Saturday, January 30, 2010

End of Cheap Money Policy

It was an expected move. Well before the Reserve Bank of India reviewed its quarterly monetary policy, many analysts and reports had predicted that the central bank would start tightening money supply. Changing the course of the RBI’s one-year old money policy without affecting the growth sentiments and disrupting the equity markets was an uphill task. But the RBI seemed to have done that, perfectly.

Though a hike in the CRR, or the portion of deposits banks are required to park with the RBI, was expected, the actual rise is higher than what many market analysts and industrialists forecast. D Subbarao, the RBI Governor who believes the central bank has an active role to play in reining in prices, hiked the CRR by 75 basis points to 5.75 percent, higher than the expected 50 basis points or 0.5 percentage points.

"As a result of this increase in the CRR, about Rs 36,000 crore of excess liquidity will be absorbed from the system," Subbarao told the chief executives of commercial banks in New Delhi on Friday.

The initial reaction to the CRR-hike was slightly overheated. The Sensex, the benchmark index of the Bombay Stock Exchange, which was trading in the red since Friday morning on fears of interest rate hike, crashed over 250 points soon after the RBI Governor announced the latest review of its monetary policy. Market analysts and economists called it an “aggressive” move of the central bank.

“The market was expecting a 0.50 percent hike in CRR -- I feel the 0.75 percent is slightly aggressive. It is more a pre-emptive move to control inflationary expectations," Bank of Baroda's chief economist Rupa Rege-Nitsure said.

But for Subbarao, the priorities were different. When there’s a credit crisis and bear run, cheap money policy is the best instrument to stimulate demand and cushion growth. But when the speculators are making handsome gains and inflation was pushing the lives of millions into perils, it’s a capital error not to give up that policy.

RBI did just that in an aggressive move to tame inflation. The country’s headline inflation jumped to 7.31 percent in December 2009 from 4.78 percent in November, mainly driven by high food prices.

Food price inflation rose to 17.4 percent for the week ended January 16 from 16.81 percent the week before.

The RBI has revised the inflation forecast for fiscal-end to 8.5 percent from 6.5 percent earlier.

On the other side, the economy was slowly returning to higher growth trajectory, giving enough space for the central bank to act. India’s GDP had expanded a surprising 7.9 percent in the second quarter this fiscal and is expected to grow as much in the third quarter as well.

The RBI has also revised the growth outlook to 7.5 percent for the current fiscal from 6 percent earlier, thanks to the fast-recovering industrial and services sector. The rebound of the equity markets in Friday afternoon shows that Subbarao’s move was in the right direction. If he had bowed down to the initial market pressure, that would have left the government in a sticky wicket to fight prices.

Cheap money will always lead to building bubbles, be it on commodities or stocks. But on the other side, costly cash will squeeze credit flow, putting the industrial expansion under risk. Subbarao chose the mid way. He raised the CRR by an unexpected 75 basis points to absorb the excess liquidity, but left the key rates – repo and reverse repo -- unchanged to help the macro economy. If the economic output continues to grow in the third and fourth quarters this fiscal, the central bank will most likely raise key rates in the next policy review.

Tuesday, January 26, 2010

Time to tighten the monetary policy?

With the Reserve bank of India (RBI) gearing up to review its monetary policy later this month, the key question doing the rounds in the financial market is whether the country’s central bank would give up its one-year old cheap money policy.

Many analysts think the apex bank would start tightening monetary policy this month as the overall economic situation has improved and inflation is rising. The bank has reiterated its commitment to controlling prices as well as fuelling growth.

India’s headline inflation for December jumped to 7.31 percent from 4.78 percent the month before, mainly due to high prices for food articles. Food inflation had reached nearly 20 percent last month and then slightly moderated to settle at 17.28 for the week ended January 8.

According to the government, food inflation is a result of supply constraints, thanks to drought and flood in many parts of the country, as also black marketing and has nothing to do with the monetary policy. But, the huge jump in the Wholesale Price Index (WPI) in December will put the government and the RBI under pressure to revise the monetary policy as cheap money would make it difficult for the government.

It’s in this context the RBI is reviewing its policy on January 29. Investors are keen to know the outcome as higher rates would suck out some cash from the financial system, putting the equity markets under some pressure.

The RBI started loosening its grip over money supply in January2009 by announcing a sharp cut in key interest rates in a move to help the battered financial market and struggling economy. At that time, the equity markets were collapsing, the industrial production was plummeting, a credit crisis was looming large and exporters were in complete disarray.

The RBI stepped in to help the government in its efforts to minimise the effects of the worst global economic crisis since the Great Depression of 1930s by cutting 100 basis points each in the repo and reverse repo rates to 5.5 percent and 4 percent respectively.

