetroChina when it listed in Shanghai, briefly making it the only firm ever to be worth over $1 trillion. Now China’s hottest corporate property is Alibaba, a private internet firm plotting a huge flotation.

The Economist may be exulting too soon over the falling fortunes of state firms. Nobody gave these firms the ghost of a chance of being highly valued, say, 10 years ago. But they did become a force to reckon with. With improvements in governance, restructuring and better market orientation, they could well reinvent themselves. The Economist had its ideological basis but it's too early to write off state-owned firms everywhere. 

Why McKinsey will stay at the top

Economist columnist Schumpeter takes a look at McKinsey's future while reviewing two books, one on the firm and another on consulting in general.

The big challenge to the to consulting firms comes from lower-priced competitors, some of whom use consultants who once worked for the big three. I doubt that lower prices will take away the bulk of the top three consultants' business- the companies who hire them are hardly the price-sensitive variety.

As Schumpeter correctly points out, McKinsey's strengths are talent, investment in knowledge creation and a network of alumni who are happy to use its services. In most companies, the people running them are so busy with operational matters that they just don't have the time or the mental space to strategise or even analyse information systematically. The bright minds at consulting firms do just that. Whether this adds value or not is not clear. But it serves a purpose akin that of the psychiatrist counselling patients:

Though lesser firms may be facing disruption, McKinsey dispenses a special sort of consultorial fairy-dust that is hard to replicate, and as much in demand as ever. The global ruling class is seized with a toxic combination of status-obsession and status-insecurity. Decision-makers also fear being swept away by one of Mr Christensen’s disruptive forces. They seek constant reassurance and reaffirmation from prestigious institutions. McKinsey knows better than almost anyone how to exploit this peculiar mindset. That will guarantee the Firm a solid future, even if no one can prove that its advice actually does any good.

Raghuram Rajan's maiden monetary policy

Rajan's maiden monetary policy produced a blizzard of instant commentaries. I thought I would wait and see how things pan out in the markets. The wait was worth it. I am not inclined to buy the contention that the policy is primarily about fighting inflation. I think it is more about maintaining currency stability.

Why do I say so? Well, the policy caused short-term rates to fall by a cut in the MSF rate. However, the hike in the repo rate will cause long-term rates to rise. The net effect should be an increase in banks' cost of funds and hence in lending rates. It cannot be otherwise if the policy is anti-inflationary. You can't have an anti-inflationary stance that causes lending rates to fall!

Rajan's maiden policy is undoubtedly anti-inflationary. But I would think that Subbarao's tightening in July was even more so. There was a rise of nearly 300 bps in short-term rates- and it was only a matter of time before long-term rates followed suit. That would have really slammed the brakes on growth. So Rajan has loosened policy somewhat, albeit at the short end.

If the focus had been primarily on inflation, then such a loosening would not have been warranted. The hike in the repo rate, which is meant to offset the cut in the MSF rate, is intended to maintain a decent differential between yields in India and those in the US ahead of tapering. It is a sort of preparation for the inevitable tapering of QE that lies ahead. Evidently, the RBI takes a rather grim view of what tapering would mean for India.

More in article in the Hindu, RBI focus still on currency stability.

Raghuram Rajan's diagnosis

Somebody sent me the link to an article on the Indian economic situation that Raghuram Rajan wrote just before he became RBI governor. It does not seem to have received the attention it deserves.

Rajan does not contend that the present situation is the result of serious economic mismanagement or that it can be rectified only through sweeping reforms, as many critics of the government do. Instead, his thesis - allow me to say that it is one that I have myself been peddling for quite some time- seems to be that the current situation is the result of a combination of adverse factors of a transient variety. They can be addressed through modest initiatives, it is not as if we need to unveil the entire panoply of 'second generation' reforms. I will let Rajan speak for himself:

In part, India’s slowdown paradoxically reflects the substantial fiscal and monetary stimulus that its policymakers, like those in all major emerging markets, injected into its economy in the aftermath of the 2008 financial crisis. The resulting growth spurt led to inflation, especially because the world did not slide into a second Great Depression, as was originally feared. So monetary policy has since remained tight, with high interest rates contributing to slowing investment and consumption.

