Monetary policy and financial stability

With very low (near zero) interest rate setting in many of the advanced economies, there have been many discussions recently (check this link) on if monetary policy should even be used as a tool to maintain financial stability? Many experts argue that any risks to financial stability is better handled through macro-prudential tools (such as regulations, oversight, capital reserve requirements etc.) and the monetary policy of setting interest rates and controlling money supply in the economy should be used only to achieve price stability and full employment.  They argue that any meager benefit one would get by using monetary policy tools to address the risks to financial stability (such as asset bubbles) is not worth the cost of losing price stability and/or full employment.

Now, in my view, there is partial truth to this, but only partial. There are lots academic papers that dwell into this, but we don’t have to go that far. Just by looking at our own bank statements, we could come to the conclusion that holding money in the bank today in, say for example, US, is guaranteed to give us a return that doesn't even exceed the inflation rate. In essence, this means that we are in a negative real interest rate setting. To put it in other words, holding money in a savings account today that barely gives 1% return annually is equivalent to losing the value of that money to inflation. So naturally, every individual is forced to chase assets that would give them a better yield. And how do they do it? More importantly what vehicles they have to do this? – stocks, bonds and real estate are the most commonly used vehicles by an average investor to make some returns on their capital a.k.a savings!

Now what is the basic definition of price inflation? – too many people chasing too few goods. So again, too many individual investors (a.ka. retail investors) chasing too few high performing assets inflates the price of these assets, thereby forming an asset bubble. And when asset bubbles form, many individual investors who were forced to invest in these assets, have a false sense of economic security – they see their net worth going up every day (not knowing why and not understanding the fundamentals) and start to take a lot of risk to further improve their net worth. It gives them a sense of comfort to take out loans (with the assets as the collateral and note: no amount of financial supervision can determine the "real" value of an asset other than the market value of the asset itself) and misallocate capital. This was one of the main reasons for the 2008 financial crisis (albeit that crisis had more to do with failure of regulators and financial supervisors to prevent banks from taking excessive risks where people who shouldn't have been given a loan were given a loan). But as you can see, monetary policy mistakes can also lead us to the same situation as monetary policy affects short term rates, which have an impact on your bank rates. In essence, a monetary policy that punishes savers is never a prudent policy in the long run. No nation or individual can survive indefinitely without adequate savings. And without a proper rate of return on savings for individuals, the misallocation of capital will continue to occur.

The problem currently is that monetary policy is in itself is seen as a solution to a financial crisis. It never should be that way. Monetary policy should only act as a cushion until fiscal policy catches up to recover the economy. The current zero interest rate environment should be seen as just that – a cushion and not a solution.

So to conclude, in my view, it is not whether monetary policy tools or macro-prudential tools should be used to address risks to financial stability, but rather both these tools should work in tandem to achieve an overall stable financial system. 

Chinese stocks make me dizzy

I am extremely worried about the Chinese stock markets. The growth in the value of the Chinese stocks has been explosive and never seems to back down. For the last few months, I haven't seen any fundamentals supporting such growth in the Chinese stocks other than pure speculation - speculation that China would introduce some sort of stimulus to offset any weak economic performance.

My guess is that part of the appreciation in Chinese stocks is because the market is young - meaning, there would probably be many newcomers to the Chinese stock market. And those newcomers, per my guess, are chasing the stocks. Is there a bubble forming in Chinese stocks? I think so. And probably it is a good time to get out. But with China's massive forex reserves, they so far have always beat any fundamental logic that would call for a correction in the Chinese stock prices. 

One of the best ways to prevent any massive bubbles in the stock market and to allow for a gradual market correction is for China to allow more appreciation of its currency. The sooner they do it, the better are the chances of preventing China from becoming another Japan. Normally, the story has been that China intervenes in the currency markets to keep its currency devalued. But recently that might have not been the case and instead the dollar's strength and europe's QE might have been the reasons for yuan's weakness more so than China's intervention in the currency markets itself. If so, China's intervention might be needed again- but this time not to weaken the yuan but to strengthen it by selling dollars in the open market. If that is done, it would be beneficial to both the US and China and in fact the world economy as a whole as that would adjust the imbalances to an extent that we are starting to see in the world economy today. 

