Better to keep track of reserves to gauge vulnerabilities of external account: Economic Times 26 Sept 2018

The falling rupee has evoked varied response from the government in terms of announcing measures to increase capital flows. There are serious thoughts on increasing tariffs on non-essential imports. Also the media is abuzz with possibilities of getting a high stock of dollars through an NRI bond. How critical is the situation today? There are varied arguments on the rate of depreciation of the rupee. To the extent that it is driven by global factors, there is nothing that can be done. But if it is due to fundamentals, which have also weakened, then options exist. To gauge the strength of the fundamentals, the single indicator is forex reserves. They stood at $424 billion in March 2018 and have dipped to just under $400 billion this month. They could go below in case the fundamentals deteriorate or if the RBI keeps selling dollars to save the rupee. Therefore, the question to ask is how strong are our reserves? The thumb rule is that a multiple of three months of import cover is good enough. As of March-end, the import cover was for almost 11 months, which is very high as there is a carrying cost. Table 1 assumes that imports grew by 20% this year mainly due to the oil bill and decline in forex reserves to alternative scenario levels of $390 and $375 billion. With reserves at $375 billion and import growth of 20%, we can still maintain a comfortable ratio of eight-month cover. In 1990-91, when the country went through a balance of payments crisis which led to the IMF loan, the import cover was just below three months

 In this context, it would be interesting to see what these numbers were in the other episodes of an attack on the rupee. Table 2 gives the import cover ratio for years when the rupee fell by more than 10% on an average post 1993. In all these episodes, the import cover ratio has been in the range of 7-10 months. However, in 1998, the panic button was struck during the course of the year and the Resurgent India Bond was floated. In 2000-01 (not included here), the rupee fell by around 5.3% after the government went in for the IMD (India Millennium Deposits). In 2013-14, the option exercised was the FCNR (B) swap facility where the RBI bore the exchange risk as they were issued at 3.5%.

The RBI took forward cover to hedge against risk. Based on past experience, it does appear that presently there is no need to look for a bond issuance to garner dollars. Two variables need to be monitored. The first is how fast do our imports grow and the second is the level of reserves. If there is depletion of dollars, it does appear that up to the level of $375 billion, the situation would be comfortable. However, once it declines below this level, an NRI bond can be contemplated. The timing will also be important. It may be expected that by November the Iran part of the external story would go to the background while the China trade war should have also played out. A clear picture on the oil price will also emerge which can become the anchor for taking a decision. Will a bond be preferable (whither NRI or sovereign) or a swap facility? A bond would be better that is driven by the market where the government can provide a hedge cover for banks. The end point is that rather than the exchange rate, we should be monitoring the level of reserves to gauge the vulnerability of our external account. This would capture the net result of balance of payments flows as well as RBI action in the market. We need not look beyond this number. (Views are personal)

External factors: Import curbs to stabilise rupee may not work: Financial Express Sept 19 2018

Export incentives are not likely to increase exports as they have tended to depend on demand conditions in importing countries and not the price.

f the announcement-effect of any government policy were to be the immediate judge of the efficacy of the same, then the five-point currency revival plan announced on Friday did not quite deliver. RBI reference rate closed on Friday at Rs 71.81/USD; the Monday rate was Rs 72.55/USD. This is not surprising when the belief is that the rupee is being driven more by external factors that make the dollar stronger and other currencies weaker. Further, the measures announced are contingent on market players responding in a positive way, which, practically speaking, would take at least six months. In that case, do these steps make any sense?

The answer is yes, as the government had to do something to stem the falling rupee. RBI has been selling dollars in the market to the extent of $16 billion in the first four months. Forex reserves have come down by around $25 billion between March end and September 7. This means that RBI intervention through the sale of dollars has not quite worked out. It was left to the government to do its bit, and the five-point agenda, combined with the proposed measures in the field of trade, were appropriate.

The approach has been two-fold. The first is to tackle the capital account by getting more inflows while the second part, which will be revealed in the course of time, is to reduce the trade deficit. Both the steps are quite clinical as they address the issue to the extent that fundamentals are reversed. The impact of these measures can be analysed sequentially.

The first part relates to external commerical borrowings (ECBs), where the government has made two specific announcements. The first is to reduce the tenure of ECBs for amounts of $50 million to one year from three. Prima facie, this sounds good, though it cannot be a permanent measure. One of the reasons for RBI to have kept a limit of three years was to ensure that the borrowings were associated with projects that were of a long-term nature. By lowering the level to one year, there will be risk of the bunching together of repayments in the subsequent year that will cause problems.

The other point made here is that the mandatory hedging condition for infrastructure companies has been done away with. Again, while this sounds exciting, the question is ‘are we increasing the forex risk of our projects’? It may be pointed out that RBI has been exhorting companies, which borrow from the ECB market, to partly hedge their exposure as part of prudent forex risk management. By letting companies go ahead without the hedging clause, we could be making this entire category of loans a risky one. Therefore, both the relaxation measures pertaining to ECBs carry a downside risk that can get magnified along the way.

