The extraordinary lectures of Hans Rosling

Hans Rosling has given an amazing presentation that debunks some of the myths about Third World. It is presented so beautifully that even total strangers to economics and public policy can understand every part of it. It should be a bible for all powerpoint presenters and those want to present analysis on the data. Watch the presentation and enjoy.

See this followup presentation on poverty:

A third video about the beauty of statistics

Will US go into recession? Part 2

Now, the last few weeks of hearing all bad news all around financial markets, made me think is the world is going to be destroyed pretty soon. Is this the Apocalypse? I mean, why is there so much of panic when a casual glance at the current situation doesn’t seem to be bad, at all. Notwithstanding the subprime case that we saw in the part 1 of this series, the tide might not be big enough to rock the boat. Here's why:

1. In most subprime hit localities, American households earn average of 75K/year and buy house at an average rate of $300K that is just 4 times the annual income, and in many rich neighborhoods that earn in 6 digits this ratio could be even less. So, is the house price sky-high? Is the ratio change too much in America’s history? Are other countries better? Brits and Europeans whose average house price is like 10 times the annual house-hold salary seem to worry much less even at the back of a 3x price growth in 10 years. In Asian countries like India, this ratio could get even higher. I don’t know about Africa and South America, but think that they wont be any better in owning houses than America.
2. Current America has a very healthy corporate cycle and unemployment rates are almost historically low. The last housing bust was at the back of big unemployment.
3. The subprime mortgages are still a small portion of total value of American housing assets and not all of them are defaulting and not all the defaulted properties have a value of 0.
4. By the very nature of the American economy, the risks are well spread out and markets are pretty deep and matured compared to almost any other country. Agreed that there is a lot of unnecessary froth at the top, but derivatives in essence builds a very strong foundation and links the stakeholders.
5. The world economy never looked so better and not all of it is based on cheap mortgage. There are quite a bit of fallbacks, unlike the previous times. Even taking the factors that are dependent on US consumption, the consumption of many Asian countries have increased sharply and Russia is back on its knees.
6. Most importantly, unlike in most other times of American history, there are a quite of bit of non-market entities that are extremely powerful and they would like to maintain status quo and have the means to do it. The foreign reserves of Japan, China, India and Korea alone are in the range of $3 trillion and each of them is much bigger than any institutional or individual player in the market and they understand the stakes. If US goes into recession or if there is a reduction in interest rates, there could be losses of hundreds of billions here alone. So, would it be stretch to assume that a couple of hundred billion dollars could get diverted by these power central banks into US mortgage and bonds to save American economy from collapsing, while making strategic buys with high yielding interests. For these central banks few billion dollars are pocket change and they have quite a bit of powers in their arms. They are silently watching and if there is a definite case of collapse, there could be a lot of invisible hands at work to clean the mess.

US is so crucial to the world economy that not many of the powerful hands will allow it to drop. And the fundamentals seem to be good – its not like inflation is going into double digits or corporate are throwing out people in mass numbers. Few hedge fund owners and a few greedy subprime buyers are fried, but I don’t understand why the market value should drop by few trillion dollars.

I agree that the Mortgage lenders have tightened up and its hard to get loans now. But, this can’t go on forever. The fundamental money generation engines have not gone away. Asian and European countries are still generating billions of surplus cash that eventually finds its way to US economy. And those sitting on fences now with hoards of treasuries cannot afford to sit there forever. At somepoint those money will get back into bonds and asset backed securities. The lending standards won’t be as lax as last year, but still I don’t think that the complete opposite that is happening now can be there forever. In fact this crisis could become a like a vaccine that has inserts weak pathogens and arouses the immune systems. A lot of countries are happy that the flood of investment has slowed down and began to take a hard look at the economy fundamentals. For example, Indian central bank was so concerned that it gets so much of portfolio investment that has started hurting the export competency by strengthening the currency and China was constantly expressing fears of a stock market bubble. Now they breath relief. A lot of corporations were very concerned by the overarching powers of Private Equity players and now don’t need to spend as much energy in warding of the PE eagles or making synthetic modifications. And prospective home buyers in US who were getting pushed out of the market are now considering a serious comeback. And banks and financial institutions that have been over enthusiastic will be concentrating on their core businesses realistically. If it is going to be just a blip will it make much sense to close up all the investment positions that have been painstakingly made, just to watch from the sidelines that the markets get back to their bull runs?