The repo rate is the interest charged by the RBI on borrowings by commercial banks. A reduction in it lowers the cost of borrowings for commercial banks. The reverse repo rate is the rate at which the central bank borrows money from commercial banks. A lowering of this rate makes it less lucrative for banks to park funds with the central bank.

The intention was clear – make money cheaper at a time of crisis. RBI has maintained this policy all through 2009. Without waiting for the next quarterly review of the monetary policy, the apex bank cut both repo and reverse repo rates again on March 4.

The rates were slashed by 50 basis points each to 5 percent and 3.5 percent respectively.

In the monetary policy for this fiscal announced on April 21, both rates were again cut by 25 points each, even as cash reserve ratio and the statutory liquidity ratio were left untouched at 5 percent and 24 percent respectively.

The repo rate is currently at 4.75 percent while the reverse repo rate is at 3.25 percent.

The RBI’s decision to keep the cost of money cheap has had its positive impact on the macro economy. India could effectively tide over the credit squeeze that nearly destroyed financial markets in the advanced capitalist countries.

The benchmark index of the Bombay Stock Exchange (BSE), Sensex, which snapped six consecutive year’s rise in 2008 by registering around 53 percent annual loss, moved back into the green in 2009. Backed by the government stimulus, cheap money policy of the central bank and the improvements in global markets, Sensex ended 2009 with 81 percent gain, its best since 1991.

The real economy is also on a somewhat firm recovery path. India’s economic output expanded 7.9 percent in the second quarter this fiscal and the government expects the GDP to expand over 7 percent in 2009-10, much higher than the initial forecast.

The industrial production grew at a two-year high 11.7 percent in November, rekindling hopes that the economy would soon reach 8-9 percent growth path.

According to many analysts, the stage is set for the RBI to act. In its October review, the bank had raised the statutory liquidity ratio by 100 basis points, indicating that it would not sit idle if inflation or other threats begin to loom.

A hike in SLR makes it mandatory for the banks to invest more funds in specified securities, against their deposits, and removes some liquid cash from the financial system.

In the January review, it was expected that the RBI would raise the cash reserve ratio (CRR) at least by 50 basis points. But higher-than-expected rise in inflation may force the central bank to revise other rates also upwards. How the industry and markets will respond to such a move is the key question.

The economic recovery is still fragile and mostly backed by public spending. Credit growth is still far below from the pre-crisis levels and the private sector demand is yet to pick up. In such a scenario, costly cash can even endanger the growth. The RBI will have to walk a tight rope.

Friday, January 22, 2010

In praise of the Americentric world

At the beginning of the century, everything looked fine for the United States. Its economy was booming, the American style finance capitalism was tightening its grip over world economies, its military operation in Yugoslavia, co-sponsored by the Nato, was a success and the world had more or less come to terms with the new political order emerged after the collapse of the Soviet Union. If somebody predicted that the 21st century would be an Americentric period, it would have been hailed by many.

But the world has changed dramatically over the past 10 years. And when the US is facing one of its worst crises – both militarily and economically – George Freidman, the best selling author of “America’s Secret War”, forecasts that the US would remain the world’s “pre-eminent” power for the next 100 years. Friedman, the founder and chief executive of the US-based private intelligence agency Stratfor, makes some brilliant but strange predictions in his new book, “The Next 100 Years: A Forecast for the 21st Century”. If somebody thought, the US Empire is on the decline, or the Communist China is on the rise to become the next super power, or the present century will belong to the emerging nations like India, Brazil and South Africa, he or she could be wrong, according to Friedman. He says Turkey, Poland and Japan would emerge as great powers of the century. Stunned by the prognosis? Well, “the most practical way to imagine future is to question the unexpected”, says Freidman. He argues his predictions are simple efforts to read history geopolitically. “It’s Geography which defines power”. The geopolitical locations of Japan, Turkey and Poland and the changing contours of global politics would help these countries emerge as great powers.

So what about China, an emerging power billed by many analysts as the next super power? Freidman believes China would be fragmented by 2020 due to internal contradictions. When its coastal regions will get richer and richer, the interior parts will plunge into acute poverty. On the global scene, China would fail to extend its influence as it’s not a major geopolitical force. The US will continue its technological, economical and military dominance and will be challenged by an ambitious Japan and its ally Turkey in 2050. Turkey, the largest Islamic economy, would emerge as the greatest power in the region as Russia would weaken by middle of the century. Poland, on the other side, will align with the US like what Israel and South Korea did in the post-war world. “In the emerging competition between the US and Russia, Poland represents the geographical frontier between Europe and Russia and the geographical foundation of any attempts to defend the Baltics,” writes Friedman.

