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Is the Rupee devaluation enough to cover the CAD of 4% of GDP?

Is the Rupee devaluation enough to cover the CAD of 4% of GDP?

 

 

The Dollar closed last week at 55.36 after having made a high of 56.38 against the Indian Rupee [INR].  The Dollar was priced at 48.56 as recently as February 2012.  In the space of the last 4 months of this year, the Dollar has appreciated by as much as 16.1% against the Rupee.  India’s current account deficit [CAD] this year could have reached as much as 4% of GDP compared the “safe level” of about 2.5% that can be financed by a mix of reliable NRI deposits, FII investments and FDI.  Each of these three sources contributes about $30 billion per annum to the foreign exchange kitty, making a CAD of like amount safe to carry on the RBI books. Has the Rupee fallen enough?  More importantly, will the fall in the external value of the Rupee be enough to reduce the CAD back to safe levels?

 

The first order of business should be to restore the perspective on the Dollar’s rise against the INR over time.  A good point to start this exercise is the peaking of equity markets in late 2007 and the subsequent worldwide crash that followed starting January 2008.  Begin by noting that steady state of the Dollar’s value against the INR was R39 per Dollar in January 2008.  From there, as the equity markets crashed and the FII flows reduced, the Dollar appreciated against the INR from 39 to 50 in November 2008.  That implies an appreciation of the Dollar against the INR of about 28% over a span of 10 months.  In that perspective, the Dollar’s current appreciation is par for course.  So what’s the big noise about?

 

The second thing to note is after hitting a high of 52 against the INR in March 2009, the Dollar fell to a low of 44 in April 2010.  This coincided with a recovery in the markets worldwide. In the span of 12 months from March 2009 to April 2010, the Dollar actually depreciated by 18.5%!!  Should the RBI have allowed this?  Would it not have been better for the economy if RBI had mopped up the excessive Dollar inflows during this period and kept the Dollar steady at R50?  With 20/20 hindsight the answer is clear.  In fact RBI’s policy bias needs to change to make this its default choice.  But alas, that realization is yet to dawn on our policy makers.  We are still in love with the idea of a strong Rupee not realizing how much it hurts our poor people and the farmers.  Be that as it may, the Dollar was allowed to consolidate at R44 between April 2010 and August 2011. This is time we thought India was invincible when any trader could have told RBI that we were in long-term bear markets and hence the FII/FDI flows would reverse.

 

 

The current Dollar’s rally against the INR has its genesis in the region of R44 in August 2011 and should be seen a run up from there.  On such reckoning, the Dollar has appreciated by 27% against the Rupee over a period spanning August 2011 to May 2012.  That’s about the same appreciation in terms of time and price as after the crash of world equity markets in 2008 when the Dollar appreciated by 28% over 10 months.  So is it that markets are working normally and the fall in the value of the Rupee is in anticipation of the drop in FII/FDI flows? In short have the markets merely discounted the inevitable effect of the ongoing crash in equity markets worldwide as in 2008?  The answer, at least partially, has to be in the affirmative.

 

The Dollar’s appreciation against the INR will cut into the attractiveness of Gold as an investment. Gold constitutes the second largest item of imports after crude.  Gold for investment has averaged $20 billion per annum.  As the cost of imported crude is passed through into domestic prices, the demand for POL products should moderate a bit. Given that NRI deposit inflows will increase slightly to around $30 billion, FII + FDI are already at about $20 billion, what exists by way of uncovered gap in financing CAD is approximately $40 billion.  Of this a fall in gold imports alone would cover around $15 billion.  Apart from that, exports of commodities like cotton, tea, sugar, soya and a pick up in software services exports should be able to cover the balance gap of $25 billion.  Hence after the current bout of Rupee devaluation, the financing gap in the CAD appears adequately covered.

 

 

The Dollar’s 18.5% depreciation against the Rupee in 2010/11 lost us a huge chunk of BPO business to Philippines.  RBI must make it a policy to monitor the weakest Indian BPOs to keep tag on marginal labor costs and use that input to guide Dollar value in Indian markets.  Let us face facts.  It is the services business of BPOs at the margin that keeps our huge army of clerks employed gainfully and drives demand of everything from housing to branded goods.  Lose these jobs and you are asking for deflation.  Never again must RBI buy into airy-fairy talk of “moving up the value chain” and KPOs etc.  Keep your feet on the ground and watch your weakest link in the chain.  That weak link is our low-end call center business and as long as there are unemployed youth, it is RBI’s business to see that they are employed gainfully in profitable BPO exports.  RBI and GoI must not forget this lesson in good times.  The weakest link at the margin matters the most.

 

So what is different in the current crisis from the one we faced in 2008?  The big answer lies in our fiscal deficit.  Back in 2008, the Government was able to step up its fiscal deficit from 4.5% to about 6% of GDP to absorb the deflationary pressure of rising Dollar along with a fall in the inflows in FII + FDI.  It no longer has that cushion and will not be able to absorb the shock as painlessly as in 2008.  Secondly, inflation in 2008 was in check.  The profligacy of the wasted years of 2010/11 is now catching up with us in terms of inflation most of which is structural and embedded deeply into food prices.  We cannot address this structural food inflation in Agriculture with monetary policy.  There have to be deep reforms in Agriculture to break the logjam of high inflation combined with a slowing economy.

