India Macroeconomic Snapshot 2011

 

For almost 2 years, India’s Central Bank has been busy battling Inflation, even at the cost of Economic Growth. However, instead of being commended on their efforts to tame this stubbornly sticky inflation (which is clearly a product of Supply Constraints and Fiscal Mismanagement), the RBI has been heavily criticized for the slowdown in GDP growth.

In response to the slowdown, the RBI cut the Cash Reserve Ratio – the percentage of deposits that banks must keep with the central bank – by 50 bps (0.5%) in its review on Jan 24, a move that would release Rs. 32,000 Cr ($ 6.5 billion) into financial system. In his policy statement, RBI governor D. Subharao said, “the growth-inflation balance of the monetary policy stance has now shifted to growth, while at the same time ensuring that inflationary pressures remain contained”.

Slowing GDP Growth

According to the official estimates, the GDP grew at a mere 6.9%, compared to 8.4% in the previous year. The slowdown was mainly driven by the manufacturing sector, where growth slowed down from 7.8% last fiscal to a meager 2.7%. Other sectors have fared poorly as well with the Industrial output slipping into negative territory at -5.1% in October before bouncing back to 6.8% in November, mostly on account of a large base-effect. Strapped for funds, core infrastructure sector too saw dismal growth at 0.3%, owing to poor execution of projects.

Inflationary Pressures

Averaging around 9%, throughout the year 2011, headline inflation has been well above the comfort levels of the Government and RBI. While their desired range for headline inflation is 5 – 5.5 %, that range has continuously been breached every year since 2005 – 2006. However, much to everybody’s relief, Food inflation declined to lowest in 6 years (6 years – what a coincidence) albeit thanks to a strong base-effect, and seasonal impact. Since monetary actions take about 4-6 months to show results in the economy, there is some respite for 2012 for inflation to be contained. However, considering the risk of oil prices spiking up, the Central Bank will have to be extremely careful and ensure that inflationary headwinds have genuinely subsided before adopting any stimulus measures throughout 2012.

Burgeoning Fiscal and Current Account Deficits

Another alarming issue for the economy has been its mounting fiscal deficit. The previous Union Budget (FY 2011-2012) had set a target of the fiscal deficit at 4.6% of GDP. However, the fiscal deficit during the first half the fiscal alone was 85.6% of the full-year target. Hence, it is quite clear that the government is set to miss the target, and the deficit is more likely to be around the 5.2% mark, or perhaps more if oil prices rise and/or tax revenues decline (I believe that both events are highly likely, and a deficit of around 5.6% or more should not come as a surprise). With tax collections sluggish, and divestment ambitions foiled by poor market conditions, the government has no option but to borrow more to pay for its ever-growing subsidies bill. In doing so, it essentially mopped up most of the funds in the market, and crowded out private sector investments (i.e. increased interest rates by excess borrowing in the money markets). Rising oil and fertilizer prices and the implementation of the Food Security Bill are all going to further increase the subsidy burden for the government. With a tax base of less than 10% of the GDP, the picture doesn’t look very bright.

To make matters worse, high interest rates, big-ticket scandals, and the government’s reform-inertia had dampened the business environment to such an extent that manufacturing and industrial production plummeted. Exports growth was very trivial (due to economic slowdown in major export destinations), and was merely a fraction of the sharp growth in imports (thanks to robust domestic consumption demand), thereby worsening the trade balance. In addition to the worsening trade-balance, imports of Oil and a huge appetite for Gold (India imported 969 Tons in 2011) dented the Current Account Deficit even further. In fact, Oil and Gold together account for about 70% of the nation’s Current Account Deficit. Furthermore, high interest rates dampened corporate investments, and foreign capital inflows dried up too. All this put pressure on the nation’s foreign exchange reserves, which reflected on the Indian Rupee.

Currency Woes

2011 was a challenging year for the Indian Rupee, which depreciated 16% in 2011 (its biggest annual fall since 2008) and was the worst performing Asian currency of the year. Concerns about the rising fiscal and current account deficits amidst an uncertain global environment, loss of confidence in the Indian reform process, doubts over its growth momentum and stubbornly high inflation led foreign institutions (FIIs) to sell the Indian currency, pushing it to an all-time low of 54.30 against the US Dollar in the December.