The second set of factors pertains to masala bonds. Here, too, there are two announcements. The first is the removal of the withholding tax, which is a positive for these bonds. The second is allowing banks to underwrite these issuances and also be a market maker. There is no problem with this rule. The important part, however, is whether or not these bonds will catch on. Masala bonds are rupee bonds raised in a foreign currency in overseas markets where investors could be Indian expats or investors looking for diversification. These bonds become attractive when rates in the country are lower and the masala bonds offer higher returns. The exchange risk is, however, borne by the investor. With interest rates increasing overseas and the rupee becoming volatile, this becomes less attractive. Hence, while the framework for raising such bonds has been liberalised and is positive, the response of players needs to be gauged. The history of such issuances has been restricted to a small set of companies, and even if this has to work, it would be over a longer period of time.

The third target has been FPIs, where their exposure to single company issuances, or shares in portfolios, has been liberalised. The response will be interesting because it was observed that when the FPI limits were raised earlier this year, the inflows had turned negative. Quite clearly, the factors which drive FPI investment are a basket of factors such as the state of growth in other countries, movement of interest rates, Fed action and so on. These higher limits may thus not be able to actually increase the flows significantly.

The other thoughts expressed by the government which will take shape pertain to trade. Curbing imports is a way out and can be done through higher duties as quotas are now passé. The non-essentials that can be targeted would be gold and electronics as oil cannot be touched given the fact that domestic prices have already gone up for refined products. Increasing taxes on such items has worked in the past and would be worth experimenting. While gold demand can be impacted, which in turn can affect exports of related industries like gems and jewellery, the demand for electronics would be mixed. Presently, mobile phones and laptops are snob articles where the price may not be a limiting factor. Therefore, higher duties and higher prices would probably mean higher inflation but unchanged demand. Therefore, in the present situation, where core inflation is rigid and in the upward direction, higher duties will only increase the inflation indices as a collateral effect.

Incentivising exports has also been spoken of. This is again something which works with lags. Export credit, access to infra and amenities, tax breaks and refunds are something that can be explored. However, these moves are more likely to improve profitability of EOUs though they may not lead to higher exports which have tended to depend more on demand conditions in the importing countries and where the price factor is only secondary.

The measures announced could be described as being the ‘final measures’ (there can still be a last one in the form of a NRI bond) taken by the government to control the fundamental factors affecting the currency. The sale of dollars by RBI can only be done intermittently and cannot be a permanent measure. Opening a separate window for oil companies can assuage demand in the market, but at the end of the day, it is a zero sum game. As reserves fall, the rupee will decline.

Besides, with the currency direction being driven more by what the US does, such measures may placate but not really succeed in completely reversing the direction of the movement of the rupee.

A decade after Lehman Brothers: Financial Express 13th Sept 2018

The dominance of the Big 3 ratings agencies and the Big 5 investment banks continues

T decade after the financial crisis permeated the veins of the financial structure of the world economy, some very interesting observations can be made. The financial crisis involved the adverse impact of financial engineering that typified the sophistication in the financial market where loans given for housing were repackaged and sold to investors (CDOs). More important, a consequence was that the originator and ultimate lender were different and not identifiable. A fall in the real estate market led to large-scale defaults where homes were confiscated, but had, by then, diminished in value. Markets collapsed as institutions went under.

Some were allowed to perish while others resuscitated. As banks stopped trusting each other and governments cut back on expenditure, central banks invoked ‘quantitative easing’ to revive their economies. This involved giving cash in lieu of securities that were not necessarily government bonds. BIS came in and introduced the Basel III norms that involved liquidity requirements. Regulation everywhere intensified and today the financial market seems more secure, or appears to be so.

But this entire process has been quite peculiar. First, the world economy is not quite back on its feet post-Lehman. While the US economy recovering has caused the Fed to increase interest rates, the picture across the major economic blocks is not clear. It is true, post-Lehman, the sovereign debt crisis emanated independently, changing the equations besides causing some disruptions in the form of Brexit and Donald Trump’s elevation as president of the US—where the approach to economic policy is now more aggressive and different from those pursued by his predecessors.

Second, while the financial crisis did lead to strong regulation across all countries, the domination of the super powers in credit rating and investment banking has not changed. While regulation spoke of having more competition in specific market segments, ironically, stronger regulation put up barriers to new players coming in as the regulatory cost became prohibitive. It was much simpler for the larger institutions to comply with the new regulatory structure as the cost could be absorbed by them. Therefore, the big three in the ratings business and the big five in investment banking continue to reign supreme.