 

What the government needs to do to works its way out of the crisis is not rocket science.  Perhaps the easiest way out would be take steps to restore profitability to lapsed BPOs and encourage more of them in selected towns that can support them in terms communication links, telephony, housing and power.  The gestation period here is small and the results should be quick.  Further afield, there is no alternative to FDI in retail as means of breaking the policy logjam in agriculture.  It is more a domestic requirement to open up the agriculture sector than to attract foreign investment.  Bold moves here would also help restore the faith of the FIIs in reforms.  Last but not the least, we need a cogent well-articulated plan to cut the fiscal deficit.  The pass through of crude prices is a beginning.  It should be carried through to its logical end without backtracking.  It would also help if government began to cap food and fertilizer subsidies in terms of an absolute value and swore off open-ended doles.  You may be poor today but you can’t remain poor forever.  Welfare programs must include processes to graduate out people who are being helped in a phased manner.

 

If you do not consolidate your gains and reform during your good times you are forced to do that in the worst of times.  If RBI and government learn that one lesson from the current crisis we will have done well. Is that too much to hope for?

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MARKET NOTES: Heading towards a death cross in the US markets.

May 26, 2012 2 comments

MARKET NOTES:  Heading towards a death cross in the US markets.

 

 

 

Gold:  Gold was oversold after having hit a low of $1527 on 16th May.  It has since been correcting for those over sold conditions but without seriously challenging its overhead resistance at $1600.  It closed the week at $1572.84.

 

 

As per my wave counts, the correction in gold from its top at $1920 is not done in terms of price and time.  There is at least another leg down to the correction, which could take gold down to test the $1430 region before the middle of July this year.  In the ensuing week gold could reaffirm the overhead resistance at $1600 before heading down to test the first floor in the $1530 region.

 

Not bullish on gold as yet, because the near term bottom of this correction hasn’t been firmly established.

 

 

DXY:  The Dollar’s rise from 72.8 in May 2011 to date [about an year] represents an interesting picture.  The Dollar has been in a very long-term decline from a level of 130 in 1985 to a low of 71.5 in April 2008.  The low formed in May of 2011 at 72.8 represents a successful test of the previous bottom in April 2008.  DXY had rallied to a high of 90 after the April 2008 bottom.  Whether the rally from the May 2011 represents a new bull wave or not is too early to tell.  What is clear is that the wave counts from the low of 72.8 in May 2011 represent a bullish picture with first target at 83.75 followed by 86.5.  This will happen over time of course.

 

DXY has cleared its first major hurdle at 82 with remarkable ease and has since retested the new floor from the topside.  This opens the way to the next target of 83.75 in the coming weeks.  Remain bullish on the Dollar.

 

 

EURUSD:  As expected the 1.26 level on the Euro did not hold and the Euro closed the week at 1.25150.  The violation of 1.26 level opened the way for a retest of 1.20 level.  However, the next immediate target for the Euro is 1.24.  It is likely to test that very soon, possibly next week itself before some consolidation sets in.  There is simply nothing bullish about the Euro on the charts any longer.  It needs to find a firm floor first and the likely candidate for that could be 1.20 although even that can’t be a certainty.

 

 

 

NYSE COMPOSITE:  The index closed the last week at 7534.33.  The index presents a very bearish picture.  The index is below its 200 DMA, which is currently 7813.  Its 50 DMA stands at 7875. The gap between the two crucial DMAs is narrowing swiftly.  A death cross could ensue during the course of the next week bringing enhanced selling pressure in the market.

 

On a more long-term view, the 7180 region on the index is crucial.  It represents the top made by the index in 2001 before correcting down to 4500.  The region has failed to act as a support on previous occasions.  A repeat of the same may be expected.  But a violation also implies a confirmation of a long-term bear market in stocks that may stretch over years.  So the level is crucial even if it doesn’t count as a support.

 

The first target for the index remains 7,200 followed by a deeper floor at 6425.  Watch for the death cross in the ensuing week.  It may bring a deluge of sell orders from long-term “buy and hold” investors that won’t be reversed in hurry.  I remain bearish on the US equity markets.

 

 

$-INR:  As expected, room was created above the previous top at 54.3 to establish a new trading range that spans from 56.4 to 54.3.  This range should be adequate to determine where the $ wishes to go against the Rupee next.  Expect a few weeks of base building in this range during which the players test supply and demand under the new trading conditions imposed by the RBI.

 

In the ensuing week expect Rupee to come back and test the new floor at 54.3.  There is absolutely no reason to think we have arrived at a sustainable value for the $ in our exchange markets given the horrendous trading restrictions imposed by RBI. The ultimate value for the Dollar has to be higher.  But in the immediate future expect a period of consolidation and testing within the new trading range for a few weeks. One hopes RBI will be closely watching DXY.  But don’t count on an immediate impact on trading in local markets.  I remain neutral on the Rupee in the 54.5 to 56.5 trading range but with a bullish bias for the $.

 

 

Sensex:  Sensex showed a small bounce from the 15,800 level during the last week and closed at 16,218.  A small rally in the index from these levels into the 17,000 area is possible in the coming week as the bourses are oversold.  On the other hand, a death cross in the US markets could trigger further FII selling in Indian bourses.  Whichever trajectory stocks take over the next week, it is very unlikely that we are done with the selling in the markets.  The possibility that the markets could decline to 15,100 before rallying to 17,000 is more logical but it’s always very difficult to predict the exact way a cookie crumbles.  To my mind it is better to go to 15,100 first before rallying to 17,000 for oversold conditions.

 

 

 

 

NB: These notes are just personal musings on the world market trends as a sort of reminder to me on what I thought of them at a particular point in time. They are not predictions and none should rely on them for any investment decisions.