The RBI refused to deploy India’s foreign exchange reserves to curtail this slide, as it was not a phenomenon that monetary action could fix alone. So RBI used alternative methods to curb speculation on the Rupee. It banned firms to enter multiple forward contracts to cover a single foreign currency transaction, and also eased rules for companies to raise offshore debt. It also raised the interest rates payable on deposits made by Non-Resident Indians. Also in December, India and Japan signed a $ 15 billion currency swap agreement. The RBI has pledged to keep a close eye on Rupee levels throughout 2012 as a weak rupee would further hurt imports, and on the flipside, exports won’t benefit much either owing to a global slowdown. In fact, firms that had resorted to foreign-currency debt in the form of External Commercial Borrowings, or ECBs (against a backdrop of rising interest rates in India), had to face tremendous pressure servicing that debt with the Rupee at such depressed levels. All in all, a weak currency would hence only add more inflationary pressure on the Indian economy.

Dominated by negative news-flow, such as the FDI in Retail debacle, or missed Divestment targets, criticisms of Policy Paralysis, failure of introducing GST, etc., 2011 was a year to forget for several investors, business leaders, and parliamentarians alike. So as we enter 2012, many “experts” will be hoping for the Union Budget in March to introduce crucial economic reforms. However, the challenges now are more complicated than they have been in recent years. Too much emphasis has been given to the role of RBI’s monetary policy, discounting the importance of the Finance Ministry (Fiscal Policy) in driving the economy. Personally, I expect FY13 to be much choppier than last year, and expect things to get much worse before getting any better. Considering the nature of coalition politics in India, any reform announced during the budget would come as a surprise, albeit a positive one.

Cows & Convertibles – Regulate India's Roads, not its Economy

I have been wanting to do a post about on further deregulating the Indian economy for some time now, but have just not been able to gather the enthusiasm… But after being stuck in the heavy traffic, moving barely 4 kms in over 40 minutes and with another 20 kms to go, I pulled out my laptop and started typing.

I saw beggars knocking at cars' windows, and children trying to sell flowers. A plebeian man was urinating in a dark corner where the streetlight wasn’t working. Another old man flicked a cigarette butt out of his car’s window in the direction of what was a street tree, but had become a garbage dumpsite thanks to relentless littering by vendors and hawkers, who were selling assortments ranging from tea, golgappas, kebabs, to plastic toys and stationary. As we moved a few more meters before stopping again at the traffic lights, a beggar with a deformed face knocked at my window, and moved on to the car next to me when I told him I had no change for him. Just then, my driver pointed towards an accident site, which was probably the cause of the traffic being so congested. A minibus (capacity: 24 seated + 15 standing) had rammed into a bike and a taxi. There was a small pool of blood thereabouts, but I guess the paramedics had already taken the victims to the hospital since no victims were in sight. We drove on.

Over the next few kilometers, I lost count of the number of construction sites. This sight of unfinished buildings, numerous cranes, massive stacks of bricks, piles of sand, and hundreds of migrant laborers rushing to complete their tasks, was gratifying in a strange way. The notion of India Under Construction was a fascinating one. However, just then I snapped back to reality as the driver slammed the brakes suddenly – an bunch of old drudges, carrying what looked like sacks of cement, were running across the street, totally oblivious to any sense of traffic and road-safety behavior. “You moron! Are you blind?” screamed my driver, and then turned to me, “Do you get to see such things in other countries?” I just smiled, but kept quiet.

Throughout the journey, I had noticed that the sidewalks were being used for everything except walking, forcing the pedestrians to walk on the streets, which in turn forced the cars to slow down and be careful not just about other cars, and traffic lights, but also pedestrians. Adding to their woes, the potholes were so aplenty that it navigating though them felt like a videogame challenge.

By the time we reached the airport, I was already worn out, and I wasn’t even the one driving. But I had realized one thing – what gives India such a poor image. It’s not the inept social structures, institutions or dirty politics as laymen usually jibe – politics, everywhere, is dirty by its very nature; and our democratic social structures and institutions are among the world’s finest. It’s us, the people! We lack civil sense, and are always looking to cut corners. We cross the street wherever we find convenient (instead of on a zebra crossing), and drive through a red traffic light (with no regard for the law). We, the citizens of this country, have accepted the red tape as standard practice; to litter or urinate on the streets as a norm. We have become impatient to wait for the traffic lights to turn green, or to walk a few extra paces till we reach the crossing. We cheat on our taxes, and bribe guiltlessly to cut corners, and often seek a bribe to do our jobs too. And yet we seek more and more freebies. We nag about working overtime, but we always seek a raise. And worse of all, we feel proud of it all. If someone points any of this out, or publically mocks us (BBC’s Top Gear being the most recent case in point), we start condemning them and demand immediate apologies without thinking twice that perhaps our behavior has genuinely given our nation and its people a despicable image.

