Unprepared for next crisis

The past five years have been a remarkably crisis-free period for the global economy

Cafe Economics | Niranjan Rajadhyaksha

Rising prices and job losses are the two most direct ways an economy inflicts pain on the average citizen. In the 1960s, the economist Arthur Okun added the inflation and unemployment rates in the US to create what is now known as a misery index. This rough and ready measure of economic despair has often been used to assess how well people have done under a particular government, though its popularity diminished after the 1980s as inflation and unemployment in the rich nations declined.

There have been variants of the Okun misery index since then. Robert Barro expanded the index by including growth in gross domestic product (GDP) and the bank rate to the two original variables. Forbes magazine has a tax misery index that adds the marginal rate of various taxes imposed on individuals and companies. According to the magazine’s website, this index is “our best proxy for evaluating whether policy attracts or repels capital and talent.”

A similar proxy can be built to evaluate the macroeconomic stability of a country. Two of the biggest threats to the stability of any economy are the twin deficits — fiscal and current account. Adding the two could give us a useful proxy of how well an economy can maintain its balance when there is global financial turmoil. The news for India is not too good.

The past five years have been a remarkably crisis-free period for the global economy. There have been no painful calamities of the type that hit Asia in 1997 and Russia in 1998. But there is no guarantee that the next few years will be equally tranquil, especially given the credit crisis in the West, the overheated economy in China, rising global inflation and the mess in the US. So, it makes sense to evaluate how the Indian economy can handle global stress in the months ahead.

I have used the economic data for 42 individual countries that The Economist publishes every week. The latest data there shows that India has a current account deficit of 2.4% of GDP and a fiscal deficit of 3.1% of GDP. Add the two. You get a macroeconomic misery index of minus 5.5. That’s outsized. And this number will grow in the months ahead as oil prices rise, the import bill balloons and the government continues to issue off-budget oil bonds to subsidize consumers.

How does India compare with the rest of the world? The US does far worse, with an index value of minus 7. Most other countries in the euro area, too, have worse combinations of fiscal and current account balances.

So, India does not do too badly compared with the rich nations. But it’s a completely different story when we turn our attention to our peers in the global arena. China and Russia both have fiscal and current account surpluses. Their index values are well into positive territory. Brazil has modest deficits that add up to minus 2.6. Malaysia and Thailand have fiscal deficits that are close to Indian levels, but these are balanced by strong current account surpluses. Actually, as far as emerging market economies are concerned, only Pakistan and Egypt are worse off than we are.

Is India slouching to a repeat of the 1991 crisis? The possibility cannot be dismissed. But though we once again have the same noxious combination of widening fiscal and current account deficits, India has several economic strengths as well. India today has a more dynamic economy, less volatile and short-term external debt, a huge pile of foreign exchange reserves and more sophisticated economic management than it did in 1991. A new report on India’s rising twin deficits by Citigroup economists Rohini Malkani and Anushka Shah points out that there are factors that “put the odds in favour of India’s resilience rather than its vulnerability”. That’s true.

But there is little doubt that the economic fundamentals are deteriorating. The hole in the government’s finances is getting bigger. It could now be close to 1991 levels, if measured correctly. The current account deficit, too, is growing and could conceivably touch 1991 levels by the end of this year. The foreign exchange market has already picked up these worrying signs. The rupee has been slipping against most major currencies over the past few weeks. Somewhere in some tax haven, a few hedge funds must be seeing these trends and sharpening their claws.

It is unfortunate and inexcusable that India is now at a point when it seems far more vulnerable than most other emerging market economies. The government should have used the splendid five-year economic boom and soaring tax collections to slash its deficit and prepare the economy for an economic downturn. It did not.

History will not judge the United Progressive Alliance government too kindly on this score. It is distressing that some of the same people who helped pull India out of trouble in 1991 have done so little to prepare for the next round of economic turmoil. One expected more from a team led by Manmohan Singh.