Third, post-Lehman, the focus on inequality and governance caught public attention, with Thomas Piketty Capital in the 21st century setting the tone. The principal agent relationship that was first enunciated by Adam Smith stood even more clearly exposed as CEOs earned their income and bonuses through all the wrongdoings associated with the crisis, but didn’t have to pay for the same. Some continue to rule, rewarded with fat pays. The asymmetric reward pattern exists even today. Not surprisingly, there is a move for more government everywhere and this kind of social proclivity is something which Karl Marx would have been happy with.

Fourth, as a corollary, those responsible for the crisis went free while the policies pursued by governments aimed at cutting expenditure and better fiscal management, especially in the European countries, meant that the poorer sections suffered as allocations for social schemes came down (especially in the PIGS nations) as part of the packages recommended by IMF and European Commission. This is unlike in India where the NPA crisis has meant that several bank heads have been under investigation.

Fifth, for the first time, central banks gave liquidity to banks and financial institutions by exchanging corporate bonds like ABS and MBS for cash. OMOs normally involve government paper, but, in order to restore trust among players, it became necessary to provide liquidity against commercial instruments, which is probably the first of its kind. This happened across all developed countries to instil confidence in the players which held on to these instruments. Interestingly, at this time the LIBOR controversy also erupted where banks tended to understate their polled LIBOR rates to send incorrect signals to the market that all was well. The unmasking of this wrong-doing has helped to bring about a more regulated price discovery in the market.

Sixth, curiously the liquidity that was provided by the central banks did not go into lending internally for furthering investment. Growth remained depressed for the larger part of the decade. The money instead went to the EMEs that witnessed an upsurge in foreign inflows that in turn helped to boost their markets and currencies. A consequence was high level of monetisation in these countries and central banks had to sterilise these flows through absorption tools like the MSS bonds in India to keep the rupee (currency) steady.

Seventh, while QE was a bonanza for the recipients, it also meant that when these flows would stop, the reverse processes would be set in motion. Hence, the US decision to roll back QE and bond purchases (which the ECB is doing as well), caused EMEs to convulse at the prospect of FI flows slowing down. Subsequent increase in interest rates in the West has meant that the FI flows have started to move into the trickle mode, affecting all countries and currencies.

Eighth, countries have become inward-looking, starting with the US and the UK. When the global crisis threatened to degenerate into a 1930s-like Depression period, countries worked towards defending their economies by becoming less open in terms of trade. The WTO remains fairly irrelevant today and controls on imports have been the main policy thrust. The days of free markets and free trade are virtually done, and, while it is not as bad as the ‘beggar thy neighbour’ of the Depression era, it is ‘domestic economy first’ jingoism that is the order of the day.

Ninth, the smug explanation given in the past of the EMEs being decoupled from the world economy and establishing their power to drive forth the rest of the countries have been diluted. China has been at the forefront of being the target for all the inward-oriented policies of the West. With the focus now on teaching China a lesson through countervailing duties, the edifice of this story has been weakened considerably.

Tenth, post-Lehman and the euro crisis and an unrelated development of Brexit, the dollar has regained its hegemony and world still moves on this basis. The euro is struggling to stay relevant as there are pressures individual nations fare facing within their jurisdictions to move away. While the currency will hold, the final hurrah would be Trump’s as the dollar remains the anchor currency.

Can the rupee fall be controlled? Business Line 10th Sept 2018

Hedging oil contracts and addressing export finance hurdles will help. The RBI should articulate its view on the rupee

The fall of the rupee has been quite sudden in the last few months and honestly no one is sure how the currency will move in future. There have been some signs of weakening of fundamentals, though admittedly the external factors are dominant. A stronger rupee vis-à-vis the other currencies, especially the euro, has led to systematic depreciation of global currencies. Nations like the East Asian economies are buffered by being export oriented. What can India do to stem the rot?

The first thing that comes to mind is that the RBI can start supplying dollars in the market to cool down the exchange rate. Up to June, the RBI had sold around $14 billion. Further, there were forward contracts purchased for $10 billion. Forex reserves have declined by $23 billion since March-end and is at around $400 billion now.

Realistically speaking, selling dollars is not practical as this can assuage the market only for a few trading sessions after which other factors will continue to drive the rupee down. Therefore, this is a short-term solution.

The second measure which can be taken is to talk the market down.

In the current situation there is a tendency for importers to rush in to buy dollars and exporters to hold back remitting their earnings on the expectation that the rupee will depreciate further. This exacerbates the demand-supply matrix for foreign currency and drives down the rupee further.

RBI steps

The RBI can ensure that export earnings come back to the country on time while importers should be urged not to rush in to buy dollars in advance. Alternatively, asking the importers to hedge can be attempted though it cannot be made mandatory. Making such statements will help lower the speculative element which comes into the picture every time the rupee keeps falling.

Third, the government should focus on exports and to the extent possible, especially on the tax credit/refund part, clear the coast for exporters. SMEs (small and medium enterprises) which are dominant in the export market have had tax refund issues and this needs to be sorted out.