 

Categories: Uncategorized

How does the external value of the Rupee matter?

May 23, 2012 4 comments

How does the external value of the Rupee matter?

 

 

An US $ fetched approximately R44 at the end of May 2011.  The $ closed at R54.42 last Friday.  Over the course of last twelve months, the $ has appreciated by approximately 21.5%.  In the first blush of reforms in 1990, the Rupee was devalued by 20% over a period of 10 days.  Is the Rupee now fairly valued?  Can it fall more?  Should it fall more?  In a system of market-determined rates, the forces of demand and supply decide these things. However, we have never had a free market in foreign exchange and the external value of the Rupee was always set by administrative fiat backed up by an elaborate system of exchange controls.  A part of these controls were dismantled in 1990 with reforms.  The Rupee has never been convertible on capital account.  RBI still has a variety of controls on who may buy foreign exchange and for what purpose in the market.  Apart from direct intervention, RBI has variety of other levers with which to guide the external value of the Rupee.  Therefore, it effectively sets a fairly defined range in which the $ trades in the foreign exchange market.  A free market in the $-INR is largely a myth.  Therefore the correct question to ask is where should the INR really be and to what purpose.

 

 

The exchange rate policy in India was designed in the 50s to achieve certain goals of development and hasn’t changed all that much even after reforms.  It is worth considering the logic behind the foreign exchange policy.

 

 

Nehru borrowed the Stalinist model of economic growth almost lock, stock and barrel from Russia after being greatly impressed by the rapid strides that Stalin had made in industrializing the USSR.  This model in essence called for massive transfer of income and wealth from agriculture into industry and developing the same using technologies developed in Western Europe. The model was successful in the USSR because prior to communists, the elites had deliberately herded common people onto unproductive farms under crippling taxes, prevented mechanization of agriculture and fought to keep industrialization at bay in Russia in order to prevent concentration of peasants in urban centers that could lead to a revolt against the feudal elites.  Stalin was able to reverse these processes.  Mechanization of agriculture led to a huge jump in agriculture productivity and wealth.  Stalin was able to tax this newly created wealth through a variety of controls and channelize the same into industrialization using western technology.  Industrialization created a huge demand for labor that was met by moving people out of farms into factories via a state schooling system.  In the initial phases, for close to thirty years, the Stalinist model created humongous wealth and prosperity for Russia.  It began to run into problems only when it failed to innovate on its own and was stifled by multiple market failures.

 

 

Nehru attempted the same in India with Russian help.  Massive dams were to be built to step up agricultural productivity through irrigation.  The wealth created in agriculture was then to be used to invest in modern industry.  And over time, the labor and people would be moved from agriculture to industry through a State schooling system.  As in Russia, the model worked for sometime in India, though not as well as in the USSR.  India was able to step up its GDP growth from something less than 0.5% pa to something over 4.5% in the two decades of 50s and 60s.  As in the USSR so in India, the model ran out of steam once the initial wealth created by agriculture had been sunk in industry but yielded no further returns due to stifling price and other controls.  In fact, since India did not mechanize agriculture as Stalin did, nor did it nationalize land into collectives, the spurt in wealth created by agriculture in the first two decades came primarily from investment in dams and irrigation.  This model of growth is so deeply embedded in our collective psyche that few think beyond it.  For most of us, even today, it is the only way to growth and development.

 

 

How did India collect the wealth from farmers to invest in Industry?  One should pause to think about this because we have never formally taxed farmers and still do not do so.  How was surplus generated in agriculture transferred to industry?  The answer lies in price controls.  We do not tax farmers but we take away any surplus they generate by paying them far below market for their produce.  Export controls on agricultural products in tandem with exchange controls lie at the heart of this mechanism for surreptitiously transferring wealth created by farmers to industry.  I have detailed how this works elsewhere.  For the nonce, note the effect of an overvalued INR.  Farmers cannot export their produce directly, or even through traders in case of food crops.  Instead, the stuff they produce like cotton, tea, sugarcane, rubber etc. is channelized to industry and the right thing to do, as per conventional thinking, is to keep these inputs as cheap as possible, since industry “adds value” before exporting them.  That is true but where does this value go?  It doesn’t flow back to farmers in any case. But farmers pay for all that they use for production or consumption at prices determined by markets rate for the $.

 

 

Why have other strong nations fought long and hard to keep their currency undervalued in relation to others?  The answer is simple.  Nations wish to maximize job creation in the domestic economy and export whatever their domestic economy produces cost effectively.  Maximization of job creation is an explicit policy goal of the exchange rate policy.  In India, on the other hand, we are in love with a strong Rupee and pay scant attention to job creation.  That was because our imports, ignoring gold, are largely petroleum and capital goods, which are price inelastic, while our exports, besides agricultural commodities like tea, cotton, jute, sugar etc. are an ill-defined basket of goods whose price elasticity is indeterminate.  Since we are a net importer, conventional wisdom dictates that we keep the INR overvalued in our favor.  That policy also favors both our industry and our middle class who are the main consumers of imported products while it further “taxes” our farmers who are net earners of foreign exchange.  The situation has changed somewhat with software and services exports where the external value of the INR directly impacts job creation for the middle class creating some awareness among them of how the dynamics of INR pricing works but not nearly enough.