Your comments are welcome at cafeeconomics@livemint.com

Inflation: a short history

The highest inflation that India has ever seen in the past two centuries is 53.8%, in the famine year of 1943

Cafe Economics | Niranjan Rajadhyaksha

India is deeply intolerant of high inflation. It’s either because we have been blessed with very conservative policymakers or because the political elite knows that the electorate explodes in anger whenever inflation crosses the middle teens. That’s perhaps a comforting thought as the inflation rate moves towards double digits. History suggests that the chances of inflation running completely amok are quite low; but then history can be misleading.

The actual track record tells a more complicated story. India has never had to face the terror of hyperinflation. Look at Zimbabwe. The most recent estimate is that prices in that unfortunate African nation are rising at an annual rate of 66,000%. Prices change every day, and sometimes every hour. Its central bank introduced a 500-million-dollar note last month. It can be used to buy two loaves of bread, Reuters had said in a 15 May report from Harare. Every citizen is a billionaire, but in terms of a currency that is worthless.

India has never had to face such insanity since 1801. The highest inflation that India has ever seen in the past two centuries is 53.8%, in the famine year of 1943. Amartya Sen has often written about the havoc wreaked by that inflation in his part of the country. Satyajit Ray captured the suffering in Ashani Sanket, a film he made in 1973. Those were terrible times, but nothing like what Germany faced in the early 1920s or what Zimbabwe has to deal with today.

Many other Asian countries have done far worse than India over the years. (The less said about hyperinflation-prone Latin America, the better.) Inflation in China reached 1,579% in 1947, when there was a civil war raging there. Japanese inflation peaked at 568% in 1945, the year of defeat and economic collapse. South Korea saw inflation shoot up to 210% in 1951, when it was at war with the communist North.

These episodes of runaway inflation are linked to political dislocations and war. So peace, political stability and credible governments do matter when it comes to keeping a lid on prices. But even if the extreme cases of inflation that have their roots in war are kept aside, India has a middling record in fighting the genie of rising prices. It has a far better long-term record than most other regional peers. India has spent about one out of every eight years with inflation about 20%. The likes of China, Indonesia, Korea, Myanmar and even Japan have done worse. But Asian economies such as Hong Kong, Malaysia and Singapore spent far less time struggling with 20%-plus inflation.

The ability to keep inflation under some sort of control is one part of India’s good economic record. The other part is the ability to stay clear of foreign defaults though, lest we forget, India has had three trysts with semi-defaults since it became an independent country. The government rescheduled foreign debt in 1958, 1969 and 1972.

he data used here is taken from a recent paper, by economists Carmen M. Reinhart and Kenneth Rogoff, on financial crises over the past eight centuries. They show that financial crises are a given in the world economy since the Middle Ages. “Serial default is a universal rite of passage through history for nearly all countries as they pass through the emerging market state of development,” they write. And add: “Episodes of high inflation and currency debasement are just as much a universal rite of passage as serial default.”

So, on the one hand, we have India’s reasonably good record in avoiding financial crises and hyperinflation. On the other hand, we have the iron law that high-growth economies tend to fall into trouble every now and then.

Which way will we go? A lot will depend on the policy response. Manmohan Singh is no stranger to episodes of high inflation. He was chief economic adviser to the Indira Gandhi government in the mid-1970s, when two years of 20%-plus inflation was attacked with the then-fashionable option of price controls. Then he was finance minister during the inflation spike in the mid- 1990s, when he and Reserve Bank of India governor C. Rangarajan pushed up interest rates to dizzying heights to bring inflation under control.

There are several reasons why we should worry about the spike in the inflation rate. Inflation is a tax on the poor and long-term lenders. Also, as Reinhart and Rogoff show, “inflation crises and exchange rate crises travel hand-in-hand”. Inflation is already too high, though it is definitely not at economy-wrecking levels. But it’s best to be serious about the threat it poses.