Also, export finance is another problem which has been bothering exporters and impediments on this front too need to be removed. But this will work only in the medium term and cannot deliver result immediately because export markets tend to be relatively inelastic and are driven by demand factors.

Fourth, as oil is the major import component, and whose prices are rising, a separate window needs to be opened for selling dollars. Also, hedging processes must be put in place to ensure that the purchases are in order. OMCs (oil marketing companies) do take forward contracts to buffer against price changes, but to the extent there are open positions hedging should be made mandatory.

Fifth, the RBI would have to monitor the other components of demand for dollars — like it did previously, which was five years back — to ensure that there are limits to the drawal of dollars for other purposes such as travel, investment, and education. This could become a pain point where corporates may be taking dollars out for investment overseas, as opportunities within the country are limited.

Sixth, the channels for external commercial borrowing should be looked at judiciously. While urging companies to explore the market makes sense, it should be noted that un-hedged positions can put on pressure on debt servicing. Nevertheless, in these conditions, such borrowings would be helpful.

Seventh, the channel for considering a sovereign bond or any such scheme for getting expatriates to invest in such bonds should be planned in advance — which may not be required if conditions stabilise. We need to look at our forex reserves and import-cover position and have thresholds below which such bonds or NRI deposits schemes may have to be explored.

Such a policy would be worth having internally as there should be triggers that are known that would lead to such possibilities being looked at.

Capital flows

Eight, the capital flows need to be monitored proactively and this is where FPIs (foreign portfolio investments) matter. The strong inflow of FPIs has the power to rein in the rupee.

The recent issues regarding KYC norms can hold back such flows and regulators should look at minimising hurdles given the pivotal role played by this constituent. Further, while the RBI’s monetary policy target is primarily inflation control, the currency is also a secondary variable that is tracked and increasing interest rates could help in drawing in FPI flows to the debt segment.

While these options need to be a part of the list that the central bank and the government need to keep on the radar, the causes for depreciation are important. When fundamentals drive the rupee down — and here oil imports are relevant — the authorities can work on improving them by addressing various components on the capital and capital accounts.

However, when the prime driving force happens to be external factors like US’ trade war with China and Turkey , which results in the dollar strengthening, there is little that can be done to hold back the rupee.

Making affirmative statements will help to steady the rupee so that the speculative element lays low. In the market there is always a view that the country is better off with a weaker rupee as it helps to increase exports. Whether or not this premise is right, the market looks to the RBI on its view on the rupee.

While the RBI maintains that it has no view on the rupee value but is interested only in its orderly play, it is interpreted as the central bank being satisfied with the depreciation. This is a good reason to trigger further depreciation. By expressing a view, the RBI can send signals to the market, which will work better than direct intervention as the ‘sentiment’ factor is addressed. While ₹69.5-70 to a dollar looks to be fair in normal conditions, the length of the volatile phase can pull the rupee down substantially until equilibrium sets in. In the very near term though, ₹72-73/$ cannot be ruled out.

There’s need to allow futures trading for fuel and pulses; here’s why: Financial Express September 6 2018

There is very little scope for rigging spot prices for both commodities and such a step will lead to efficient price-discovery.

Logically, any commodity that can be traded should be allowed on the futures platform as it gives a chance to users to hedge their risk. In fact, if the rules of the game are played out well, it should lead to efficient price-discovery, which is what a futures market is all about.

Two sets of products are being pushed, of late, for inclusion in the futures-trading basket. One is from the energy sector and comprises petrol and diesel while the other is in agriculture and includes tur and urad. The latter did have a fairly efficient history of trading before a ban was imposed while, for the former, there is a compelling case for introducing the same. With prices moving up and the government not willing to relent on duties or subsidies on fuel, the inflation cost of fuel price today is high. The reservations against their inclusion are more on the sensitivity issue, where any constituency can make political capital by linking futures trading to higher prices and call for a ban on such trading at a future date. And, in an election year, even the most progressive government will prefer to ban futures trading rather than lose votes due to negative propaganda. Therefore, there will most probably be little support for futures trading in such products, though the arguments are compelling.

Let us look at petrol and diesel. The prices are based on the Indian basket of crude, which is a mix of various crude prices and is fixed—in the sense that these prices are determined overseas. Then, there is an exchange rate that is used to convert the same to a rupee price. To this, the processing charges are added as are the various sets of taxes that are outside the GST. The price is hence a sum of all these components that are all liable to change depending on how things move. When anyone takes a call on the futures price of petrol, one is talking of betting on crude oil price (that already exists in a contract on Indian exchanges), the exchange rate (that also has derivatives being traded on Indian platforms) and taxes that are fixed by the government. If two components are tradeable, then, logically, trading the sum—including the institutionally fixed tax rates—makes sense. Therefore, not allowing such trading cannot have a founded basis.