Moreover, India’s institutions for allocating natural resources, granting clearances, and acquiring land were overwhelmed during the period of strong growth. India’s investigative agencies, judiciary, and press began examining allegations of large-scale corruption. As bureaucratic decision-making became more risk-averse, many large projects ground to a halt.

Only now, as the government creates new institutions to accelerate decision-making and implement transparent processes, are these projects being cleared to proceed. Once restarted, it will take time for these projects to be completed, at which point output will increase significantly.

Finally, export growth slowed, not primarily because Indian goods suddenly became uncompetitive, but because growth in the country’s traditional export markets decelerated.

 And how do we fix these?

The immediate tasks are more mundane, but they are also more feasible: clearing projects, reducing poorly targeted subsidies, and finding more ways to narrow the current-account deficit and ease its financing. Over the last year, the government has been pursuing this agenda, which is already showing some early results. For example, the external deficit is narrowing sharply on the back of higher exports and lower imports.

Every small step helps, and the combination of small steps adds up to large strides. But, while the government certainly should have acted faster and earlier, the public mood is turning to depression amid a cacophony of criticism and self-doubt that has obscured the forward movement.

There is no suggestion in the above of serious economic mismanagement on the part of UPA II. True, the fiscal deficit increased to an uncomfortable level post the crisis. But that is at least partly because the sharp slowdown in growth in recent years- caused, to  a large extent, by the sputtering of the Eurozone and the rest of the world- just could not have been anticipated. 

IAS/ IPS officers can now get medical treatment abroad!

I haven't seen any news item about the above, and I got to know about it when I read a great piece by Rama Baru in the Hindu:

The Government of India’s Department of Personnel and Training (DoPT) has decided to reimburse approved expenditure on treatment abroad, for a defined range of medical conditions, for officers of the Indian Administrative Service (IAS) and Indian Police Service (IPS). In doing so, it is extending to them a benefit available to Members of Parliament and officers of the Indian Foreign Service (IFS) when posted abroad. In addition, the travel and treatment costs for the officer and an attendant will be borne by the government. The order confers benefits over and above the entitlements under the Central Government Health Scheme (CGHS).

The existing rules, according to Baru, are as follows: 

Existing rules permit civil servants to secure reimbursement for medical treatment abroad or at a private hospital in India based on what it would cost to secure the same treatment in a private ward at the All India Institute of Medical Sciences (AIIMS), New Delhi.

If the government wishes to reimburse treatment of IAS/IPS officers at actual rates at a private hospital in India (and not at the AIIMS rate), it would be understandable. Allowing officers to go abroad for treatment is a different matter. The move, alas, will only reinforce popular perceptions of the collusion between politicians and babus in appropriating the spoils of government. The conclusion that most people will draw is that now that the politicians have done the babus a big favour, they can count on the babus to help them out where required.

I do not know whether MPs have raised this issue in parliament; if they have not, that would not be a surprise. Netas already enjoy the privilege that the babus will now get.

PS: After writing the above post, I checked the news online. It appears that medical treatment abroad will be permitted only for certain complicated ailments, which are mentioned in the order. Presumably, these are ailments for which comparable treatments are not available in India. This point is not properly reflected in the article I have cited. I have had to tone done my criticism somewhat and have modified my original post accordingly. I am hesitant to take my criticism back entirely. Which ailment requires treatment abroad is a matter of judgement and  such judgement, in our scheme of things, may end up being exercised independently of the merits of a given case.

Modi for PM: why did Advani want to wait until November?