Your comments are welcome at cafeeconomics@livemint.com

Cracks in the consensus

Central bankers are in deep disagreement about what to do next. They are not following the Americans

Cafe Economics | Niranjan Rajadhyaksha

A sharp slowdown in the US economy could have three effects on India—the good, the bad and the ugly.

Financier Mike Milken hosts an annual conference on the global economy at his eponymous institute in California. This year’s conference was held in April and featured four Nobel economists—Gary Becker, Myron Scholes, Michael Spence and Edward Phelps. One of the issues they discussed is how a US slowdown could affect economies such as India’s.

“When the US goes into a slump, that is tough for exporters in the rest of the world. So, production of goods for export tends to fall. At the same time, when the US goes into a slump, that tends to reduce real interest rates in the US—which to some extent pushed down real rates around the world. That can send up asset prices globally and actually stimulate investment because investors are looking for higher returns. So there are these two opposite effects, one through trade and one through asset prices,” said Phelps.

He believes that the effects on asset prices were more important till the 1980s. The high US fiscal deficits in that decade pushed up real interest rates, lowered asset prices and dampened investment. That negative effect was more powerful than the positive effects that came from the demand generated by extra government spending in the US. “Because trade has become a much larger proportion of economic activity in the last 20 years, I now think it is a horse race between the two,” says Phelps

A lot of the decoupling debate that raged a few months ago could be re-examined in the light of what Phelps is saying. On the one hand, the slowdown in the US is likely to lower exports from Asia. Global economies continue to be coupled. And on the other, the steep reductions in US interest rates to fight the financial meltdown there sent a lot of money to this part of the world, sending asset prices sky-high and firing up corporate investments. That underlines the case for decoupling.

That is the good and the bad. And what about the ugly?

The ugly possibility arises when there is a US slowdown and yet interest rates go up. Unlikely? Take a look at the state of the world right now. There is both a slowdown in growth as well as a rise in inflation. We have a mild version of the 1970s’ style stagflation. It could get worse. The growth slowdown—and perhaps outright recession in some parts of the world— will push central banks towards cutting interest rates. But higher inflation will send them scurrying in the opposite direction. In this case, there are few easy exits.

A lot will then depend on what central banks believe to be the bigger threat: an economic slowdown (mixed with a financial crisis in the West) or higher inflation.

That’s where the story gets interesting. The men in the central banking citadels are in deep disagreement on what to do next. The rule till now was simple: Follow the US Federal Reserve as far as possible. The Americans can run global monetary policy, especially in countries that have a fixed exchange rate against the dollar and where monetary policy has essentially been outsourced to Washington.

The consensus is now cracking. The biggest disagreement seems to be across the Atlantic. The Europeans have refused to follow the US and cut interest rates. Columnist Wolfgang Munchau wrote in the Financial Times earlier this month about another type of decoupling—monetary policy decoupling. “In the past, European central bankers tended to follow the US Federal Reserve, often with delay, never perfectly, but generally in the same direction,” he wrote. “The policy response to our most recent financial crisis has been different. While the Fed cut by an accumulated 325 basis points, the Europeans first refused to follow, and they are now moving in the opposite direction.”

Much the same is happening in Asia. Central banks across the region—including the Reserve Bank of India— are busy tightening the monetary screws, a sign that they are more worried by the threat of double-digit inflation than with modestly lower economic growth. Australian central bank governor Glenn Stevens has been blunt. He said last week that the biggest problem for emerging markets is not “the credit crunch about which we hear so much…but inflation”.

There are now signs that even Ben Bernanke is increasingly worried about the jump in inflation. If the US Fed begins to increase interest rates later this year, we will have a mirror image of the monetary policy scene since the mid-1990s. The Americans are following the rest. It is too early to say this will happen.

All those bothered about the effects of the US slowdown on the Indian economy should keep a close watch on what central bankers are saying and doing. A fall in US demand for exports and a rise in global interest rates could lead to far more damage to Asian economies than assumed.

