Thursday, March 15, 2012

The Indian Policy Week

This article of mine was published in Hindu Business Line yesterday on March 14, Link . Haven't written something exclusively for this blog in this year but working on an interesting concept (a little philosophical though) that would need extensive development, so posting on this blog would be the first step.

With the budget and the RBI economic policy coming up, this week would see both the fiscal and monetary policy in action and thus could end up sealing this year’s economic course. The RBI has already made its move with a 75 basis point CRR cut, however the more critical action on interest rate is needed now and at the same time the government should show some teeth by cutting back on its ultra-loose fiscal policy stance by bringing its expenditure under control, perhaps it is too much to expect from the besieged but certainly that is what is needed to rejuvenate the faltering Indian growth engine.

The RBI has already cut the CRR by 125 bps in the last two months. To put this into perspective of how grave things are; a CRR cut of this magnitude or more has been witnessed only twice before in the past decade, once during 2001 post Sep 9/11 and the second during the financial crisis of 2008 post the Lehman collapse.

Certainly there is some seasonality to the liquidity issues involved but what should not be missed are two serious structural underpinnings; slowdown in private sector credit growth and slowdown in the growth of forex reserves in the past two quarter.

Ever since the end of financial crisis of 2008 the private credit growth started to recover but unlike in earlier times in the past 2 decades this was accompanied by an increase in the government credit growth as well.

As can be seen in the graph; since 2009 unlike previously whenever private credit growth started to take off the government credit growth used to taper off thus enabling the country to tread on the path of high growth with moderate inflation (the golden period from 2003-2007 as can be seen in the graph). However post 2009 both the private sector and the government sector credit have seen a rapid increase, unforeseen in the last two decades.

The government credit growth has largely been as a result of its re-distributionist policies that is causing serious misallocations of capital and not having much of an effect in increasing the real supply, thus reducing the economic productivity. This has resulted into a near double digit inflation for the past 2 years.

The RBI with all its good intention tried to reign on this unabated credit growth and thus the inflation with the increase in the interest rates. Unfortunately the fiat monetary system that we are living in is like an inverted pyramid scheme which implies that even a moderate slowdown in the credit growth can cause severe stress in the system. So as a result of the increase in the interest rates by the RBI the private sector credit is only expected to grow by 16% this fiscal compared to 21% last year making it harder for the borrowers to service the debt and thus contributing to the liquidity stress but at the same time the government credit growth which is the real source of inflation continues unabated (expected to be around 25% this year).

The slowdown in forex inflows in the last year and the severe fall in the rupee that made the RBI to intervene in the forex markets has been another source of stress in the system that has resulted in the slowdown in the increase of base money.

The only way to get out of this mess and at the same time to keep a lid on the inflation is for the country to play a three tune symphony by again attracting substantial forex inflows especially in the form of FDI, reduce government expenditure and increase private credit. Hence on the fiscal front it is critical that the government in this budget presents a credible plan in cutting down on its expenditure and at the same time show its resolve to improve the investment climate in the country thus attracting the forex inflows. This would help in improving the stock of base money and maintain the value of the rupee.

On the monetary front this should be accompanied by rate cuts by the RBI, this would translate into higher private credit growth and in turn higher economic growth rate and thus the relieving stress in the system.

Greece Debt Deal - Only A Pause Before The Avalanche

This article of mine was published in Hindu Business Line on Feb 22, 2012 Link

The Bailout package announced by Euro Finance ministers for Greece is more of the same can kicking exercise which is unlikely to last.

First let me point out some of the key ingredients of the deal:
-          -  Greece government would be given 130 billion euros to pay down its creditors and also for its re-financing needs
-     -  The plan is to reduce the Greek debt to GDP ratio from 160 percent to 120 percent by having a dual approach of austerity and reducing the NPV of the Greek debt by making the creditors take a voluntary haircut of around 53.5% on their debt holdings by reducing the coupon payments on the debt and extending the maturity of existing debt

-         -  The ECB has swapped the Greek bonds worth about 50 billion euros that it was holding in its books with another set of Greek bonds that won't be subject to any future forced restructuring like those held by private bondholders.

Now let me elucidate the fallacy of each of the above three salient points of the deal. First let’s see how these 130 billion euros are expected to be distributed among various parties.

As can be seen from the graph only 19 cents for every dollar goes into spending inside Greece, the rest gets paid to the creditors. So almost 80 percent of the European taxpayers money is being channeled to the banks and financial institutions.

Secondly the plan to reduce the Greek debt burden from 160 percent of GDP to 120 percent of GDP without almost wiping out the debt held with the private sector banks/creditors would prove to be a mirage. According to the studies done by Kenneth Rogoff and Carmen Reinhart no country save for Swaziland has ever came out of the debt trap without hard restructuring of its debt or currency devaluation. For Greece being part of the Euro, currency devaluation is not really an option. Without the option of massive currency devaluation or such a restructuring a simple cursory understanding of economics would reveal the near improbability of bringing down the Greek debt load.

From basic  economics we know that a change in  change in private sector savings is equal to the change in the government spending net of change in the current account balance i.e. ∆S = ∆G + ∆NX. Greece is currently running a current account deficit of 6.7% of GDP and assuming it remains constant, as being part of the Euro Greece has relatively open borders for free flow of goods and labour within the Euro Zone thus making it difficult to impose huge tariffs and duties on imports. Now the government’s primary deficit is planned to be reduced from 2 percent of GDP (total deficit is 9.5 percent) in 2011 to a surplus of 4.5 percent.

This can only happen with a sharp reduction in Greek Savings or if the Greek citizens can come in and take more debt. With The private sector in Greece equally levered like the government and at the banking sector facing severe capital crunch , it would be difficult for the Greeks to take in more debt as a result the proposed massive public austerity would lead to a sharp reduction in the savings rate. This would cascade into the banks calling back the loans already given to corporates and public thus further lowering the growth rates and in turn the government tax revenues.

The chart below describes this growth conundrum:

As can be seen from the diagram that this austerity drive if not accompanied by massive debt restructuring/forgiveness or currency depreciation would lead Greece into a vicious circle of deflationary depression spiral.

Lastly the swap of bonds that the ECB has done is going to set a dangerous future precedence as now the sovereign bonds held at ECB would rank senior in any future restructuring and so the next time ECB buys the sovereign debt of Spain and Italy after this brief post LTRO hiatus it could lead to further turmoil among private bond holders.

The current debt deal would only ensure that the Greek depression that has continued for the last 5 years!!! is going to prolong much longer and so the only way out for Greece in getting back to a sustainable growth trajectory is to either restructure its debt even more wherein the private bondholders may end up getting completely wiped out (the ECB holds about 40% of Greek debt which as mentioned earlier is hands-off to restructuring) or break out of the Euro zone and re-ignite its industries with a competitively devalued currency.