 

 

A further factor that closed the minds of our policy makers in the past to use of agricultural exports for domestic job creation and growth was the closed nature of export markets for agricultural produce in the EU and other developed countries.  Import quotas, subsidies to local farmers in these countries and variety of other trade barriers shut Indian farmers out of these markets.  That has changed with shifting demographics in these countries and the emergence of China as the world’s largest importer of food and other agricultural commodities.  This development has barely registered in Indian policy circles and intelligentsia despite the fact that it can completely change the game for Indian farm exports.  China is the world’s largest importer of Soya, corn, and increasingly other cereals dwarfing total consumption in other countries as its middle class grows.  India needs to focus on China as an export market for its farmers and we must begin creating the mechanisms necessary to facilitate opening up the Chinese markets for our farmers.

 

 

Tapping the Chinese market cannot be left to markets alone.  Think tea, rubber, soya, jute.  Recall the huge role the State had to play in creating trading markets for these products, setting up of price discovery mechanisms, transportation & warehousing linkages, ports, export houses and the like.  This is not asking for subsidy or state intervention in price discovery but for creation of the institutional mechanisms whereby trade is facilitated.  What was done in respect of tea or rubber or soya needs to be replicated across things like corn, rice, wheat etc.  The State has to play its role in facilitation of trade, which it isn’t doing at the moment.  The whole policy orientation towards agriculture and export markets for its produce needs to be rethought and revised top to bottom.

 

 

RBI can afford to let the market play a greater role in determination of the external value of INR for a while without undue panic or worry.  India is fundamentally a viable economy producing far below its potential because of flawed policies.  We need to let the market play its due role in generating pricing signals that guide policymaking.  Have faith in yourself and trust the markets to get the direction right.  Policymaking must not replace the market but follow it in order to fine tune things.  If that means the INR needs to go to 65-80 ranges before people start investing in farms to grow Soya or corn for export, we should let the market lead the way.  It should be obvious that once the exports get going the INR will revert to a higher value again.  Equally obvious is the fact if policy makers facilitate policies that make exports of Soya or corn to China quickly the INR may not need to go to 65-80 ranges for that to happen.

 

 

The depreciating INR creates new opportunities.  Rather than fight the markets it is high time we learned how to use markets to set the right policies in order to achieve higher growth.  Let the Rupee our thinking be free.

 

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MARKET NOTES: The major trend across markets remains down

May 20, 2012 2 comments

MARKET NOTES:  The major trend across markets remains down

 

 

Markets across all asset classes are in turmoil.  With torrents of news flow, mostly bearish, and heightened volatility, making sense of the markets is like solving a huge jigsaw puzzle made up of a large number of other jigsaw puzzles.  Not all of it makes sense at any given point in time, but seen as a process over time, the pieces do fall in place, sometimes much after the events themselves have passed on.  We appear to be halfway through such a period of flux, in price if not time.  So treat what follows with a bit of caution.  I have done my best to keep things simple and sensible.

 

 

Gold:  As blogged often here, 1550 was the target for gold for the correction that commenced in September 2011 from a price level of 1920.  That was achieved on 16th May when gold made a low of $1527 and closed at $1538.  Had tweeted that shorts should take partial profits then.  Gold has since bounced back to a high of $1597, closing last week 1591.8.  Where does it go from here?

 

First off, in term of time, if not price, the correction in Gold is not yet over.  That period ends some time in July.  Secondly, a reactive bounce from 1550 region was to be expected and has happened.  A decisive cross above $1620 would be the first signal that the price may have reversed.  Until then, the bounce from $1530 is merely a reactive bounce that could be reversed in the ensuing week.

 

Can Gold go lower than the low of $1523 that it made in December last year?  The answer is yes.  A significant low below $1520 will signal that the gold move down from $1920 is not just a correction but also an impulse wave down with a much lower target than $1520.  Hence price action over the next two weeks will tell us where the market intends to go next.  Until then, it is best to stay on the sidelines for traders.

 

 

Silver:  Silver, much like gold, bounced from its floor in the region of $26 to close the week at $27.8.  Silver could rise further to test its first overhead resistance at $30.  A firm break above $30 would be the first indication of a price reversal.  There is little on the Silver chart to suggest the metal has bottomed out.  Therefore, it can return to test $26 again and possibly breach the level.  There is no bullish case for Silver yet.

 

 

$-Index:  This blog has been bullish on the $ when the world was bear.  [And bearish on gold when the world was a bull.]  The odd fact about the $ is that it should be correcting down to sub-75 levels when it is actually perched close to its first major overhead resistance at 82.  And this happens at a time when the yields on 10 year US treasury notes are at lowest being just 172 bps.  It is a bizarre world!

 

A break above 82 would see the $ shoot towards 90 and it is possible that a break above 82 could occur over the next two weeks if the Euro$ turmoil sends the Euro significantly below its floor of 1.26.  On the other hand, the downside in the $ is no more than 79.5.  So the trend favors the bulls in the mighty $.  So how come it is the $ that is being debased?  It would take too much time to address that conundrum.  I am not a $ bear.

 

 

Euro$:  As expected by this blog, the Euro collapsed from the level of 1.32 to make a low of 1.26930 during the week.  Expect the Euro to rigorously test the 1.26 level in the coming week and perhaps breach it.  Having said that, the Euro is in oversold territory and an immediate decisive breach of 1.26 is highly unlikely.  All bets would be off if Greece exists the Euro.

 

My gut feel says the authorities will let the markets fully price in a Greek exit before it happens to take the sting out of the event.  That process will be signaled on a decisive breach of 1.26 to test the floor at 1.20 where the Euro commenced its life as a currency.  So watch prices to discern policy.  Not a time to trade the Euro unless you are one of those policy wonks who bet on event risk.