March 18 Prattle

The Fed did exactly what I had expected, but the markets didn't .. Poor me :( 

Speculative trading, market over-reaction and fear-mongering crushes any fundamentals or logic in today's market.  

Oh, by the way, what's wrong with the guy in the Fox news channel who keeps comparing Israel's president to Winston Churchill and the US president to Neville Chamberlain? And he calls Israel's ambassador to US on his show to second this opinion of his? Mate - you might not like your president, but he is still YOUR president! Imagine Johnny telling Kevin repeatedly that his wife is not as beautiful as Kevin's and asking Kevin: "Is it not true, Kevin? Is it not true Kevin?" - and that too on national television. Shameful! (Oh, and a disclaimer: I have no political bias.)

Oh and the other news today - President Obama endorsing a view of making voting mandatory! That's a brilliant view, in my opinion. People who argue for freedom of choice to not vote in an election are mistaken! No one has the "right" or "freedom" of "choice" to drink and drive. Why? - because not that anyone cares much about the person who is drunk, but more about the fact that a drunk person driving could put other innocent people in harm by causing accidents. It's the same logic. Few people in a democracy electing a crazy bloke to very powerful positions whose actions can influence the country as a whole is quite dangerous. If everyone votes, we could ateast know the true democratic wish of the people. 

A Washington times article( http://www.washingtontimes.com/news/2015/mar/18/obama-calls-mandatory-voting-us/ ) says that the general election turn out for the 2014 midterm elections was just a meager 36.4% and for the 2012 presidential election - just 58.2%. So much for the world's oldest democracy. This is a joke! Folks - vote! It's your RIGHT that you must exercise for the well being of the society! - and that includes you! As a prime example, you could see people in India thronging to the polling station whenever an election is held these days. There used to be times when the voting percent was just 40% or 50% or 60% there, but recently the numbers are 70% and 80% in many constituencies and that is already showing great results in many states and even at the national level - you could how some parties are trounced these days because of their corruption and what-not and the kinda mandate that people have been giving to effect change on the ground! (well, they still have to vote for the lesser devil, but that's altogether a different matter!) All this being said, voting should also be made easier using newer technologies rather than punishing people to stand in long queues! More work needs to be done in that area!

King Dollar & The Fed

The US dollar has been skyrocketing. It is up against almost all major currencies and is up more than 20% against the euro from the start of 2015. This has put enormous downward pressure on the prices of various commodities (as most commodities are bought and sold in US dollars in the international markets). The US economy has been clearly showing considerable strength for the past many months (especially when looked from the net jobs being added every month in the US). So with the dollar strengthening (especially at a time when other countries are trying to devalue their currencies to fight off disinflation or deflation forces), the question has arisen if the US Federal Reserve should raise the federal funds rate?

Now, there are arguments from many experts saying that the Fed should wait to see considerable inflation (which is running way below Fed’s target of 2%) before the rates are raised. And many argue that the wage growth is still tepid despite strong growth in the number of monthly jobs being added.

I, for one, believe that the federal funds rate should be raised, but not in summer and instead in fall of this year. Below I note some reasons for that:

1.      Wage growth is shortly about to arrive. I say this because from the recession of 2008, workers have been denied a pay raise. That lag is now closing. With an improving economy, companies will be more willing to raise the pay that is long overdue for its workers. We are already seeing that in companies like Walmart, TJ Maxx etc.

2.      More hiring, even with an assumed slower wage growth, should increase the consumer prices as measured by the consumer price index in the coming months. With winter behind and spring and summer to come, there would only be increased business activity and more hiring in the coming months. With more people having disposable income, this should only increase retail spending thereby giving a boost to the CPI.