Yes, the government, or the local municipalities rather, should look at this stalemate on our roads (both, road conditions as well as civil sense among the masses) as a serious predicament. As disposable incomes continue rising, the rising number of cars (more affordable now) is only going to worsen the situation. Are our roads ready to accommodate all those new cars? Some among us have managed to afford Ferraris or Bentleys, but do we have the roads for them? Could you imagine an IT entrepreneur in his Ferrari in Bangalore, trying to navigate though potholes, or a banker from Mumbai trying to shoo away beggars from his Bentley? Could you imagine an Industrialist from Kolkata trying to navigate through a swarm of pedestrians on the streets while cheeky bikers are riding past on the sidewalks? Or imagine a political lobbyist from Delhi waiting for the cows to give way to his newest BMW. These images are not just figments of my imagination, but true incidences.

Yes, there are new highways, new roads, but the same old 3^rd world mindset prevails. Even Bollywood celebrity Mr. Amir Khan has been campaigning (on TV) about civil sense – I wonder if his efforts have been fruitful. I’m no expert on urban planning, so I won’t pretend to sound like one, nor make any airy suggestions. However, having lived overseas for a decade, and having traveled a fair bit (3 continents covered so far), I’ve witnessed better civil sense in just about every country I’ve been to when compared to India. So please allow me to share a tiny wishlist if I may: I would like to see a cleaner city (more dustbins please). When driving, I’d like to see less chaos and some orderly traffic flow (and pedestrians using the sidewalk please).I do not want to see men urinating on the streets (public toilets please). Instead of hijacking every street corner possible, I want to see hawkers and vendors in an organized market-like setup (municipalities could perhaps consider Marrakesh’s food-stalls in Djemaa el-Fnaa, or the night markets which are already popular all across Asia as models to adopt). Readers who’ve never been to India might find these as hilarious 3^rd world problems, and it is just that. But, it’s torturous enough to make me write about it.

As for regulation in the economy, lets save it for some other time, shall we? Its 2012, and while people are talking about what they want from this year, this is what I want from 2012, or 2013, or even 2020 – or any year within my lifetime for that matter.

Fate of the US Dollar - Greenback making a comeback?

After looking back at the events that shaped and defined 2011, a follow-up post on previewing 2012 ought to have been natural progression. But considering the way that the US Dollar has defied all economic theories in 2011, I think it deserves to be the focal point of 2012’s first post.

Background

In August 2011, for the 1st time in history, rating agency Standard & Poor’s downgraded the long term rating of the United States of America from AAA to AA+ on the back of “Political Risk and Rising Debt Burden” and maintained the “Negative Outlook” which they had announced earlier in April. The announcement came 3 days after the US Congress voted to raise the Debt Ceiling of the Federal Government by the means of Budget Control Act 2011. This flag of caution was mostly ignored as the other 2 major rating agencies (Moody’s and Fitch) maintained their superlative ratings. However, Moody’s had lowered its outlook to negative in June, and Fitch too did the same later in November. The S&P had already lowered their outlook earlier in April, sending the Dollar to a 3-year low within a couple of weeks.

The blame game started practically immediately after the announcement. President Barack Obama blamed the Bush Tax-Cuts (which he had actually extended). The Republicans blamed the liberal Democrats for out-of-control entitlement spending, and demanded Obama to seek US Treasury Secretary Timothy Geithner’s resignation. Meanwhile the Democrats blamed the Tea Party Movement for provoking the idea of US Defaulting on their Debt. The Independents blamed everybody.

But then...

It was not the 1st time that the USA’s National Debt had formed headlines. Since the 2007-08 Crisis, America’s economic recovery had not exactly been remarkable; neither had they drastically reduce their debt. In fact, at over $ 15 Trillion, the US Debt is already 100% of the GDP. Also, at sub-2% GDP growth, economic rebound has been abysmal. And yet, the US Dollar has shown tremendous resilience, and surprisingly perceived by investors as the safest haven for their money. This is not because the USA did something right, but because the rest of the world, chiefly Europe, got several things wrong. And when talks of Greece defaulting on their debt, and Europe going into a recession surfaced, it was the panic among risk-averse investors that drove them back into the Dollar. Now brokerages and some pundits are suggesting that the trend could continue and the Dollar could dominate most of 2012. However, I am still not convinced about the prospects of the Dollar, and once again, would prefer to take a contrarian stance. Let me throw some light on the dynamics that give method to my madness.