And slightly OT here… does the periodicity of business cycles and recession cycles for US still valid? I mean, many of those researches were made before 1990 when significant changes occurred in world economy that multiplied market sizes by many times. In just year 1989 Berlin Wall collapsed, USSR pulled out of Afghanistan leading an eventual collapse of the soviet, China had Tianenmen Square massacre that forced it to join market forces, Indian elected a moribund coalition eventually leading to a bankruptcy and opening of economy…. And thus from start of 1990 the recession cycles are way off and even the Asian crisis of 1997 or dot com crash didn’t dent economy too much and house prices didn’t dent.

Will US go into a recession? - Part 1

The last few weeks of credit crunch has made people to start thinking about a recession. If you go by the historical periodicity of economic cycles, a recession is a long overdue in the US. The last one in 2001-02 was not a big one, and a lot of believers have come to predict that next year might be a recession year. The biggest factor this time seems to be the mortgage crisis, in particular, the subprime mortgage crisis where lenders were very lax in providing loans to people with spotty credit history. So, this part would focus on that.

A background on Subprime crisis:
In US, home loans, like those in most other countries, used to be a direct relation between a lender and the borrower. The borrower puts up some money and approaches a bank and if he has good financial track record and has the means to pay the loan, the bank gives a loan for the rest; and this is given from the deposits made by its customers. The borrower puts atleast 20% of the amount and has about 30 years to repay the remaining 80%. Usually, home prices doesn't go down more than 20% in normal circumstances and hence the bank always have the option of pulling the loan from the borrower and selling it in the market, if the borrower ever defaults. Since, the borrower puts 20% and takes a risk of losing the entire investment in case of crisis, looks carefully before buying and make sure he could pay the loan for atleast 2-3 years down the road. And normally, the rental cost is not too much more than the interest paid on the loan and so there is always an option of renting the home and pay the lender from the rental returns. So far, so good.

Now, the lenders wanted to expand their businesses and bring more liquidity. After all, if they just lend with the savings deposits they get from retail investors, they would still be a small business. And its risky too. What if all the customers want the deposits immediately (savings deposits are for shorter term) while the bank cannot get loans in a split second from the borrowers who have a period of 30 years to pay. This situation is called the "run-on-the-bank" and during the 1929-33 depression, a lot of banks failed because the depositors wanted money too quickly sensing a panic. So, to reduce the risk and save their asses, banks wanted to marriage the borrowers with those who could invest for pretty long and who might not want the money immediately in case of a crisis. Enter bond markets and institutional investors.

Now, the bank makes ten loans for say $1 million and then packages them into a bond. This bond would yield at a rate slightly less than the rate charged by the bank to the borrower and the bond is secured by the ten homes for which the loan was given. This bond would be bough by big brokerae firms and other big institutions who might slice them into say 1000 pieces of $1000 each and so on. At some point retail investors who plan for retirement or want to invest for their kids education would buy these bonds and they look long term. In the long term, houses always appreciate usually with the rate of inflation. So, even if the borrower's default, the house could be sold and the bond repaid. And the chances of borrower default is very low given that it is given to only good people and the borrower has significant equity that he doesn't want to lose on foreclosure. Given that less than 5% of borrowers would ever foreclose and the individual piece you buy is so spread-out (your $1000 bond piece might contain $1 pieces of 1000 loans) that the risk is not too much. The lender is now just a conduit who needs to lend to good borrowers and package the loans to long-term investors and so has very little no-risk. For the borrower, the loan interest rate goes lower as he could choose from the huge pool of liquid options. So, its a win-win for everybody.

But, human greed sometimes can blind objectivity and when the risk is not directly visible the greed directly takes over sanity. This win-win equation seems to suit everybody and it looks like irrespective of who the loan goes to, the final investor gets his return. To make matters worse, at each level, the reputation of previous level adds up thereby reducing the risk (apparently). So, John Doe goes for $1 million loan. This is a bit risky, so the lender charges slightly higher. The lender, a small and reputable bank can get a much better rate for its Mortgage backed security and sells it to say, Fidelity*. Now, when the final investor buys from Fidelity he thinks of all the great corporations involved in the chain and agrees for a much lesser interest rate for his bond, than what he would give it to John Doe directly. Since, he agrees for much lesser interest rate, Fidelity can give the next loans to the local lender at a much lower rate and the lender hence gives the borrower a lower rate. This chain of lowering interests come to point where the interest rate between what you get in super-safe Government bonds and treasuries and what you give it to a spotty borrower like John Doe is infinitesimally small. And the investor keeps full faith on housing market that always seems to go up and thus the spottiness of John Does doesn't matter. You can always get the house from him and sell it in the market.