Unlike the previous world wars, the war between the US and Japan would not be fought as the first two were. It will begin with attacks on American military space stations and the US and its Polish ally will eventually emerge victorious.

The victory will further strengthen the US power and it will start another major technological surge similar to that of its post-war policy. BY the end of the century, America’s neighbour Mexico will emerge another great power and a potential threat to the US influence on the earth. That conflict will be one of the defining developments of the 22nd century.

Reading Freidman’s book is an enjoyable exercise, though it’s biter to swallow most of his arguments. The US as a whole -- its capitalism, its military power and its unipolar world – is undergoing the worst crises in decades. It’s president himself has hinted the changing role of the US in an unfolding multilateral world order in which both China and India are set to have higher stakes. China, the fastest growing economy in the world, is likely to overtake Japan as the second largest economy in 2010. Friedman seems to be sidestepping these facts, while most of his forecasts looked based on certain fixed notions like the “immunity” of the US and the role of naval power and global trade in defining the greatness of countries. However, it remains to be seen how much the Stratfor founder is correct in imagining the world ahead.

The Next 100 Years: A Forecast for the 21st Century”, George Friedman, Doubleday: 2009 (Reviewed for Purple Beret)

Thursday, January 7, 2010

A Decade of Wars, Crises and Rises

In international politics, decades are important tools that help us understand and interpret history better. The major developments in the past often come to our mind with tags of decades -- the economic crisis of 1920’s, the wars of 1930’s, the reconstruction of 1950’s, the Lost Decade, and so on. Now, standing at the starting point of a new decade, how do we analyse the bygone one (2000-10)?

According to British historian Andrew Roberts, the first ten years of the new century, or the Noughties, were full of troubles. It witnessed two major wars, one of the gravest financial crises in decades, a number of natural disasters including Tsunami, and changes in global power dynamics. At the beginning of the century, not many might have forecast such a troublesome first decade.

The Noughties followed a decade that the saw the collapse of the Soviet Union, and the subsequent emergence of the US as the sole super power in the world. The successful tests of American hard power in the Balkan and the Middle East in the late 1990’s underscored the opinion that the new century would be an American century. President George W. Bush, who assumed office in 2001, vowed to accelerate American style free market capitalism and expand the military capabilities of the country. Everything looked set for paving the way for the US to reshape and lead the global order without major hindrances. But the path of history often lies beyond the scope of prediction.

The beginning of sweeping changes of the decade started on September 11, 2001, when the World Trade Centre, the tall symbols of America’s economic might, was attacked by a few terrorists. The attack became a reference point of the decade, if not of the century. In the same month, president Bush declared America’s “war on terror” and the US started this war on October 7 by bombing Taliban-ruled Afghanistan.

The US could drive the Taliban out of Kabul within weeks of bombing, and set up a puppet government of Hamid Karzai in the capital city. But the war did have ripple- effect across the Muslim Middle East. The war on terror was interpreted by many political Islamists as an “imperial crusade” of the West against Islam. This notion gained currency when Bush opened another war front in the Islamic world in 2003. Accusing the Saddam Hussein regime in Iraq of supporting al-Qaeda in the region and mobilising weapons of mass destruction, the US declared war on the Baathist country in March 2003.

Two months later, president Bush declared victory in Iraq. Saddam Hussein went absconding, the regime was toppled and a provincial government was established, which was followed by a bloody resistance by Iraqis against the occupation. Saddam was captured in December 2003 and hanged on December 30, 2006.

According to many reports, the neoconservatives in the Bush administration wanted to expand the war to Iran, and further to Syria as part of their plans to reinforce America’s hegemony on the entire Middle East. But the Iraqi resistance bogged America down for years. When things started returning to a new normal in Iraq, the economic catastrophe limited America’s military possibilities.

If America’s hard power faced fresh challenges in the first half of the decade, its unique economic model was nearly destroyed in the second half. The unregulated capitalism, which the US championed for years, drew flak from all corners when Wall Street investment banking giants like Lehman Brothers collapsed in 2008, plunging the entire world into an unprecedented liquidity crisis. The woes of the financial sector soon expanded to the real economy, leaving most of the advanced developed countries in recession.

The new president of the US, Barack Obama, in complete realisation that his country was not in an advanced position to cope with the world’s problems, came forward to formulate a new cooperation mechanism with the emerging economies including China and India. Many countries, including the US, put caps on the flow of capital, implemented fresh regulations and expanded the scope the government to fight the crisis.

The Rise of China
Another major twist of the decade is the rise of emerging powers, including China, India and Brazil, onto the global stage. Of these, China stands out. According to many analysts, the this century is China’s. British academic Martin Jaques says the stage is set for China to rise as a counter power to the US and radically overhaul the international system. China’s escape from the global slowdown nearly unhurt has forced many analysts to take a more positive view vis-à-vis the Asian giant. China is the fastest growing economy in the world and is set to overtake Japan as the second largest economy in 2010. It is also a fast rising military power and a regional hegemonic state in Asia.