A strong US Dollar actually hurts export growth thereby expanding the trade deficit. This is bad news as it hurts American competitiveness in the modern age where, thanks to globalization, consumers have the choice to buy Asian, European or American products. This is the last thing America needs as its economic recovery struggles to gain momentum. This is the reason why the US and Europe have been so vocal about the Chinese Yuan being artificially undervalued apparently. More recently, the US Treasury even criticized Japan for trying to weaken the Yen. So it’s fair to say that the US Treasury is closely monitoring the impact of a stronger Dollar.

If there was one single most influential event that triggered the flight to the Dollar, it would have to be the Euro-zone’s Sovereign Debt debacle. To summarize the entire EU shipwreck in a jiffy, it was simply a case of too much reckless spending by Greece, funded by debt (as it always is), mostly issued by France and Germany. Since participation in the EU required fiscal and monetary discipline, the Greek government kept this mountain of debt a secret, and misreported the nation’s official economic statistics, until the truth finally emerged in 2010. This was the point where the concerns regarding a sovereign debt crisis in Europe, especially the PIIGS (Portugal, Ireland, Italy, Greece, and Spain) got louder, and the markets started losing confidence. Hence as the sentiments in Europe got jittery, because of disappointing bond auctions in August, and then Greek bondholders having to take a haircut in October, investors flocked to the Dollar for Capital Conservation.

However, by the time 2012 draws to an end, two possible scenarios could transpire: (a) the Euro-zone resolves their problems and has a concrete plan of action in place (perhaps over-optimistic) or (b) the European Union could either dissolve or expel the troubled nations (most possibly Greece). But the truth is that both those scenarios are extremes and unlikely to materialize. But either way, the one thing that is certain is that the Dollar will see an exodus of capital flowing into either a resurged Euro or a successor to the Euro (especially with Germany’s backing) in the 2nd half of 2012.

The Euro-zone troubles led to some resurgence in the US Dollar. But in the grand scheme of things, there has been a secular shift away from the dollar – both as a reserve currency as well as a trading currency. These are the two essential roles that the Dollar plays in the modern, globally entwined economy, and with those roles reduced, the Dollar will surely lose its supremacy. Let’s take a closer look at what’s happening on these fronts, starting with the USD as a reserve currency. China and Japan are the largest holders of US Treasury Debt (Look at the figure for USA’s foreign creditors). As of August 2011, over 60% of China’s $ 3.2 Trillion foreign exchange reserves were denominated in US dollars (including $1.1Tn in US Treasury Bonds). However, according to Standard Chartered Bank, while China’s reserves grew by $200bn in the 1st four months of 2011, 75% of this comprised of non-dollar denominated assets. China also bought Euros in 2011 in the form of sovereign debt from countries like Germany, France, Italy, Portugal, Spain, and Hungary, thereby adding to their previous European holdings. Chinese Premier Wen Jiabao declared that as long as Europe is serious about resolving its issues, China would continue to help financially. In addition to purchasing sovereign bonds, Chinese investments in European corporations too have grown phenomenally as they bought corporate bonds worth $72bn in the 1st half 2011 alone. 

And that’s not all. China has steadily been accumulating Gold reserves too. While its Gold holdings are only 1/8th of America’s, it’s steadily rising. China’s share of global Gold demand has tripled in the last decade from 6% in 2000 to 18% in 2010. And considering it is still only the 6th largest holder in the world with 1,054 tones, which accounts for less than 2% of its total reserves, it is expected that China’s hunger for this yellow metal is all set to rise. China’s not alone in the Gold rush. Other countries too bought gold in 2011 in an attempt to diversify their reserves. South Korea bought 40 tonnes, Mexico 98 tonnes, Russia 63 tonnes and Thailand bought 53 tonnes. Other countries that added gold to their national reserves include Columbia, Bolivia, Kazakhstan, and Venezuela. India’s central bank RBI made an early move, buying 200 tonnes in October 2009 from the IMF. Furthermore, according to estimates from World Gold Council, Indian households bought another 1,059 tonnes of gold between Sept2010 and Sept 2011, taking the aggregate Indian household holdings to 18,000 tonnes. The 2 illustrations below show which countries have the largest gold reserves, and how much does gold account for. 

China and India aren’t the only ones diversifying their reserves earnestly. Japan too has been following suit as its Finance Minister Jun Azum raised concerns about Japan’s $1.3 Trillion foreign reserves being dominated by US dollar denominated assets. In December 2011, when Japanese Prime Minister Yoshihiko Noda visited China, he announced buying Yuan Bonds worth $10 billion, and also agreed to use Yuan for bilateral trade with China. Furthermore, it also entered into a $15bn currency swap agreement with India recently. The agreement would give India 15 billion dollars to meet its short-term liquidity needs, and Japan would get Indian Rupees to trade with India directly and diversifying reserves at the same time.