Can anyone rig the market? The answer is no. All contracts are currently settled on the price of IOCL, HPCL and BPCL that arrive at this in consortium; hence, there is no scope for rigging the spot price. The futures price will be efficient and clean. There is no chance of prices being pushed up when PSUs already decide the final price based on their formula. Given that PSUs are owned by the government, there is no reason to suspect the price and futures trading will actually give a lot of depth to the market. Even if one wants to push up or down the price, it will result in a bad solution as the final settlement price is being decided by the OMCs. Therefore, prices will necessarily be orderly. The same holds for diesel and, hence, these contracts should be on the table. There can be a case of these products not working out as large buyers of such products may be limited, but this can be a call to be taken by the exchange. There can be no national harm.

Let us now look at pulses. In the last three years, we have struggled to support farmers growing tur and urad. First, the crop failed and prices shot up making inflation a major problem. Subsequently, thanks to the cobweb syndrome where farmers decide on their crop based on prices in the previous year, there was over-sowing of tur and urad that led to higher crop production and fall in prices. Farmers lost out due to low prices and the rural demand story came apart. Also, there has been farm-distress and the government believes increasing MSP is the solution. But, will that work? There are reports that Maharashtra has made buying below the MSP a crime. This may sound really odd. But then, it is a desperate way to ensure farmers get a higher price. However, what if it leads to inflation and RBIhas to increase rates further?

The solution is to have futures trading in these commodities so that the right price is discovered. We need to get out of the mindset of having the farmer getting the highest price or the consumer paying the lowest price—else, we will only be messing up our markets. Now, looking back at why urad and tur were banned, low production led to prices flaring. It was suspected that the spot price was rigged to ensure that settlement took place at the wrong price. The solution was to ban the product.

This was over a decade back, and the market has moved considerably forward since then. We are happy today at the e-NAM taking off. Why then can’t we use the e-NAM price as the spot price for settlement where transactions really take place and the market is monitored by the government? The futures platform will get the right price for all farmers and the government need not unnecessarily try now to get everyone to buy at MSP. Farmers can keep swapping choice of crops and sell forward the output in advance, based on futures prices. This is a very good market-led solution.

While political noises can get toxic for any government, the logical corollary to having an eNAM is to also integrate all such marketing with futures trading to get a robust agri market. Futures trading in commodities is required to make the system complete. Otherwise it will be a halfhearted attempt as most of our initiatives tend to get diluted along the way. This should not be allowed to happen.

Gauging the industrial environment is not easy: Financial Express 31st August 2018

Is there a leading indicator for industrial growth? Not really. A part of the reason is that industry has been subject to significant disruptions like policy upheaval, stalled projects, volatile consumer demand, global influences, demonetisation, GST, etc, which have made the index numbers extremely volatile.

Gauging the industrial environment is not really easy. Very often, we tend to look at various variables and then conclude that there has been a turnaround. But within a couple of months, the same variable appears to be a mirage. Recently, the high level of capacity utilisation in the Q4 of FY18 was taken to be a positive sign of industry turning around, and the argument looked credible given that industrial growth has been steady.
However, given past experiences, it does appear that it would be premature to celebrate as the low base effect of last year on account of GST led to some degree of turbulence, which depressed production numbers as de-stocking took place, and which was replaced during the course of the year. Besides, Q4 is normally a good time for these capacity utilisation numbers as companies, too, increase production to meet the targets. Are there any leading indicators for industrial growth?

Four variables have been looked at for the last five years to ascertain if there is a correlation with industrial growth. The information on capacity utilisation is a quarterly handout by the Reserve Bank of India (RBI), which has been linked to the quarterly Index of Industrial Production (IIP) growth. The same has been done with growth in sales of non-financial companies, which, ideally, should be related to production. For bank credit and Purchasing Managers’ Index (PMI)—which are the other indicators that are available on a contemporary basis—the monthly data has been analysed. For bank credit, quarterly growth rates are also linked with industrial growth. The brief answer to the question as to whether these variables can be the lead indicators is a big ‘no’.

The accompanying graphic shows that high capacity utilisation does not go along with higher industrial growth as the coefficient of correlation is just 0.13. In fact, in each of the five years looked at, the Q4 capacity utilisation was the highest and fell in the Q1 of the succeeding year. The number of 75.2% in FY18 is not unusual and was achieved in FY15, too, while in FY14 it was even higher at 76.1% in the fourth quarter, before it declined to the low seventies. Therefore, unless the capacity utilisation level keeps increasing progressively, it will be tricky to conclude that production has taken off on a new trajectory.Second, the relation with corporate sales is better at 0.26. Theoretically, if sales are increasing at a steady pace, production, too, must be moving along in line. However, this relation does not appear to be too strong here, and a high growth in sales does not necessarily imply higher production and this is where the inventory management is critical. Sales can move independently of production if inventory is being drawn down. This could be severing the link between the two.