(Your comments are welcome at cafeeconomics@livemint.com)

RBI cocks its ears

The central bank last week made public, for the first time ever, its survey of professional forecasters

There is a new style of central banking in town.

Like its peers elsewhere, the Reserve Bank of India (RBI) has started listening intently to what voices outside the citadel are saying about the current state of the economy and its future direction. The Indian central bank is now regularly quizzing various groups of outsiders on the economy—be it economists fiddling with forecasting models, businessmen poring over sales and inventory data or housewives coming home from the bazaar.

And it is now also sharing this stuff with others. RBI last week released, for the first time ever, the results of its survey of professional forecasters. This release was ignored by much of the financial press, even though it is an important step in the evolution of central banking communication in India.

The public release of the survey data tells us how RBI’s style of operation is gradually changing. The central bank is now increasingly trying to gauge what people expect in the future, rather than being content with official data on what happened in the previous week, month and quarter. So, it is now more keen to state inflation expectations than the actual inflation number released by the government’s statistics office every Friday. It’s looking ahead rather than just in the rear-view mirror.

RBI has been asking 29 select forecasters about their expectations on everything from economic growth and inflation to interest rates and corporate profits. The first such survey was done for the quarter that ended in September 2007. RBI has been using this survey (in tandem with its own internal assessments) as an input in its monetary policy decisions since then. This is the first time it is sharing its results with the outside world. Private businesses and investors would also do well to take a close look at these results to help in their own decisions.

The professional forecasters’ survey has the great advantage of showing that peering into the future is fraught with uncertainties. While there is headline news there—annual economic growth for 2008-09 is expected to be 8.1%, which is less than what was expected by these forecasters three months ago—RBI has also slipped in a lot of probabilistic stuff that highlights the ifs and buts in economic trends.

In other words, the forecasters have been asked what they think is the probability that economic growth will be within a certain range in a given year. For example, there is a 40% probability that economic growth in 2008-09 will be between 7% and 7.9%. This is in welcome contrast to the almost arrogant certainty with which economists divine the future, down to the second decimal point.

Besides the survey of professional forecasters, RBI has also been conducting surveys of business expectations and inflation expectations. In its report on the Indian economy that was released a day before its April monetary policy statement, RBI published the results of its latest survey on business expectations. The results of the survey on inflation expectations— perhaps the most important one right now—are still under wraps.

“The use of statistics has increased manifold and the demand is for real- time or near-real-time data on almost all aspects of life and economy. The system of national accounts and the related accounting system on balance of payments, fiscal and financial statistics provide the basic framework for collection of statistics. As the monetary policy responds quickly to emerging developments in the economy, and its effectiveness depends on market expectations, the set of data required for the same, (such as) business expectations and inflation expectations, need to be collected through quick surveys,” RBI governor Y.V. Reddy explained in a June 2007 speech.

Surveys are just one way that popular expectations about growth, inflation and business conditions can be measured. A more effective way to do this is by keeping a close track on how various prices in the forward markets behave—and that’s because the beliefs of thousands of traders are aggregated in these markets.

In the US, movements in the Fed funds futures tell us a lot about what probability the markets are assigning to interest rate cuts or increases from the Federal Reserve. The traded prices of inflation-indexed bonds are a great gauge of inflation expectations.

India cannot use these prices as trustworthy indications because there is very little trading in the bond markets and prices are dominated by the actions of the central bank. Neither bond prices nor the shape of the yield curve could predict the sudden spike in inflation that we have seen this year. That’s unfortunate.

The use of surveys by RBI is a welcome first step in trying to understand what other participants in the economy expect in the days ahead. The next step will be to create deeper and more liquid bond markets—and a yield curve that is far more than the mere curiosity it currently is. RBI needs to tap into the wisdom of the crowds.