The new decade will see China further expanding its economic influence and making efforts to convert that into political clout. According to Goldman Sachs, China will move past the US as the largest economy by 2027. If the trend of Noughties continues in the new decade, it will have radical effect on the existing global order, so far dominated by the West. So, gear up to live in a rapidly changing world.

Saturday, January 2, 2010

Is the government too optimistic?

While addressing a crowd of industrialists and mediapersons in the national capital last week, Finance Minister Pranab Mukherjee was upbeat about the country’s economy. Taking even the most optimistic observers by surprise, the minister said that the economic output would expand 7.5-8 percent in 2009-10, a far higher expectation than the initial forecast of 6.7 percent. He didn’t stop even there. The growth rate, according to Mukherjee, will return to 9 percent in two to three years!

The finance minister’s optimism soon reflected in the equities markets. The benchmark index of the Bombay Stock Exchange, Sensex, soared 539 points the same day and a further 129 points on the next day i.e. Thursday to close at a 19-month high of 17,360.61 points. The Nifty of the National Stock Exchange also rose to close at 5,178.40 points, its highest since May 5, 2008.

This turnaround story was surprising given the predicted impact of the global financial crisis. At the beginning of 2009, market analysts across the world had warned of a sharp erosion of capital in equity markets that could leave the real economy in perils.

Contrary to these claims, Sensex surged nearly 113 percent from its year’s low of 8,069 points, outperforming most of its peers.

The recent indications show that the real economy is also recovering from the effects of the global slowdown. Indian economy grew 7.9 percent in the second quarter this fiscal, the fastest pace in six quarters, as against 7.7 percent in the like period last year. The GDP growth in the April-June quarter was 6.1 percent.

The growth in the second quarter was mainly powered by a surge in the industrial production. The factory output expanded 9.2 percent year-on-year, signalling a strong recovery in one of the worst-hit segments of the slowdown.

Foreign direct investment (FDI) flow into the country also jumped 60 percent in the first eight months this fiscal, while exports, the worst-hit sector by the slowdown, registered 18.2 percent positive growth for the first time after 13 months in November.

The Other Side of Recovery
Good signs galore. But are they enough to claim that the recovery is sustainable? According to the government’s critics, it is a “stimulus-powered” recovery. Since the collapse of US investment giant Lehman Brothers in September 2008, the government has announced three stimulus packages to help the industry to weather the downturn. Besides, the Reserve Bank of India (RBI) slashed key rates to pump liquidity into the financial system and strengthen the credit flow to industries.

Moreover, the government’s decision to implement the Pay Commission recommendations has boosted domestic demand, which got a further fillip during the Lok Sabha elections.

The key question is, what will happen to the economy if the government withdraws the stimuli? The ruling class will have to take some brave decisions in the new year which may have far reaching implications on the economy. The biggest challenge before the government is to put a cap on the runaway food prices without jeopardising the growth sentiments.

Though the finance minister and Planning Commission Deputy Chairman Montek Singh Ahluwalia have reiterated many times that high food inflation is a result of supply constraints, it’s still not clear whether the RBI would hike rates when it reviews the monetary policy next month.

If the central bank decides to give up its cheap money policy, it will certainly have an impact on the industrial sector as banks may turn reluctant to lend more. If the central bank retains the low rates, the government will have to look for alternatives to contain inflation.

Another major concern is the performance of the global economy. Unless the global economy stabilises, exports from the emerging countries would not pick up. Although the exports registered positive growth for November, it’s mainly due to the low-base effect of the year-ago period.

Exports declined 22.3 percent to $104.2 billion during April-November this year from $134.2 billion in the corresponding period last fiscal.

Planning Commission deputy chief had last week said exports were unlikely to return to the pre-crisis levels unless there’s a robust recovery in the advanced developed countries. Even the most optimistic forecasters say it will take at least five years for the industrialised economies to return to the pre-crisis growth rates.

So what can India do? According to Ahluwalia and many other like-minded optimists, the fundamentals of the Indian economy are strong and the government should take measures to stimulate domestic demand to make up for the losses caused by the exports decline. Will that be possible without breaching the fiscal rectitude? Well, one has to wait and see.

India entered 2009 with little hope and many apprehensions. At the beginning of the year, equity markets were down, industrial and agricultural output was plummeting and the money supply was facing constraints. In sharp contrast, when we are set to welcome 2010, the macro economy is better placed. But it still remains to be seen whether the recovery is sustainable or not.