Third, the PMI also appears to be an approximate proxy, though not a strong one, as the coefficient of correlation is also at 0.26. This probably is understandable as IIP growth is always year-on-year while PMI is a survey-based approach that compares the state of industry today with that of last month’s. It is based on impressionistic statements such as whether dispatches or employment in the current month were better or worse than in the last month. Therefore, the two are not really comparable and the weak result is quite expected. The same test has also been done for PMI with IIP changes on a month-on-month basis, and the relation is even weaker at 0.13.

Fourth, bank credit is another variable often used to denote that industrial activity is picking up. Here again, one is in for a disappointment, as higher growth in credit has not been associated with similar tendencies in IIP. This is so because, in the last 3-4 years, bank credit is being led by retail loans, which have weak linkages with industry. Also, with other modes of finance such as bonds, external commercial borrowings (ECBs) and equity being used by companies to finance their funding requirements, bank credit is just one option. There has been evidence of constant substitution between market-driven rates of funding and bank loans, which makes the linkage with industrial growth difficult. The same relationship has also been looked at on a quarterly basis, and the coefficient of correlation is weaker at 0.15.

Probably the only indicator that does indicate, to an extent, the direction of industrial growth is the core sector data, which comes out 12 days before the IIP numbers are released, where the coefficient of correlation is 0.59. But then, this is a subset of IIP and hence would tend to be related given that it constitutes around 40% of the main index. While this can be treated as advance information, it may not be very useful to extrapolate into the future.

It does appear that it is hard to find a reliable and consistent leading indicator of the state of industrial activity. A part of the reason is that the sector has been subject to significant disruptions like policy upheaval, stalled projects, volatile consumer demand, global influences, demonetisation, GST, etc, which have made the index numbers extremely volatile. In fact, of late, this volatility has increased with the trajectory never being single-directional. The shifting of the base year to 2011-12 did increase the growth numbers, but the links with other economic variables remain tenuous. This may continue to be the norm as even the GDP calculation depends on the corporate results to a very large extent, and probably around 20% of the GDP gets related with IIP.

This also means that monthly industrial growth numbers will be very hard to predict based on other economic indicators, and trends in the growth rate, if any, would probably be more effective in forming opinions on the same. It does appear that PMI cannot be used as a proxy as it is much different from IIP. Also, the capacity utilisation rates, even if sustained in the upward direction, may not get related to higher industrial growth numbers. Conjectures would, at best, be guesswork, where the indicators analysed may, at times, provide clues, but will never be sustained.

The fracas over GDP back series data: Business Line 30th August 2018

In a statistical sense, it’s fairly naïve to relate GDP performance to governments; growth is determined by market players

The presentation of the back series numbers on GDP has quite expectedly created a political storm with protagonists, apologists and critics from all sides joining the animated debate. It is now clear that the numbers put out have not been accepted by the CSO and there can be other variants coming out in course of time. Two things need to be put in perspective here. First, what exactly is this back series about? And, second, do governments bring about GDP growth or do they only facilitate the same?

On the first issue it should be understood that when the base year changes from 2004-05 to 2011-12, the goods and services included in the basket is changed making it more representative. Outdated products move out and new ones are included in the series.

A challenging task

Now, to get information when creating a back series is challenging as several imputations and statistical proxies are used, especially if information did not exist before. Combining various techniques, the back series is created. Now the one which has been put up shows that the period coinciding with UPA-1 has a higher average growth rate compared with the NDA-1 regime. As it has taken a political turn, there is a verbal game being played to show which government did better.

This is where we need to ask the question as to what exactly is the contribution of the central government to GDP growth. To begin with, we have a federal structure where there is a central government, state governments, urban local bodies and panchayats. All of them provide the systems in which economic agents operate.

While there has been a tendency to relate growth with the central government, the other entities are forgotten even though they are more critical when, say, a company operates. The World Bank ‘Doing Business’ rank is good at the Centre, but for a company in Tamil Nadu the permission required for construction or electricity is dependent on State laws and is not affected by the Centre.

Second, if one looks at the actual contribution to the GDP for the government, it would be linked with the size of the budget. A larger size gets a better GDP value-added number in the component of ‘public administration, defence and other services’.

This will also include all the other components of non-development expenditure which economists frown at. Higher subsidies reduce GDP growth while higher tax collections act as a prop. Interestingly, the capex, which is echoed by economists, is of the magnitude of around ₹3-lakh crore (including defence of around ₹0.8-lakh crore) which is a very small part of the overall GDP of around ₹170-lakh crore.

Third, the critical role played by the government is in providing a policy framework for the operators. This is where one can compare initiatives taken by various governments and it is here that the NDA record is impeccable.