Advani (and, until the last minute, Sushma Swaraj) is said to have asked the BJP top brass to defer Modi's anointment as PM candidate until November. Many people see this as mere pique on the part of the old warhorse or even a mere stalling tactic: put off the decision first, then get it spiked. Veteran columnist Rajinder Puri has a more plausible explanation:

What is so important about the November assembly results? Mr. Modi’s candidature as future PM raises some misgivings among potential future allies for a coalition government. That is why it is necessary for the party to obtain an outright or a near clear majority on its own if he is to be the next PM. Going by media reports, the reaction of its party workers, and opinion polls, BJP leaders are convinced there is a nationwide tidal wave in Mr. Modi’s favour that renders single party majority likely. However there is as yet no tangible evidence of this support translating into votes.......

....In November all the BJP units going to the polls are expected to comfortably win with or without Mr. Modi’s support. Except the Delhi assembly election in which the BJP sits in opposition. Delhi therefore will test in November how far Mr. Modi’s perceived charisma can deliver results. That is why perhaps Mr. Advani and Mrs. Swaraj want to delay Mr. Modi’s candidature as next PM till after the November poll. If BJP cannot win Delhi there could be serious rethinking and the party would need a prime ministerial candidate acceptable to potential allies who would be badly needed. 

Puri also suggests that, in the event that neither the BJP nor the Congress is able to form a government, there could be an effort to install Mr Pranab Mukherjee as PM. 

In November all the BJP units going to the polls are expected to comfortably win with or without Mr. Modi’s support. Except the Delhi assembly election in which the BJP sits in opposition. Delhi therefore will test in November how far Mr. Modi’s perceived charisma can deliver results. That is why perhaps Mr. Advani and Mrs. Swaraj want to delay Mr. Modi’s candidature as next PM till after the November poll. If BJP cannot win Delhi there could be serious rethinking and the party would need a prime ministerial candidate acceptable to potential allies who would be badly needed. - See more at: http://www.boloji.com/index.cfm?md=Content&sd=Articles&ArticleID=14933#sthash.D1TpHSWh.dpuf

What is so important about the November assembly results? Mr. Modi’s candidature as future PM raises some misgivings among potential future allies for a coalition government. That is why it is necessary for the party to obtain an outright or a near clear majority on its own if he is to be the next PM. Going by media reports, the reaction of its party workers, and opinion polls, BJP leaders are convinced there is a nationwide tidal wave in Mr. Modi’s favour that renders single party majority likely. However there is as yet no tangible evidence of this support translating into votes. - See more at: http://www.boloji.com/index.cfm?md=Content&sd=Articles&ArticleID=14933#sthash.D1TpHSWh.dpuf

What is so important about the November assembly results? Mr. Modi’s candidature as future PM raises some misgivings among potential future allies for a coalition government. That is why it is necessary for the party to obtain an outright or a near clear majority on its own if he is to be the next PM. Going by media reports, the reaction of its party workers, and opinion polls, BJP leaders are convinced there is a nationwide tidal wave in Mr. Modi’s favour that renders single party majority likely. However there is as yet no tangible evidence of this support translating into votes - See more at: http://www.boloji.com/index.cfm?md=Content&sd=Articles&ArticleID=14933#sthash.D1TpHSWh.dpuf

What is so important about the November assembly results? Mr. Modi’s candidature as future PM raises some misgivings among potential future allies for a coalition government. That is why it is necessary for the party to obtain an outright or a near clear majority on its own if he is to be the next PM. Going by media reports, the reaction of its party workers, and opinion polls, BJP leaders are convinced there is a nationwide tidal wave in Mr. Modi’s favour that renders single party majority likely. However there is as yet no tangible evidence of this support translating into votes - See more at: http://www.boloji.com/index.cfm?md=Content&sd=Articles&ArticleID=14933#sthash.D1TpHSWh.dpuf