 

 

$-INR:  As predicted in this blog month’s back, the INR not only tested its previous high at 54.33 but also decisively breached it.  We are now in uncharted territory.  I am not going to predict prices based on Fibonacci numbers or other such techniques because it makes no sense to me.  Instead I am going to concentrate on getting the direction of the Rupee moves right over the next few weeks.

 

Firstly, note that in terms of time and the good round figure of 20% devaluation, the policy intent behind the INR move is probably complete at 54.50.  In other words, GoI probably doesn’t INTEND further devaluation of the INR and that is confirmed by the chart pattern thus far.  Secondly, note that the $ is bullish against most major currencies and may appreciate against the INR irrespective of GoI intent.  Lastly, it will be a good 2 quarters before the new level of $ vs. INR impacts exporters like the software companies to deliver more $s in the markets.  In all, the $ could rise higher to say 57/58.5 range in order to create a new trading range with a floor of 54.5.

 

In short I expect the $ to trade in the 54.5 to 58 trading range for a few months before long term trends assert themselves.  A fall below 54 is highly unlikely in my view.  The range extension to 56/57.5 should happen over the next few weeks before the lower bound is tested.  An extension of the trading range to 56 would also signal further weakness in the INR in the years before 2014.

 

 

BSE 500:  As readers may have noted, I am highly suspicious of narrowly defined popular indices of the Sensex or Nifty kind, which are often used at market extremes to generate confusing signals.  Last week we looked at DEFTY to see how we were in a bear market that started in January 2007.  This week we look at the BSE 500 index to confirm the prognosis from the DEFTY.

 

Note, the BSE 500 never made a double top or new high in November 2010 unlike the Sensex or the Nifty.  That confirms that the broader universe of stocks in the Indian markets is in a long-term bear market that started in January 2007.  The message from the DEFTY was not an isolated one colored by an exclusive FII perspective.

 

Where does the market go from here?  First some numbers.  The BSE 500 made a top of 8960 in January 2007 and a low 2962 in March 2009.  It then bounced to 8420 in November 2010 and we are in a down move from that point on to the present level of 6115.  The index made a low of 5730 in this down move in December 2011.

 

The minimum target for this down move then becomes 5730, which corresponds to roughly 15,000 on the Sensex.  There is no major floor between the current level and 5730 so expect this level to be tested in the next 2 weeks.

 

Will it stop there?  That is for the market to tell us by its reaction to the 5730 area.  I wouldn’t bet on the outcome even in the event of a small bounce from there.  In terms of time, we are in the middle of one of the most destructive waves in a bear market.  It will take a couple of months to fully unfold.

 

 

NYSE Composite:  The NYSE Composite index best illustrates why narrower indices like DOW are best used with some caution.  Unlike the DOW, there is much more clarity in the broader market.  That said, the broader index is firmly set on the path down to 6500 area.  It is not oversold and has plenty of time to get there.  It had a minor floor at 7500, which was breached last week.  Minor pullbacks apart, the next level to watch for are 6,500.  That corresponds to the 1100 area on the S&P 500.

 

 

Will take a look at EU markets and agricultural commodities in a separate blog by middle of this week.

 

 

 

NB: These notes are just personal musings on the world market trends as a sort of reminder to me on what I thought of them at a particular point in time. They are not predictions and none should rely on them for any investment decisions.

Categories: Uncategorized

Understanding India’s Stagflation – Why INR needs to tank

May 16, 2012 10 comments

Understanding India’s Stagflation

 

 

The Rupee has sunk by 20% in last 4 months, while India’s industrial growth rate is [minus] 3.5% year on year.  What is going wrong?

 

Let us set up a simple equation based on standard definition of national accounts to understand what has been going on in the Indian economy since the financial crash of 2007.

 

 

Let all domestic private household and firms savings be S, the investments made by the domestic private firms in businesses be I.  Then [S-I] represents the net incremental cash available in the economy from the private sector.  Likewise, T represents the totality of all tax revenues available to the government while G represents the totality of all its expenditure.  Thus [T-G] would then gives us the net incremental cash generated or used by the government in a year.  The sum of [S-I] + [T-G] then represent the net cash generated by the economy in an year and should be reflected as an increase or decrease in the reserves held by the central bank.

 

On the other hand, let M be the totality of all imports into the economy, and X the exports out of the economy.  In that case [X-M] represents the surplus on the external trade front and will be reflected as a increase or decrease in reserves of the central bank which then has to be deployed overseas or financed overseas.  In short, we have:

 

[S-I] + [T-G] = [X-M]

 

 

We must note two things in the Indian context in relation to the above equation.  The gap in external trade account is financed by flows from [1] incremental NRI deposits, [2] FII investments and [3] FDI and external borrowings.  All these sources are in the nature of financing decisions made by us and are independent of the investment decisions or the I part of the [S-I] in our equation.  If there were other funding sources available, I could still be high even if FII or FDI flows diminished.  Investments, or I depend on the attractiveness of an investment considering its profitability and the aggregate demand in the economy.  It is in a sense independent of how it is financed.