There have been a slew of reforms introduced in the areas of power (UDAY), telecom auctions, mining allocations, GST, FDI, doing business, and budget management, among others. Governments can provide the right field to play on, but the onus is on the non-government players to deliver.

Fourth, if one looks at the components of GDP, then this argument becomes clear. Agriculture output is driven by the farmers and monsoon and while government supports through procurement, MSP, marketing (eNAM), there is no direct role here. GVA from mining and manufacturing is based on the P&L accounts of companies in the field, where again there is no direct government involvement.

Power is in a joint effort of private sector with the State electricity boards and Central PSUs — but not the government. The contribution of the construction sector is based on cement and steel, which is in the ambit of the corporate sector. GVA from trade is based on GST data, transport on data from various modes of transport, hotels from P&L accounts, and communication from telecom companies.

The P&L again drives real estate which has a share of 72 per cent in the group of financial services, real estate and professional services while banking business determines the GVA on the financial side. The last component of GVA, which is public administration and other services, is based on Union government expenditure. Curiously, as governments get badgered for more spending, this component is probably the ‘most real contribution’ to GDP growth.

Putting all these arguments together, it does appear that while the rhetoric around which government did better serves the purpose of occupying media space, the GDP numbers per se do not really tell us the story. It is the structures and systems that have to be compared and often the results flow over a period of time.

The construction of a metro line, for example, provides benefits over a longer period of time than the initial expenditure incurred, which cannot be captured in the GDP numbers.

It is fairly naïve to relate GDP growth with governments in the statistical sense. This is a fallacy which is also witnessed when one associates regimes with current account deficits, which is actually driven by oil prices most of the time. As an extension, governments cannot really take credit for a stronger rupee which is an outcome of the balance of payments situation. Inflation too is almost always on the agricultural front where governments can never really go against the tide in case of crop failure.

Growth enablers

In an economy which is run on the basis of markets, governments become enablers of growth while addressing social issues that are outside the purview of the private sector. An effective government provides the right playing field but the players determine which way growth will move.

Direct intervention through specific spending helps to bring discipline at times to keep the economy on track. Further, deep reforms like say GST will have significant benefits flowing with a time lag and to attribute say, hypothetically, higher collections or more taxpayers to the future regime (if different) at a later date would be erroneous when the effort has been put in by the present regime.

Making sense of the markets Economic Times 29th August 2018

TThe markets have always been high on expectations and this is why there is general scepticism about whether they really indicate that things are looking up. In fact, post-demonetisation after a decline in 2015-16, which was a big shock for the economy, the Sensex has moved only upwards and the number of 37,000 inspires visions of 40,000. The economy growth has actually slipped from a high of 8.1 per cent in 2015-16 to 7.1 per cent and 6.7 per cent subsequently. What can one make of it? 

Growth in the Sensex is linked with earnings and probably this would be the best indicator. Doing a simple regression analysis for movements in the Sensex post-reforms indicates that the changes in the index are best linked with changes in net profit of the corporate sector and FPI flows into the market. Variables like GDP growth or IIP growth do not matter. Surprisingly even the growth in sales of companies does not get linked with the market and there is a negative 

relation. 

What this means is that these two factors (which explain 65 per cent of the relationship) quite sharply drive the Sensex and the other economic variables do not really matter. Hence, if net profits on an average increase by say 10 per cent, we can expect the Sensex to increase by around 5.5 per cent. Similarly, every ?10,000 crore of FPI inflow changes the Sensex by around 3 per cent, or ?70,000 crore (or approximately $10 billion) by around 21 per cent. Both the factors are hence important.. In the last three episodes of decline in the Sensex, 2008-09, 2011-12 and 2015-16, either one of these two variables or both were negative, which dragged down the Sensex. 

For FY19, it has been seen so far that the FPI flows have been bordering on negative territory which will probably be the trend given that conditions in the US and the West are improving and there is less of easy money around. Therefore, corporate profits will be the main driver of the market and the indication .. 

Another factor that will now be driving the market in the absence of the push from FPI is mutual funds. In the last couple of years, mutual funds have become more important in the equity markets and it can be said that post the rollback of QE, FPIs had slowed down and mutual funds have made some significant advances. The table below gives the share of mutual funds in the sum of AUM of FPI and mutual funds. 

Table 2 shows that the mutual funds have increased their share in AUM of FPI and mutual funds combined. A movement of around 8 per cent upwards in share in total means that on an incremental basis the increase has been even sharper. In 2017-18, they had a share of almost 38 per cent in incremental AUM. Therefore, mutual funds would be taking on the role of prime driver from the institutional side and their pattern of investments will be important. 

The positive news is that after March, they have increased their AUM in equity which was something to watch out for given the new tax dispensation for equity schemes announced in the Union Budget. It can be inferred that as the same holds even in the equity market for long-term gains, investors have continued investing in these schemes. 