What is so important about the November assembly results? Mr. Modi’s candidature as future PM raises some misgivings among potential future allies for a coalition government. That is why it is necessary for the party to obtain an outright or a near clear majority on its own if he is to be the next PM. Going by media reports, the reaction of its party workers, and opinion polls, BJP leaders are convinced there is a nationwide tidal wave in Mr. Modi’s favour that renders single party majority likely. However there is as yet no tangible evidence of this support translating into votes - See more at: http://www.boloji.com/index.cfm?md=Content&sd=Articles&ArticleID=14933#sthash.D1TpHSWh.dpuf

What is so important about the November assembly results? Mr. Modi’s candidature as future PM raises some misgivings among potential future allies for a coalition government. That is why it is necessary for the party to obtain an outright or a near clear majority on its own if he is to be the next PM. Going by media reports, the reaction of its party workers, and opinion polls, BJP leaders are convinced there is a nationwide tidal wave in Mr. Modi’s favour that renders single party majority likely. However there is as yet no tangible evidence of this support translating into votes - See more at: http://www.boloji.com/index.cfm?md=Content&sd=Articles&ArticleID=14933#sthash.D1TpHSWh.dpuf

What is so important about the November assembly results? Mr. Modi’s candidature as future PM raises some misgivings among potential future allies for a coalition government. That is why it is necessary for the party to obtain an outright or a near clear majority on its own if he is to be the next PM. Going by media reports, the reaction of its party workers, and opinion polls, BJP leaders are convinced there is a nationwide tidal wave in Mr. Modi’s favour that renders single party majority likely. However there is as yet no tangible evidence of this support translating into votes - See more at: http://www.boloji.com/index.cfm?md=Content&sd=Articles&ArticleID=14933#sthash.D1TpHSWh.dpuf

A spy novel- in more senses than one

Does the name Valerie Plame mean anything to you? Well, during the second Iraq war, she shot into unwanted fame as a CIA spy who was keeping tabs on Iran. And the people responsible for her getting unmasked were none other than those in the inner circle around President George Bush. They were upset that her husband, a diplomat, was not toeing the official line about Saddam Hussein having weapons of mass destruction- and sought revenge in the pettiest of ways by exposing his wife, who had spent many years living dangerously for the CIA. Plame's life became hell thereafter, with friends deserting the family and the couple getting death threats and what not.

At that time, Bush is said to have quipped rather callously that Plame was "fair game", meaning it was okay for his buddies to go after her. Plame wrote a book about the affair which was then made into a movie. The movie was a hit not least because the heroine in real life was everything you expect a lady spy to be - blonde, beautiful and very bright. Although Plame did tell interviewers that women, who were spies, did not necessarily conform to the James Bond version. As she put it then, the CIA had not invested a huge amount in her training so that she could go "horizontal".

Now Plame has come out with a spy novel, Blowback. Gillian  Tett reviews it in FT. Tett's conclusion is sobering:

The next time I read a newspaper story about western efforts to prevent Iran from obtaining a nuclear bomb (or Syria from spreading chemical weapons), I will ponder the twists of that Plame-cum-Pierson tale. If nothing else, it is a timely reminder that behind all the stories about Iran and Syria there is a second tale too: hordes of hidden young intelligence officers toiling away to make sense of events, in tough and (often) thankless jobs. And, for the most part, battling in complete silence.

QE reversal: does India face a financial emergency?

This is the question more than one reader of this blog has posed to me in recent weeks. I hope the appreciation of the rupee and the rise in the Sensex in recent days has assuaged their concerns somewhat. My own view has been that, yes, it is a challenging time but hardly cause for panic. The fall of the rupee below Rs 65 was a case of overshooting, so it is no surprise to find it oscillating between Rs 60 and Rs 65.

I guess the key question is: what happens when the Fed reverses QE? It is expected to make its intentions clearer on September 18. There is a view that this will unleash a tidal wave of withdrawal of funds that will devastate emerging markets, as in the East Asian crisis of 1997; India is in for a beating.