3.      Oil prices, in my view, have stabilized a bit. There might be one more downfall of oil towards the $40 - $45 range, but that’s it and even that downfall will be short lived. Wit Europe’s QE and other nations’ interest rate cuts, demand for oil should increase to a level where prices may stabilize around $55 - $65 range by summer (and not to mention the eventual reduction in oil output from global players in 2015 due to the low oil prices). This increase in oil price should give inflation a mild boost in the coming months.

4.      As dollar becomes stronger, it might add to downward pressure on the oil prices, but data from Europe signal that the euro region is on a growth trajectory. And I believe Europe’s QE should act as a cushion against deflationary forces from that region – though disinflation could be very well be likely in 2015.

5.      It is better to increase the federal funds rate in a gradual fashion from near zero rather than to give a jolt to the economy by allowing it to heat up and raising in a more aggressive fashion (I know some banks have been calling for such a measure, but that will play only to the benefit of banks who play the equity markets to make a lot of money. Given the global scenario, such a measure will not work well for the general economy).

6.      Leaving interest rates near zero beyond 2015 will likely result in asset bubbles. Depending on where the bubble is, the burst might be disastrous for the general economy.

7.      Even if interest rates are raised starting from the fall of 2015, it would still be low – leaving enough rooms for businesses to continue borrowing for their business activities and for individuals to borrow for purposes like housing loans, vehicle loans etc. Remember we are at a near zero interest rate now and it is going to take years of monetary policy normalization (including all the QE money printed in the last few years) before the rates are at a level where we want them to be in the longer run.

Now, I say that the federal funds rate should be increased in fall rather than summer because of a particular statistic that I don’t agree - And that is NAIRU (Non Accelerating Inflation Rate of Unemployment) which the Fed believes is in the 5 – 5.5 range – meaning unemployment below this range is supposed to trigger inflation at a faster rate. Currently the unemployment rate is 5.5% and analysts believe that the number would be close to 5% by summer putting it will within the range where the Fed should act to raise interest rates. But I disagree with that range. Since we are coming out a massive recession, and with the oil sector being hit, and the fact that the unemployment number is not very accurate and generally has potential to be more on the upside, I would wait until the unemployment falls within the 4.5% – 5% range before starting the normalization process. And that would mean fall of 2015.

In the meantime, I expect gold to drop further, Fed to drop the word “patience” in the March meeting, dollar to become even stronger, Germany to grow and oil prices find a floor sooner than later.

Where is the money going?

First of all, before I write anything, congratulations to President Obama for getting re-elected. It was really a hard fought campaign by both him and the republican opponent Mr. Romney. The campaigns by both men were a lesson in itself for anyone who closely followed this election. Now, throughout the campaign, I had many friends telling me how they disliked both the candidates. But I for one liked both of them and listened to many of their passionate debates and arguments about each other’s policy proposals. True that there were at times false, empty or just pure political arguments that clouded over the real issues. But bottom line: I always said to all my friends that I will be happy for anyone who wins and sad for anyone who loses. And that’s how I felt.

 
So now let’s gets back to the “fiscal cliff” and other tax breaks/increases that are supposed to be worked out before this year end. The statements from both sides so far is just like a deja vu to me! Increase taxes on the rich! Decrease taxes for everyone! Oh, by the way, who is rich here? – joint filers who earn above $250,000 annually? I am not sure how many living in big cities across the US would agree to that. But anyways, let me get back on track. Now, I have been hesitatingly on the side of increasing taxes on the rich (forget the 1% for now. I am talking about upper middle class – as $250,000 dollar family income, to me, in many big cities across US, is just that). As much as the other side of the argument was tempting and even made me rethink many of the policies that I thought was right, at the end of the day, I just had to give myself a gentle knock on the head and remind myself the word – “Demand!” And the aggregate demand has been low due to poor job growth and the overall gloom that hangs in the US and the world economy as a whole. And that gloom has prevented private corporations from stepping up investments as much as we would like. The few private capital spending we see from corporates is, to my knowledge, largely because of inventory replenishment. And so, though I am hesitant to say this, I still believe, government investments are needed now to push up growth in the US to a higher trajectory (the reason why I am hesitant is just due to the basic fact that government many times wastes money). And so this requires more revenue to the government in the form of tax reforms and some increases.