Therefore, it does appear that in the medium term, there is some method in market madness. The current high levels would be sustainable only if institutional interest continues and corporates continue to deliver healthy profits. The other macro parameters may not matter, while the sentiment-based factors such as elections or trade wars and RBI action would cause transient disturbances for a couple of trading sessions before reverting to normal. This can be the takeaway. 

The money trilogy: Everything about money and finance explained in a set of three books: Financial express 26 August 2018

The author has put in a lot of work to get this project right. It is based on wholesome research of many events, which makes it a good academic collection.

he title says Easy Money, but the set of three volumes looks daunting. However, the author’s name encourages you to read the books, even raising expectations of them being as exciting as his other articles and views on business matters.

When you start reading the first volume on the evolution of money, you are enthused to read how Vivek Kaul has written three exhaustive books on money in an easy style that cover almost every aspect of the issue, from theory to complex financial structures. One can decide whether the word ‘easy’ refers to Kaul’s style of writing or an ‘easy guide’ to a complex subject, or how money has degenerated over the years to become ‘easy’ so as to engender all the scams and crises. That call can be taken by the reader, though the reviewer will vouch for all the three.

The first volume talks of the evolution of money, which is a good guide for students, as it combines textbook knowledge with several anecdotes. It talks of various things that served as money, the evolution of currency and so on. You also get to read about how the Bank of England came into existence and it is quite a revelation to know that it was to have a fixed tenure when it was established. The creation of the Federal Reserve System is interesting and one gets to know about the ‘how’ and ‘why’ of the existence of multiple central banks in this system. The gold standard and the implications, especially in the context of the Great Depression, are significant parts of the book as well. Almost every segment in the book is independent, which means that you do not have to read through the evolution of paper currency to know about the Bank of England.

The second book is on the evolution of the global financial system as we see it today. This is vintage stuff, as Kaul explains in very simple terms all the big crises in the global financial system. Black Monday of 1987 is explained in rudimentary terms, as well as the S and L crisis, which has become some kind of a benchmark for understanding the flaws in lending operations that were replicated in different forms in all subsequent crises. The action of the Federal Reserve was proactive and the idea of allowing cheap money to bring the system back on track started at this time, becoming a habit now. The LTCM crisis is explained in simple terms with examples, making it easy to understand what went on in the background before the explosion took place. The same holds for the Asian crisis of 1997, where the role of Japan is brought in, as it tended to invest all its trade surpluses it earned with the USA heavily in Asian economies, thus creating a bubble. The way players played the market on each of these occasions, which set off the contagion, reads like a novel, but is real.

Here, one can actually read through the history of financial systems, which starts from the Depression when the Fed did nothing to the so-called proactive policies pursued today. So you get to read about ‘Say’s law’ and Keynes, and how their prescriptions differed in the era of stagflation in the Seventies and the reaction of the central bank when Friedman became more important. We also get to understand the Volcker rule of 1979 and the relentless pursuit of Greenspan to keep money easy.

Here, Kaul points towards a major anomaly in the system where the USA got the divine right to spend more than it should have to enable dollars to be available for others. This he terms as one of the major Ponzi schemes, where the same dollars accumulated by countries like China come back to be invested in US bonds, as the government runs huge deficits.

The third volume is the most contemporary discourse on the greatest Ponzi scheme ever and how it threatens the global financial system. This is the financial crisis of 2007-08. He takes us through how it plays out in some detail, which is very engaging. In the course of this debate, he explains the concept of securitisation and how NINJA loans became a household name after this crisis. The way in which some institutions were allowed to fail, like Lehman, while others were merged, like Bear Stearns, and a third set were bailed out by public money, like AIG, is argued very well. This, along with the quantitative easing strategies pursued where central banks actually bought commercial bonds (through the MBS and ABS routes) to infuse liquidity, was quite unique, but has set a precedent. Rolling this back has caused pain, but the important thing is that one is not sure what type of new problems or bubbles have been created by cheap money. The emerging markets first benefitted a lot from these flows, but now face a serious backlash when the money has been withdrawn.

In fact, the concept of carry trade became popular, as investors started borrowing at low rates and investing in currencies or sticks of other outcries for better returns. This created problems of handling capital inflows for central banks, as they had to sterilise them, which created different sets of problems on monetary policy and interest rates. The reversal of such policies invariably has even more severe repercussions, which countries are witnessing today.

Kaul has put in a lot of work to get this project right. It is based on wholesome research of many events, which makes it a good academic collection. The jargon has been explained in layman language and when he tells us how hedge funds work with simple examples, things make a lot of sense. The same holds for CDOs or even the origin and spread of the Asian crisis. This is, hence, a unique combination of academic rigour and journalistic panache to deliver excellent treatises on a complex subject like money and finance. Putting it in three volumes is pragmatic, as there is no economy in explanation and narration. This set of books will be enjoyed by all readers irrespective of their knowledge of the subject