I had a look at the data on FII flows, and I am not persuaded. Since end May, when the Fed first gave indications of tapering the QE, only $3 bn has left the equity market (until September 6); most of the flight has been on account of investment in debt, $9 bn. Cumulative FII investment in equity is $137bn at the moment; that in debt only $28 bn. Even if more of the investment in debt leaves, that is not an issue. We face a serious problem only if there is an exodus of equity. The considerations underlying debt flows are quite different from those underlying equity flows. Debt will flee the moment interest rates in the US and the advanced world perk up; equity flows will flee only if growth opportunities change dramatically.

In the East Asian crisis, the exodus happened mainly account of foreign bank loans (which is similar in characteristics to FII investment in debt) and domestic residents taking their savings abroad, thanks to full capital account convertibility. (That is why the reduction in annual remittances of Indians from $200,000 to $75,000 is a sensible move). FII flows were not a crucial factor in the  East Asian exodus.

There are other differences as well between East Asia in 1997 and the current situation. I highlight these and make the point that emerging markets remain vulnerable in the long-term to advanced economy monetary policies unless they impose some restrictions on volatile capital flows- all this in my article in the Hindu, Easing troubles in the long run.

Raghuram Rajan's arrival

The  media went to town about Rajan's "rocking" arrival speech. Although Rajan had been careful to downplay expectations by warning that he did not have a 'magic wand' for India's problems, the media came close to suggesting that he was on his way to waving away India's economic woes. Some of the stuff I heard on TV sounded absurd: a century on debut; no, a century in the first session of play; and if this was his performance in the first session, what might one expect in the slog overs? Even by the abysmal standards of private channels these days, this was the pits.

Ok, so what did we have on the first day? Monetary policy, whether interest rates would be lowered or kept where they are, was deferred to the policy statement, which itself was deferred by a few days. RBI to offer low-cost hedging for banks that bring in NRI deposits in foreign currency. But this means the RBI is indeed focusing on currency stability and not just price stability. At the very least, commentators might have noted that Rajan was not strictly adhering to the ideology of focusing on price stability alone. 

Most of the announcements were about financial sector reform, mainly banking. New bank licenses to screened by a committee headed by Bimal Jalan (Jalan, if I am not mistaken, has had reservations about corporates getting into banking); a committee on financial inclusion under Nachiket Mor; SLR to be brought down once government finances improve, which is easier said than done.

Bank branch licenses to be made freely available except in the case of banks where RBI has concerns. Much was made of this but, as many bankers pointed out subsequently, getting branch licenses is not a problem today. Getting banks to apply has the effect of imposing a certain discipline on banks- they get to thinking through the commercial and other aspects more carefully- and it is also a means for the RBI to convey messages to banks (on say, customer service). So dispensing entirely with branch licensing might sound like "big bang reform" but may not be that.

What else? An inflation-linked bond. How will these be sold? Through banks? If so, what will be their motivation to push these at the cost of their own deposits. And, if it is sold through other agencies and works perfectly, what happens to deposit growth, the sheet anchor of our banking system? Gold bonds might be a better idea, so that idle gold is monetised and the need for gold imports is reduced but Rajan was silent on this. As for going after promoters with high NPAs, that's too much to expect in India's brand of crony capitalism.

It was left to FT to strike a cautionary note in its Lex column. How to stabilise the rupee is the main issue and this might require work outside the RBI; the G-20 declaration to create a fund for the purpose is a sign that all central banks feel helpless in the wake of the impending reversal of QE, not just the RBI.  Good to have a classy governor at the RBI but any euphoria is misplaced.

Subbarao rocks (or plans to)

Subbarao plans to learn Salsa after retirement. Other things on his wish-list include: making up with his mother-in-law (who is upset about soaring prices), watching matinee shows and studying math an linguistics. One thing he will not miss: having to say something profound every time he opens his mouth (he says he was asked about the world economy when he was at a wedding at 4 00 am!) For more cracks, see this post.

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.