 
But recently, I have also started to fear and listen more carefully to the other side of the argument: that government does not create jobs! The reason: in the last four years, I have seen more printing of money than investing it. So, there goes my question - Policy makers from both sides of the aisle have been calling for reducing debt! The form varies. But ultimately, one thing would happen: government would end up with relatively more revenue for now. But let’s be careful – this might not last! Why? - because the government might just waste that money that would only add up to problems in the future. And maybe loss in revenue and higher debt again! So my question is – if we are going to follow the path of higher taxes, then where would that money end up going? What investments will be made? I would be willing to shout at my highest pitch to stress the word “Investments” here!

 
I know certain things have been promised – like higher spending on education, infrastructure, green economy, tax breaks to companies that invest locally, energy efficiency etc. But all this to me is as vague as it can get. All this sounds nice, but can we be more specific please? And I must say that I am little hesitant to just push forward the “tax increase” strategy without knowing what will be done with that money. I fear we are working in the reverse way of collecting money first by not telling the one who gives money on what we are willing to do with that. Maybe I haven’t followed the specifics much, but as far as I know, I am not satisfied that I have enough information on where the money would end up going by the government in the next four years. Can we please, please be more specific?

De-colonize the mind!

The Indian government last week sent out final notifications to allow foreign direct investment (FDI) in the country’s huge retail sector, which by some estimates is more than a $500 billion market. Foreign companies like Walmart, Carrefour and such have been literally waiting at India’s door for almost a decade, hoping that someday the doors would open. The doors did open last week for the much awaited multi-brand retail sector allowing a maximum of 51% FDI in this enormous market in India, leaving individual states to decide on whether they would want this FDI in their states. The minimum investment that needs to be made to enter this market was set to $100 million, with a mandatory $50 million in backend investments that the government hopes would improve the rural infrastructure.

 
And as expected, there was a huge political backlash. While the concern of small retailers, popularly called “mom-and-pop” shops, was always the hot button in this issue, I was also struck by a very popular question among India’s masses. And this time the question came from none another than my own Dad, which I wouldn’t call “surprising”, but was a stark “reminder” on how much re-influence of minds is needed in a country that still carries the wounds of the ugly imperialism brought upon by the British, when India remained a British colony for more than 200 years until 1947. While my Dad did not oppose FDI in this sector, in the heated discussion on this topic over the phone, he put out a strong but worrying comment, with his voice giving way to a mixture of confusion, uncertainty, distrust and fear. The comment was – “I don’t know if this will lead us to a form of financial imperialism, where today’s independent small traders will have to work for or be a subcontractor for these foreign giants, completely dependent on the terms and conditions set by them.”

 
For some reason, while experts and economists have tried to explain the benefits of FDI in this sector, going to the extent of the prime minister himself appearing on national television to promise that the entry of foreign retail giants would not decimate local small retailers but rather would increase the trade for the very same segment of the population, no one has cared to explain and root out the fear of “financial imperialism” in the minds of the masses.

 
Will this really lead to India being financially colonized by foreign investors? I think, at this moment, that fear is unwarranted even though I would call that a genuine concern. First of all, the English East India Company that set foot in India in 1600, and that gradually colonized the whole country with the monarch of Britain finally taking charge of the entire administration of British India, is very different than the companies that the country is inviting today to invest. In those heydays of imperialism, companies like the English East India Company were directly backed by their Kings and Queens. These companies had monopoly rights when it came to operating on the soil of their colony. They had their own armed forces, police, judiciary and other agencies to carry out the dictate of their Kings and Queens in the name of protecting trade. In effect, this meant that the British Queen was directly ruling over India with a proxy trading company. When the local populace did not agree with their rules, they were subjected to the law and order set by the British high command, with enough financial and military resources to back them in case of a conflict. Many times in those days, the local traders were either decimated due to the insane rules of the colonizer or due to manipulation of the minds of the illiterate or by just pure force.