China has made it no attempt to hide its ambitions of the Yuan replacing the Dollar as the world’s next reserve currency, and is not only slowly expanding Chinese bond markets, but also making bilateral trade agreements especially with its Asian partners, promoting Yuan denominated trade. It is expected that as the Hong Kong based Dim Sum Bond Market grows in market-capitalization (current m-cap is 35 billion), more countries & corporations will take notice and participate. Already having signed deals with Thailand, Japan and Pakistan in 2011, China is now well on its way to materialize its plans of signing an agreement with the 10-member Association of South East Asian Nations (ASEAN) to settle bilateral trade in the Yuan. The trading bloc is collectively China’s 3rd largest trading partner, and promoting Yuan settlement with them would be a major step in the dragon nation’s long term campaign to make its currency widely-used beyond its own borders, and take up a bigger role on a global stage. According to the Wall Street Journal, the Yuan accounted for less than 1% of China’s trade in 2010, but that number rose to more than 10% in 2011 and is expected to rise to 15% of the total trade in 2012 according to estimates from Deutsche Bank. China has been doing this (signing currency swaps to facilitate Yuan denominated bilateral trade) since the crisis period of 2008. In the graphic below, I highlighted the nations that China has signed such deals only in the last 2 years. As expected, the countries with closer geographical proximity have already been taken on board, and it would be little surprise that within another 2 years, more nations will follow suit, and this graphic will have more shades of red. Hence, in this backdrop, one would have to be very sanguine to maintain a rosy outlook of the dollar. 

Case for the Dollar

Having said all the above, it would be very naïve to write the US off so easily. A strong US Dollar does provide some benefits too. 1st of all, cheaper imports could help boost consumption in America. This rationale often attracts criticism that “Made in China” goods are the root cause of the USA’s deficit, but if an economic paper released by Federal Reserve Bank of SanFrancisco is of any merit, then that criticism is flawed because 85% of every Dollar spent by Americans on products “Made in China” benefits America, while China only gets 15% of the benefits. How? This is because the actual cost of production of those goods is under 15% of the final price that the consumers are charged, and the rest of the costs come from services such as transportation, logistics, retailing, marketing, etc. which are all done within America. However, since the masses do not realize this when they see a “Made in China” label on their goods, and also since 2012 is an election year, one should expect Washington to make politically popular decisions at the expense of prudent economic ones (call it if you want, business as usual).

Some people aren’t as cynical as myself and believe that the USD is indeed the safest best. Investment bank Morgan Stanley recently called the US the “best safe haven “and forecasted that the USD will get stronger in 2012 as deleveraging will cause balance sheets to shrink not only in Europe but around the world. According to another investment bank UBS, US fund managers, who collectively hold $40 trillion in US Dollar assets, and are 1 of the 3 largest holders of the US dollar (other 2 groups being sovereign wealth funds, and foreign central banks), have now stopped diversifying their portfolios. They are now planning on repatriating funds if the US equity markets continue to out-perform its peers.

Albeit at the expense of exporters, a stronger dollar benefits the consumers at some levels as it makes their imported discretionary expenditure items cheaper. However core expenses such as food and housing remain unaffected. Furthermore, cheaper imported raw materials are also a boon as it lowers input costs of production. However, this may not be useful at a time when business confidence and capital expenditure are low, and unsold inventories are already quite high. It should be noted that another implication of cheaper imports is that the country’s trade deficit widens. So I personally think that a stronger dollar, while benefits consumers at some levels, actually hurts the economic productivity of the country. Some companies would relocate their manufacturing base overseas to gain from lower labor costs and cheaper raw materials thereby maintaining healthy margins. This relocating however causes job loss in America (and no jobs means no income, which means no discretionary expenditure, which makes the cheaper imports fruitless).

Finally, a stronger dollar gives the US an opportunity to pay off some of its national debts at a favorable exchange rate. However, this opportunity comes at a time when conflicting political beliefs may make it impossible to make the most of it. As we all know, 2012 is an election year for the US, and any decision made by the Obama Administration, whether good or bad, will be shredded by the Republicans in the Senate, much like they rejected the American Jobs Act a few months ago.

So to conclude, while many pundits are getting bullish on the dollar, I want you to base your own stance on secular, longer-term trends and filter the short-term hullabaloo. And that secular trend is pointing towards a shift of economic power from the West to the East, and there is no better manifestation of this than the descent of the greenback.