Now, the lender doesnt need to ask for any income proof or repay ability from the borrower. The average investor Jane Smith doesn't plan to ask that and if the final investor is not asking, why bother. The lender and broker could happily loan to any shabby, shady little person with just a couple of document signatures and pass the securities to final investor. How better you business could get? Every body is happy in this land of paradize. To make it worse, the Fed (American central bank) reduced interest rates so low that now its barely above zero. So, anybody could be given a loan with almost no interst rates and since house prices *always* go up (short or long term doesn't matter), every Tom, Dick and Harry jumped into the game. They didnt have to put 20% from their pockets, didnt have to worry about planning for payments 2 years down the line or even worry abount Rental incomes. HOUSE PRICES ALWAYS GO UP YOU MORON. And the lower interest rates are taken for granted and people went for Adjustable rate mortgages where interest rates go with the market rates, rather than one fixed rate for entire duration of the loan.

So, what if the housing markets start going down, interest rates start going up and the poor investors like Jane Smith start using their brain? You will get the current crisis. Those who got million dollar loans with no income, start suddenly thinking that they cannot repay. So, they go to the market and sell the home and pocket gains after repaying the lender. It turns out that every other moron tries to do the same, and just as in the "Emperor without any clothes" fable, suddenly people start realizing they are all naked. The house prices start falling down. Now the big brokerage houses start waking up (aroused by Jane Smiths) and they start asking the lender to give back teh bond amount or foreclose those houses that are not paying interest. When they try to foreclose they realize that the house is worth just 75% of what the loan is and everybody start scrambling. The investors threaten the brokerages and big banks and they inturn put their hands in the lender's throats. Result: Lenders start closing down, and brokerages are hit big and have to take some of the losses and pass the rest to its investors, starting a chain. Now, many people who thought they were loaning Fidelity* or Bank of America*, realize they were in fact loaning the shady loan applications of Joe Does who wont repay. Thus, this whole mess.

This subprime market is more than $2 trillion and no one is sure how many of their famed institutions are involved in what amounts. As uncertainity is the mother of bears, we are feeling this great pinch and the dormat investors are now suddenly running helter-skelter to get their investments back.

Next: Would it really cause a recession?

* This is taken just as an example. It is not to be taken literally to mean that Fidelity has very high mortgage exposure.

http://en.wikipedia.org/wiki/Subprime_lending
http://onlinejournal.com/artman/publish/article_2341.shtml

A Brief history of Current Crisis

The last couple of weeks the world markets are choppy. Stocks are crashing, finance companies and hedge funds are on their knees, emerging currencies are heading lower and there is a virtual panic in the capital markets. Even commodities and real-estate were not spared. Even having a not too aggressive portfolio, I lost more than 1300 dollars in just 7 days. But, things are far from being over. The Monday opening could be a very crucial factor that could affect the world economy for a long time to come. If things stabilize, then its business as usual (we have successfully postponed the crisis), but if the waves get higher and panic goes in a vicious circle then whole world could go into a recession, dwarfing the Asian crisis of 1997. This article would briefly explore the history of current crisis.

The historians would always disagree when the core events for the current crisis started, but I would say 1989 as the year from which world economy started getting very different and is a crucial year for the current crisis. It was the year when USSR pulled out of Afghanistan accelerating the collapse of the Union of Silly and Stupid Republics two years later. It was the year when Berlin wall collapsed, crashing serially all the imaginary walls built by the socialistic societies of the 20th century and forming a formidable economy of Europe - Germany. It was the year when Chinese government massacred a large group of innocent students in the watershed event at Tienanmen Square of Beijing, leading to unprecedented international pressure that caused China to abandon communism and join world economy. It was the year, when a loose and directionless coalition of political parties took power in India, making it finally bankrupt in 1991 and forced to abandon socialism join World economy. Free elections were held and Brazil became a democracy leading it to overcome an economic crisis and become a big world player. And in Eastern Europe nations got decoupled from Soviet Russia and its Warsaw Pact, with nations like Hungary declaring independence. And in South Africa, apartheid was coming to an end leading to the end of years of economic isolation.