But that situation is very different from what is today. Today, we set the rules when the foreign companies want to come in and invest, not them. Today, the country has well passed the threshold of succumbing to any foreign military pressure. And today, these companies are not backed by their governments in military or even financial terms. The country is not devoid of intellectuals and think-tanks anymore. The country is not completely blind to what is happening in the outside world or what these companies’ interests are in. Above all, today, the country is well integrated into the global economic order, for the good. 

 
Debates can go on, but we also have to realize that the country is severely lacking the financial capital that it needs to augment the strengths of the huge human capital that is at its disposal. We tried in the past to use our own money and resources for everything. But that was not sufficient then. And it is not sufficient now. If we ever have to eliminate the crushing poverty, disease, illiteracy, malnutrition and ignorance that prevail in modern India, we need to realize that we have entered a “no-return-zone” in this integrated global economic order that defines and will define the 21st century. The ideologies of the past will not change this definition. And let us remember, this is for good!  
 

In today’s globally integrated economy, India is a major player. Capital flows in all directions. It is up to the populace of an area to absorb as much capital as possible to productive areas where there is a need. Else, that capital is not going to vanish in thin air, but would rather flow to other places where it is not desired, or would end up boosting our own neighbor’s wealth, thereby making us look poorer in the same street, even though what we earned yesterday is no different than what we earn today. And of the three forms of capital (FDI, Equity and Debt) – FDI is the most preferred, as that promises real investments in plant, machinery, human capital and other infrastructure. All this would lead to more jobs. This is much better than equity or debt financing through the Foreign Institutional Investment (FII) route that results in value of “paper” going up without a promise in the improvement of the lives of the people who deserve most. 

 
As I have said many times in this blog, the world is awash with liquidity, and it is in India’s best interests to attract as much capital as it can through the preferred FDI route, with promised benefits to millions of people, who deserve that capital the most. Of course, nothing comes without risk and it is the government’s utmost duty to protect the vulnerable,with efficient policies and regulations, who will initially be disturbed by the shake in the economy due to this inflow of foreign capital. But that shouldn’t prevent us from doing what is best for the country and the masses in the long run. We exercise today to remain healthy tomorrow. We were wrong yesterday to allow government backed monopolistic companies to dictate us their rules. We will be wrong today if we do not allow private capital to compete and flow to sectors where there is need and space. 

 
And my Dad finally calmed when I reminded him that by not allowing foreign capital to compete with local capital, we will be inviting imperialism by our own countrymen!
  
References:
1. http://www.thehindubusinessline.com/news/politics/article3922165.ece

2. http://timesofindia.indiatimes.com/business/india-business/Wal-Mart-eyes-51-stake-in-new-India-retail-arm/articleshow/16583338.cms

3. http://in.reuters.com/article/2012/09/14/india-fdi-reform-retail-facts-idINDEE88D0DM20120914 

Diesel is not Petrol!

These days, one can hear growing calls in India and from abroad to de-regulate diesel prices in India. Though this is what should be done in an ideal free market society, such a move will wreak havoc across a huge population of middle, lower, poor and very poor households across the country. It is agreed that the government supported oil firms have been facing quite a huge loss of revenue due to the fact that the government fixes the price and keeps it down (a subsidy). But at the end of the day, government compensates their loss by using the taxpayers’ money – which in turn is a huge expenditure to the government that balloons up the fiscal deficit. First of all, to be honest, I have been very uncomfortable with the government subsidizing diesel for all Indians for decades. Multi-millionaires and billionaires get a subsidy to ride their luxury cars. Not fair! So my point was always to find ways to eliminate these wrongful subsidies, but an all-out elimination of diesel subsidies will shoot inflation to unimaginable levels that the poor will find very difficult to cope with. And already, inflation is unbearable to many of India’s poor. Ultimately, the goal here of intellectuals asking for a de-regulation in diesel prices is to reduce government’s deficit and debt – which could then be used to serve the poor in better and efficient ways in the forms of jobs, opportunities and markets. I agree! But come on guys! In our intellectual thinking we got to mix practical facts as well! Do we really expect the government to come up with “immediate” steps to tackle the sufferings of the poor and the middle class with the rise in diesel prices ?– which will undoubtedly shoot up the prices of literally everything within a short period of time – literally everything that requires transportation – from food to building forts! And the international oil situation doesn’t look favorable now to determine this to be the right time to de-control diesel prices. (By the way, I have never supported petrol subsidy which was rightly eliminated sometime last year).