 

Secondly, to the extent [S-I] is positive, or the private households save more than they investment in businesses, the Government has to run a deficit in order to offset the excess saving else aggregate demand in the economy would fall leading to a recession in the economy because we always have an excess of imports over exports which reduces domestic demand and increases demand overseas.  In other words, given the “structural” constraints in our export mix and import needs, so long as [X-M] is negative, the government must, repeat must, run a deficit [T-G], else the excess of savings over investment in the private sector & households would deflate demand and lead to a recession.  Actually, the deficit created by [T-G] has to not just offset [S-I] surplus but must be slightly larger – something like 3-4% of GDP – in order to stimulate the economy by creating incremental domestic demand.  This is crucial to sustaining aggregate demand in the economy.

 

We need to make one additional modification to the simple logic of the algebra of national accounts and we will be ready to go.  This is due to our peculiar affinity for gold, which got pronounced after the financial crash of 2007.  Where does gold fit into the national accounts considering all of it is basically imported?  We will consider the net gold imports for simplicity, which are total gold less what is exported as jewelry.  These are approximately of the order of $20 billion a year. Let D [for dead investment] be the net gold imports that are used by households for investment.

 

 

Our equation for cash generated in national accounts then becomes:

 

 

[(S – D) – I]  + [T – G]  = [X – (M + D)]

 

 

That is to say, since any savings diverted to gold cannot be used to finance domestic investment by businesses, we remove D, the value of gold used as dead investment, from the total stock of private savings from the economy.  Our new level of saving is thus (S-D) and these are used to finance I.  [T-G] remains the same.

 

On the external balance front, we basically split imports as all imports as before less gold which is shown separately as D.  So the change in reserves is now given by [X – (M+D)]

 

 

Now we are ready to resolve some, not all, the mystery of the emerging stagflation that is getting a grip on the economy over the last 3 years.

 

 

Consider first the conundrum that despite the financial crisis in 2008, and global recession, we had a fairly resilient economy and a robust growth rate.  How did that come about?

 

 

Consider our revised equation.  Let us say, gold imports suddenly jump by $20 billion because of a certain perception that it is a good investment.  When that happens, the supply of savings by the households goes down by D since only (S-D) is now available to finance investment by firms.  Firms will continue to invest the same as before because I is fairly independent of financing and is determined by aggregate demand & the profitability of the investment.  Therefore, I remain the same.  Our imports, other than gold, are largely oil and industrial machinery and raw materials and do not change in the short term. Neither do our exports given their nature.  So to accommodate the same level of I to sustain the supply side of a given level of GDP, the government deficit must increase by D.

 

That is the hidden implication of gold imports for investment purposes by households.  To the extent households divert savings to gold, government has no option but to increase its deficit by a like amount to support a given level of investment.  Failure to do so will result in investment being crowded out due to lack of domestic savings resulting in lower output and supply side constraints to future growth.  Gold imports for investment by households must result in an increase in government deficit.  Which is precisely what the government did in 2008/2009.  It responded to a quantum increase in gold imports by stepping up its deficit.  That may have boosted aggregate demand, saved investment levels in the two years following the crash.  But that’s not the full story.

 

The crunch comes because government deficit cannot be increased indefinitely without letting other genies out of the bottle.  There is an upper limit to sustainable government deficit at given level of exchange rate.  To go into that would complicate the picture.  So lets keep the argument accurate but simple.  Remember, [X-M] the trade deficit has to be financed.  And foreign investors, well aware of the exchange implications of an unsustainable large fiscal deficit, will simply not lend/invest money in your economy unless the fiscal deficit is capped.  So governments don’t have the luxury of offsetting a fall in availability of domestic savings by running up correspondingly higher deficits.  We had reached that limit by end of 2010.

 

 

If government deficits cannot increase, but gold imports remain stubbornly high, what must adjust to meet the constraints imposed by the national accounting equation other than simply exhausting reserves?

 

 

A shortage of savings will drive up interest rates.  We saw that happen.  Higher interest rates will curb investments leading to a fall in aggregate demand and reduced future profitability of investments.  But the most important factor is that since government deficit no longer offsets gold imports, there is an immediate fall in aggregate demand that brings about a deflationary pressure on the economy.  The latter factor is the one we must focus on because it is not so obvious unless we explicitly take gold into account in the national accounts.  Gold imports, apart from driving up cost of investment via interest rates also result in an immediate drop in aggregate demand if not offset by an increase in government deficit.  And that precisely is what we are seeing now – a steep fall in domestic industrial growth due to the cumulative and combined effects of gold imports not offset by an increase in government deficit.  I hope that is crystal clear.

 

 

Now consider financing the gap represented by [X–(I+D)].  As we know the entire gap of $90 billion or so [I assume services exports are more properly treated as part of X here] is met by NRI flows, FDI and FII investments each of which averages about $30 billion a year.  Policy paralysis by the government has vitiated the attractiveness of India an investment destination.  If we are lucky FDI + FII may total about $30 billion this year.  Since there is no way to finance the gap, either reserves must fall, or the government must cut its fiscal deficit further triggering even more severe deflationary pressures.  Note there is no option.  If financing for the external gap is not available, either D must fall to 0 and/or government deficit must be cut to balance accounts.  The world is a very cruel place when you run out of money.

 

 

The only response from the government so far has been a 20% devaluation of the Rupee by stealth. In a round about way, this is the price we must all pay for as a tax on wealth.  Its real impact will come when the import prices of stuff like petro products are passed on to us through increase in domestic prices.  So far we have hardly noticed the pain as if the devaluation in no way concerns us.  A far more detailed analysis than possible here is required to suggest ways to save the economy from a severe deflation.  Unfortunately, we have a government in denial and a people who don’t care to look at numbers.