Too much for a single year? In economics and politics, things linger for a long time and when they start coming down they come down like a pack of cards. Whatever it be, it was a watershed year for international capitalism. In one stroke - the biggest countries of the world joined the world economy that earlier just had just Uncle Sam and kids (Japan, UK and Western Europe) that were far more homogeneous. They had similar per-capita incomes, similar political systems and far more open markets and financial systems. But, these new countries - Brazil, Russia, India, China, South Africa (BRICS) had vastly different economies and political systems. They are some of the biggest countries in the world, with vast histories and totally different per-capita income levels. Even today, India's per-capita income is one-thirtieth of those in Western Europe. The new entrants of world economy were greatly welcomed and in 2000's they all had sputtering growth - India became a service superpower and China built the greatest industrial establishment of history. Russia and Brazil became major commodity superpowers much later. There was an humongous gain in productivity in China and East Asia.

Fast forward to 1997. The vast increase in investment opportunities in these emerging markets were a great blessing for international capital markets who took them with too much of enthusiasm. While, China and India were pretty closed, rest of Asia welcomed these capital with four hands. Thailand and Malaysia were particularly too kind to these. But, things started getting bad. Investors and economists started to realize that productivity gains were not too much and most of the growth was just an illusion caused by speculation and capital flows. These emerging markets are not an elixir for all the woes for international investors, and as the realization started to sink in, a crisis was looming and before anybody could realize the summer of 1997 was a bloodbath in East Asia. Indonesia, Malaysia and Thailand were devastated and even after 10 years, their real economic level has not come to their pre-1997 levels. And the echo started falling all over Asia and due to few other factors (like Hedge fund manipulation) Russia became bankrupt in 1998. The sum total of all these factors led to a massive inflow of capital back into United States, leading to a collapse of all these currencies, as panic-ridden investors always look for safe havens in times of crisis.

Forward to 2000. Capital never stays calm. It is a fluid and it has to find a lot of new resting place. Where did they go? They went to a new found fad in California, called the dot-com boom. Any tom, dick and harry who knew to put like ... Bunch of trash ... started a company, went on an IPO and sucked millions of dollars. The process could not be slowed by statements of caution of wise men (Alan Greenspan said a prophetic 'Irrational Exuberance') and this farce continued till some one had to say "the emperor had no clothes". And everything came down with a thud in March 2000 and continuing all the way upto 2001.

Now, the US fed got into thinking. It had to pull out of recession caused by the crash and find alternative means of growth. In a series of breathtaking sessions, it brought the interest rates down to ridiculously low figures and by 2003, it was just around 1%. In the meantime, lending standards were relaxed and any jane and mary with just an existence to show, could borrow millions to buy dozen of housing properties. This had three big effects. One is that all that money found into places like Real estate and commodities that were long ignored. The oil prices went up by 5 times in a space of as many years and there was boom in all those metals - steel, copper, gold, etc and house prices doubled and trebled in many places. Second, the bad experience in US markets and the low interest rates pushed money out of US and they directly entered emerging markets. Parallely, India and China established themselves as great players in their game and opened their economies much further. This combo effect had billions of capital inflows in the form of FII and FDI. Brazil and Russia also were back on their feet with commodities soaring. These currencies suddenly started appreciating further and hurt their domestic industries a bit. Third, the cheap capital caused the Hedge funds and Private Equity to take control of world economy. Corporations like Chrysler and Hilton found their way into the kitties of companies that had nothing to do with automobiles or hotels.

The current crisis is thus a series of flip-flops where investors swing like monkeys from one investing to tree to another. Commodities were not so kool in 1990s and they were the hottest plays of 2000s. Emerging markets were too risky in late 90s and they were the toast of the day in mid 2000's. Housing markets were not so interesting in 90s and in 2004 they all believed "house prices will always go up and no one can lose in real estate". Dollar is a loser in early 90s, safe haven in late 90's, loser again in middle 2000's and now again a safe haven. Most of investing is now just momentum and bringing new fad of the day, than an appreciation for grey cells. The most important of all is that world still has not come to terms with globalisation.

60 Great years of freedom

What a great time for India to have its 60th birthday. Normally in India, 60th birthday would mark the passing of the retirement era where the old gives way to new. The day is celebrated pretty grand as a mark of recognition for the 60 great years of living. But, surprise for India it is more like a celebration of the first birthday. The nation is so young and so much of energy left in it, that the following years are going to be the most crucial and significant ones. Our basic problems like - rural decay, over dependency on Agriculture, adult illiteracy, poverty, gender inequality, inadequate buffer to face routine forces of nature like flood, cyclone and earthquake... have not changed much in the 60 years. We are still as divided as we started out with and the religious tensions have not smoldered. Thus, it will be the future that will be more significant for India than the immediate past. Most of the instrumentation to solve these colossal issues are getting available only right now.