Your comments are welcome at cafeeconomics@livemint.com

The long and winding road

Since 1950, only 13 countries have been able to grow at more than 7% for 25 years. India will have do even better than that

Economic development is a long-term game: more Test cricket than Twenty20.

Some countries have succeeded in this game. Many have failed. A few started off well and then lost their way. And economists—though most would refuse to admit it—cannot say for sure what has separated the successful ones from the failures.

Can India become a rich country in the near future? How fast will its economy have to grow to abolish poverty? A new global commission on growth and development has identified the task before India in the statistical appendix that has been published at the end of its recent report.

A team of 21 economists, business leaders and policymakers spent two years trying to understand why some countries break out of poverty and move into prosperity, and many don’t. Nobel economist Michael Spence headed the commission. Its final report was published earlier this month (Planning Commission deputy chairman Montek Singh Ahluwalia was a member).

One question that the commission asks in its statistical appendix will interest all those who are deeply interested in India’s long-term future: What will it take for India to catch up with the rich countries?

To get to the answer, Spence and his team have made some simple but useful calculations. They start with an assumption. The prosperous countries will keep growing their average incomes at the rate of 2% a year. By 2050, citizens in nations such as the US, Japan and the members of the European incomes will thus have an average income of $75,130 a year. India is already way behind the rich countries in this game. Its 2006 per capita income (in terms of purchasing power parity) was a very modest $3,306. It has serious catching up to do—and the only way it can succeed is by growing rapidly over the next few decades.

How fast? India will have to increase its per capita income at an average rate of 7.4% a year, all the way till 2050. The slower it grows, the more time it will take to catch up.

In other words, the Indian economy will have to keep expanding at its current rate for more than four decades if standards of living are to reach those in the rich countries. There will be the inevitable ups and downs along the way, of course.

Can India do it? The task is a tough one. Only 13 economies have been able to grow at more than 7% on average over 25 years since 1950. That’s a very small number. South Korea is one of the lucky 13. It was once one of the poorest nations in our continent. It is now better off than the likes of Slovenia and Portugal.

The main task of the growth commission was to sift through the evidence and see what countries such as South Korea did right.

There are no easy answers. Economists have been deeply divided over the big question: What explains the wealth and poverty of nations? The growth commission, too, says that there are no “silver bullets to create long-running, inclusive growth”. Grand blueprints will not work.

But the commission does point out to some factors that have been common in the development strategies of the 13 countries that broke out of their poverty traps. One, they integrated into the world economy to gain access to markets and knowledge. Two, they maintained macroeconomic stability. Three, they could push up savings and investment rates. Four, they let markets allocate resources. Five, they had committed, credible and capable governments.

A test: Check for yourself what India did right and wrong in terms of these five parameters over the past 50 years.

The splendid acceleration in growth that we have seen since the middle of this decade shows that the Indian economy now has the ability to stay in the run chase. And, unlike some countries such as Russia that have seen higher growth because of higher commodity prices, India’s growth is more firmly rooted in long-term factors such as higher rates of savings, a growing labour force and productivity growth. Investment bank Goldman Sachs had said in its now-famous report on the growth prospects of the four Bric countries—Brazil, Russia, India and China—that India is most likely to maintain high growth rates in the long term.

But, at the end of the day, it’s not just about the big macroeconomic numbers. A country needs a well-trained labour force and dynamic companies to take advantage of growth-inducing policies. The authors of the growth commission report put it in smarter language: “The growth of GDP can be measured up in the macroeconomic treetops, but all the action is in the microeconomic undergrowth, where new limbs sprout, and dead wood is cleared away.”

That’s the challenge defined in another way: to encourage efficiency and creative destruction, while designing policies to protect people who are hurt in the inevitable process of change.

Your comments are welcome at cafeeconomics@livemint.com

Food and economics 101

Wheat is trading at a nine-month low in the international markets

The steep rise in global oil prices has perhaps distracted us so much that not enough attention has been given to what has been happening to food prices.