 

 

The 20% devaluation is but the first step towards recovery.

 

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Have Pakistan’s generals overplayed their hand in Afghanistan?

ANALYSIS: Have Pakistan’s generals overplayed their hand in Afghanistan? — Sonali Ranade

 

What can Pakistan possibly gain from a total control of Afghanistan that it cannot gain otherwise by peaceful means?

Back in October 2011, I attempted to summarise Pakistan’s options in Afghanistan in light of the evolving situation then. The article is available at: http://dailytimes.com.pk/default.asp?page=2011%5C10%5C02%5Cstory_2-10-2011_pg3_5. The present attempt is to see how many of the assumptions I made then have come true and to reassess Pakistan’s options in relation to the new situation. The idea is not so much to stress what went wrong but to see how things can be set right in the interests of all stakeholders in Afghanistan. The focus of course will be on the play of interests of Afghanistan, Pakistan and India.
Begin by noting that the worst possible outcome of the Afghan conflict for Pakistan is at hand. Its key lies in the US determination to keep a few thousand Special Forces troops in Afghanistan for the next 10 years, complete with two or more dedicated airbases that will house drones and other fighters to protect them. In addition, the US and its allies will fund the Afghan national Army (ANA) for the next 10 years as it takes over security duties from US troops. The new US strategy is minimalist in deployment and works on the basis of denial of control of areas to the Taliban and their backers. While the US may not be able to prevent the Taliban from taking over some southern parts of Afghanistan, the US presence along with the ANA will ensure the north remains with those elements aligned with Kabul. It will be exceedingly difficult for Pakistan and its proxies to knock off completely both the ANA and the US forces to take full control over Afghanistan. In other words, should the parties fail to negotiate successfully, the arrangement ensures the continuation of a low intensity civil war in the country for the foreseeable future.

Iran, India, Russia and China have vital stakes in the area that Pakistan cannot overlook. None of them, not even China who is the closest to Pakistan in this group, is going to wait for Pakistan to prevail in Afghanistan. They will all move to secure their interests as best as they can, with Pakistan’s help if possible, without it if necessary. Pakistan has the capability to deny peace in Afghanistan but it can do so only at great expense to itself and at the risk of isolating itself from the world community. A prolongation of the conflict in Afghanistan has grave risks for Pakistan’s internal security and balance as well. Some of the state’s proxies are already out of control and others are exhibiting classic signs of developing political ambitions independently of their sponsors in the Pakistani ‘Deep State’. Pakistan’s GDP has been stagnating; its internal debt is too large in relation to both its GDP and the government’s revenue raising capacity. But for workers’ remittances from abroad, amounting to about $ 12 billion, Pakistan’s internal and external finances would be precarious. With a burgeoning population, deteriorating law and order, little investment, Pakistan cannot afford continuation of the conflict in Afghanistan indefinitely without risking an implosion at home. As it is, many investors are pulling out in the face of mounting political risks.
Be that as it may, why does Pakistan need to act as a spoiler in Afghanistan? What can Pakistan possibly gain from a total control of Afghanistan that it cannot gain otherwise by peaceful means? Where do Pakistan’s true interests lie in Afghanistan and how are they best secured?
First, let us get the nonsense about strategic depth out of the way. With a nuclear arsenal that is now larger than India’s, does Pakistan really fear an Indian armoured blitz that will cut Pakistan into two halves in a matter of days? With China sitting pretty in Kashmir and Afghanistan, can India really confront Pakistan with a two-front situation using Afghanistan? In other words, the old security arguments that called for complete domination of Afghanistan by Pakistan and its proxies are more or less irrelevant in the evolving situation. Absent these considerations, what else can Pakistan really achieve by a full domination in Afghanistan?
The overland oil routes to Iran from India and China, and access to Central Asia by India remain two valid considerations for Pakistan to seek influence in Afghanistan. But does such influence need to be complete dominance? The fact of the matter is that Pakistan cannot encash the economic value of its strategic position in relation to Central Asia without a cooperative relationship with Afghanistan and the rest of the players that include Iran, Russia, China, India and the US. Unless the interests of all of these players are accommodated, India, Iran or China will never fully trust their strategic trade routes to Pakistani dominance. Pakistan simply cannot afford to wait indefinitely for the day when Afghanistan will fall into its lap and it will then decide how to accommodate the others and on what terms. The time to figure out a via media is now or perhaps never.

The US retains several vital coercive cards to play in the Afghan-Pakistan status quo should Pakistani belligerence continue. The Americans are old hands at using insurgency as a weapon of destabilisation and Pakistan’s north and south offer fertile areas where the US could engineer a counter-offensive. Balochistan is an obvious candidate for many reasons. Denying Gwadar port to the Chinese, bottling up Pakistan and opening a sea route for Afghanistan independently of Pakistan come to mind. The local insurgency in Balochistan, a result of past colossal mistakes, offers a convenient cover. Denial of trade, aid, and restrictions on access to external financing are other cards that the US will seek to play to keep Pakistani aggression in Afghanistan in check. So overall, Pakistan’s strategic capacity to defy the US indefinitely in Afghanistan is very limited now. It did hold a trump card in terms of logistics before it played the card. Its generals recklessly threw away the card in a fit of unprofessional pique or perhaps it was acute political embarrassment?
Pakistan has nothing to lose by coming to the negotiating table with the US and others and everything to gain from it. By negotiating, it can give itself another chance in Afghanistan. Therefore, one should expect Pakistan’s Deep State to recognise the obvious compulsions and find a way to return to the table. However, Pakistan needs to reassess earnestly its entire strategy in Afghanistan top to bottom. Pakistan is playing a 19th century game of trade routes in the 21st century. The world is getting smaller and more tightly integrated by the day. The US began its Iraq adventure thinking the country was its legitimate share of the spoils of war. Much blood and treasure later, and a near total loss of face, it realised that in the television age, one could not own another country even as the world’s only superpower. The Afghans are no pushovers. Pakistan needs to think Pakistan first, India last — not the other way around.