Unless the government and the population as a whole are clear about how the people would be protected by undue rise in diesel and other commodity prices that would follow as a result of de-regulation, the government should not de-control diesel prices across the board. It is understood that the markets would adjust themselves based on the factors of supply and demand - which, I agree, has a lot of favorable factors when looked at a broader angle (“green economy” comes to my mind).  But my point is that this adjustment should not come by breaking the backs of the middle income and poor people. The think tanks and intellectuals should be talking and thinking about coming up with a solution that would do no or less harm to all, rather than blindly following the text book line of market-based pricing. India is a unique country with “billionaires and “below-poverty line-ers” and hence the situation warrants unique models that are based on the principles of equity. And for small businesses across the country, they have a long way to go to catch up on technology to cope up with every day fluctuations in diesel prices. So giving them time, clarity and directions is a basic courtesy.

I personally think India should push more for sanity in international oil pricing in international forums such as G-20. There is enormous work that needs to be done from OPEC to plugging holes in international commodity futures trading. In the last few years, the trend has been such that oil prices would remain at around $90/$100 range, no matter if the economy is improving or declining, unrest in Middle East or democracy in Middle East, flourishing emerging markets or slowing developing economies. With traders becoming more and more tech-savvy and profit hungry, they have clearly found ways to manipulate markets that is so difficult to regulate correctly. At this point, I am unable to say if the markets have priced oil right or if the speculative powers have run wild, though I fear the latter. An article in Bloomberg.com caught my eyes that day – it read – “Oil rose for a third day, the longest winning streak in a month, as slowing growth in China fueled stimulus speculation and U.S. equities advanced”. Now, I am sure oil will rise for the fourth day as well even if the news read something like – “China’s growth is NOT slowing as much as it was predicted earlier”. So a slowing growth or roaring growth – oil prices somehow manage to remain at levels where it is “kinda” uncomfortable to the common man. I know that trading deals with high levels of sophistication that cannot be so simply explained or ignored citing speculation. But hey! It’s complicated, right?  So one has every legitimate reason to atleast “speculate” that speculators are running wild – either knowingly or unknowingly! And count me in that league.

But coming back to the India case, the country needs to focus on other methods of reducing debt and deficit – like selling stakes in government owned enterprises, opening certain sectors to more foreign investment, tax reforms, rooting out corruption and removing wasteful subsidies. And that does not, in my opinion, involve blindly de-controlling diesel prices all of a sudden for the entire population.

Finally, I understand the huge benefits of completely eliminating diesel subsidies in the long run, and I agree that at some point in time, diesel prices have to be de-controlled. But my opinion is that this is simply not the right time. And this is not the way we should do! We cannot dream of a prosperous 2020 economy by destroying the economic lives of millions of Indians in 2012.  

References:

1. http://www.bloomberg.com/news/2012-07-13/oil-little-changed-in-new-york-reversing-earlier-gain-of-1-4-.html
2. http://www.thehindu.com/business/Economy/article3662137.ece
3. http://www.thehindubusinessline.com/industry-and-economy/government-and-policy/article1628103.ece
4. http://www.indianexpress.com/news/diesel-deregulation-to-up-price-rs-14.3-ltr/937955/