Wheat is trading at a nine-month low in the international markets. Rice has become cheaper in recent weeks. There is no reason as yet to declare that the global food crisis is over. But the drop in food prices shows that trusting the basic laws of economics and sensible international cooperation can help the poor far more than panic moves to control prices and ban exports ever will.

The fall in the price of rice can be traced back to a congressional testimony by an Indian economist — Arvind Subramanian, a fellow at the Centre for Global Development (CGD) and the Peterson Institute, two think tanks in the US. Subramanian told US legislators in the middle of May that Japan was sitting on 1.5 million tonnes (mt) of rice that it had imported from the US. “Releasing this rice to global markets would prick a speculative bubble and bring rice prices down fast, while also encouraging China and Thailand to release their surplus stocks,” noted a CGD policy note released a few days before the congressional testimony.

That is indeed what happened. The Japanese government agreed to send some of its food stock into the global market by selling 250,000 tonnes of the cereal to the Philippines. Much of this was rice that Japan had earlier imported from the US. The latter could have used global trade rules to prevent the re-export of “its” rice. The US did not press charges. Rice prices dropped.
Countries such as Cambodia have been emboldened to ease export curbs on rice. Other rice exporting nations may follow, especially as some of them are expecting better production this year. The modest fall in global rice prices—which are still at gut-wrenching heights for the poor — has been the result of enlightened international cooperation. And it also illustrates that protecting national food mountains at any cost will push up food prices further. Some element of food security is fine. But blanket bans on the export of food will eventually starve the global markets and harm consumers.

India has a lot to learn from this episode. Its own mercantilism has been uninspiring. Here’s what the CGD blog says in a recent posting: “India, which set off the current rice crisis, is a prime candidate for…diplomatic initiative. Unusually large wheat imports in 2006-2007 following weather-related damage to the wheat crop set off a firestorm of criticism, from farm interests and the political opposition. With a view towards upcoming state elections in November, the ruling coalition decided to pursue a ‘starve thy neighbour policy’ — curtailing wheat imports and boosting staple stock by banning exports of non-basmati rice. This triggered rice export bans and hoarding elsewhere in Asia.

“Now, however, India is facing record rice and wheat crops, which are expected to shatter last year’s record food production by 10mt! The Indian government has also rebuilt its food grain stocks to very comfortable levels. The time has come for Delhi to reverse course and once again allow buyers in Bangladesh, Sri Lanka, and the Middle East to buy India’s excess stocks.

“The food ministry is supportive of a proposal to resume exports to ‘strategic neighbours’ and the government reportedly is considering a proposal to allow 1.3mt to (select) African markets. The trade ministry, however, apparently is opposed, while the agriculture ministry appears to be neutral. With India sitting on food grain stocks that exceed its targets, Delhi should do its bit to help alleviate the crushing world rice prices which are hammering the global poor.”

Shanta Devarajan of the Asian Development Bank (ADB) has shown how rice prices in Dhaka spiked each time the Indian government chose to either impose an export curb or raise the export price. Of course, dealing with a country such as Bangladesh, which hasn’t exactly been friendly towards India in recent years, should also involve geopolitical calculations. But the general point stands—smart international cooperation and a belief in markets will help ease food prices.

The Food and Agriculture Organization (FAO) is currently hosting a food summit in Rome. This is one indication that the genie of high food prices is still out of the bottle. FAO says in its new Agricultural Outlook that food prices in the next 10 years are likely to be higher than their average over the past decade.

Meanwhile, there are signs that high prices have (not surprisingly) acted as incentives for farmers to produce more food. A BBC report says that farmers in Afghanistan “are turning from opium to wheat because it pays more at current rates”.

Letting markets work, keeping borders open for trade and sensible cooperation usually works in most circumstances. There is no reason to believe the food crisis is any different.

Your comments are welcome at cafeeconomics@livemint.com