The writer is a trader. She can be reached at ?sonali.ranade@hotmail.com or @SonaliRanade on Twitter

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MARKET NOTES: High time for North Block to get the market message right

May 12, 2012 1 comment

MARKET NOTES:  High time for North Block to get the market message right.

 

 

Gold:  Gold decisively broke below its significant floor at $1610 to close at $1579.44 for the week.  With this break, gold signaled two things.  Firstly, it confirmed its next significant target of $1540 in the near-term future.  More importantly, the pattern it opened up is beginning to look more like an impulsive move.  Taken together from the last top of $1920 in June 2011, we could be in Wave 3 of an impulsive move down for gold, with a price target of $1480.  The confirmation for the new target will come on sustained break below $1550.  The short-term oscillators suggest a mildly oversold market.  There could be some consolidation before an assault on $1550 is made.  However, there is nothing remotely bullish on the charts about gold.

 

 

Silver:  Silver decisively cracked the floor at $30 to close at $28.88 after making a low of $28.4 where the metal has a minor floor.  Expect a few days of consolidation above $28.4 before the metal makes a bid for its next target of $26.  It’s very unlikely that we will see any significant pullback in the metal before we hit $26. There is not much between $26 and $20 for Silver by way of resistances.  Hence a break of $26 will result in a bloodbath.  There is both time and space for such a move and so ruling it out will be foolish.

 

 

WTI Crude:  WTI Crude decisively broke below $100 to close the week at $96.1.  Its next logical target is $91 and it may consolidate a few days before testing that floor.  A break of $91 would open the way for a test of the more substantial floor at $75 though not in the immediate future.  In that sense, the $91 floor is crucial in resolving the befuddling wave counts in crude. However, until $91 is decisively taken out, or causes a sustained bounce from there, the long-term picture in Crude remains unresolved in my view.

 

 

NYSE Composite:  The wave picture in the NYSE Composite is far clearer than in the narrower indices like S&P 500 and DOW.  So I shall use the composite index to study the underlying forces and trends working on the market.  The first thing to note is that we remain in the firm grip of a bear market that commenced in October 2007.  The second equally obvious fact is that in the last rally the NYSE Comp failed to reach the previous top of 8738 despite its narrower cousins having done so convincingly.  In terms of my wave counts, that means the index has commenced its descent to 6400 area from its recent top of 8260 and has time until the end of December this year to get there.

 

That corresponds to target of roughly 1100 on the S&P 500 and 10,600 on the DOW.  Dow will have confirmed this target in the medium term on a violation of 12,700 and its 200 DMA, which is currently at 12,465.  Likewise S&P 500 would confirm its target on a violation of 1335 or its 200 DMA now placed at 1315.

 

In the immediate term of the next week or so, the markets are like to pullback mildly or consolidate above the mentioned critical levels before attempting an assault on them.  Use rallies to exit if stuck.

 

 

$-INR:  The $ closed at 53.15 after making a high of 53.88 during the week.  The $ is not overbought on the oscillator charts.  In terms of time, there is room for the $ to go higher.  So most like the $ is consolidating before taking out the previous top at 54.31.  RBI has been intervening in the market daily.  So it is impossible to predict which way things will break after the previous top is taken out.

 

 

Sensex:  This week, instead of the Sensex or the Nifty, we shall look at a lesser-discussed index, the Defty which is nothing but the Nifty expressed in US $ as at close daily.  It has a fascinating story to tell.

 

 

First note that Defty never made it back to the all time high of 5582 achieved in January 2008 in the rally that ended November 2010.  Instead it made a significantly lower top at 4980.  This is in stark contrast to the Sensex and the Nifty that made it to their corresponding previous highs in January 2008.  In other words, for the FIIs, in $ terms, which their reference currency, India, like the rest of the world markets, remains firmly in the grip of bears.  So forget the hoopla that the synthetic bulls on popular TV programs feed you.  FIIs are not putting their money where their mouth is.

 

In terms of wave counts and possible targets, the picture that emerges is even bleaker.  Firstly, from the top of 4980 on the index in November 2010, at the minimum we are in wave C down that has made a low of 2950 already.  Its immediate target remains the same in the current fall.  That corresponds to a level of approximately 15,000 on the Sensex.  That is the good news.

 

While 2950 on the Defty is a good support, the long-term bull market line spanning from 690 in April 2003 to 1800 in March 2009 lies at 2765, below 2950.  That corresponds to level of 12,650 on the Sensex or 3785 on the Nifty.  Whether the INR indices get there or not depends on the INR’s external values.  But the picture emerging on the charts is bleak.

 

High time somebody in North Block actually sits down to rethink FII and FDI numbers in light of the above analysis if we are to avoid a catastrophe on the BoP front.  Our CAD IS ALREADY NUDGING 4% OF GDP.

 

NB: These notes are just personal musings on the world market trends as a sort of reminder to me on what I thought of them at a particular point in time. They are not predictions and none should rely on them for any investment decisions.

 

 

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