In some aspects, we have not done bad and in fact done much more than expected. Who in the 1940's would have expected India to lead the world in Technology, software, satellite communication, etc? We are among the top 10 nations in economic size, stock market volumes, satellite capabillity, software production, super computing, nuclear generation... We would soon replace US as the country with the second most telephone connections after China and we are just couple of years behind the cutting edge technology in communication. This is a far cry from the days (just 7 to 10 years ago), when India had a place among world nations with the poorest teledensity and telephonic infrastructure. Our Television and Radio reach is complete and we have among the highest world viewers of Cable Television. We have produced some of the world's most respected educational institutions in Technology, Medicine and Management and Indian graduates go for a premium in international job markets. Tell that to someone who was sleeping for the last 20 years and he wont believe. Our film industry has matured enormously and is second only to the Hollywood in size and viewership.

There are cries of inequality and "rich-getting-richer". But, look around. How many rich people did you see in 1947 and how many do you see now? There are now atleast a 100 to 150 million credible middle class population dozens of times more than a couple of decades ago, and this class is rapidly bulging. While Indian companies were small dots in global picture, as late as 2003, now they are audacious enough to take on the world giants. Tata has gobbled our former colonial master's biggest steel maker and vying for Landrover and Jaguar, a car that transports English aristocracy. Reliance is hunting for GE's plastics division, the Pharma players are looking for big ticket acquisitions and companies like Bharat Forge and Moser Baer have reached the top in their fields. We had a handful of big corporations a decade ago. Now, you have Bharti, Infosys, Reliance, Ranbaxy, Tata Steel, Tata Motors, Wipro in every spectrum of production. Well done, India. We produce much more entrepreneurs than most other countries and our boys are there in the boardroom of every major company now. A few Giants like Vodafone and Pepsi have Indians at their very top. And this is not including Mittal who has built a world steel and energy empire almost single-handedly.

In 1940's our only rich people were the Maharajas and Zamindars who had squandered other's wealth and coasted on theis ancestors wealth generation. Now, the richest billionaire Indians - Lakshmi Mittal (Arcelor-Mittal), Ambani brothers (Reliance), Sunil Mittal (Bharti), Kushal Pal Singh (Real esate giant DLF), Azim Premji (Wipro) were almost nobodys 2 decades back, and almost built fortune with their own efforts (for Ambani brothers, a big start was provided their illustrious father). And there are thousands in the wings - just take a rough glance of the world's top B-schools and most of them have huge Indian contingent. Each huge company have a positive rippling effect on hundreds of thousands of people, and with so many huge companies thundering Indian economy never looked rosier.

Looking at the negatives, we have huge volumes of them. Take any social problem in the world, and India would rank top 10. Poverty, illiteracy, sectarian troubles, gender divides, class/caste issues, Communalism, Tuberculosis-Malaria-HIV-Polio, Corruption... our health care and primary education facilities are in great decay and rural India is almost sinking. In fact, we have come to the point where none of the major problems look very surprising. We are so used to glancing our morning newspapers where the headlines would have a major rail accident killing hundred people, terrorist gunning dozens in Assam or Kashmir, a major politician indicted in a big ticket scam and smilingly coming out of prison, floods drowning hundreds of villages or religious violence burning an entire city - these are just news points in a fast mesh of problems we face. We are now so insulated from our problems.

Thus, looking at our future, I would like to see these core problems solved before we rest on our laurels and enter the world's elite clubs. There is no use in just praising ourselves that we have IIT, IIM or AIIMS, when half of Indian kids dont go to school. There is no use in becoming a medical superpower when majority of citizens dont have access to proper health care. But, the solution to these are not more of commie stupidity or Arundati Royism, but lies in carefully planned policies that involves all the constituents - the government guiding and overseeing, corporations implementing, and the local communities working to even out the benefit spread. We would like to see the Mittals and Ambanis of Schooling, Agriculture and Medical Care and this is where India's future lie.

Future of Rupee - Part I

Now that the inflation in India is tamed, the central bank in India (RBI) started back to its good old ways - buying humongous loads of dollars and increasing money supply bringing down call rates and also simultaneously increase Cash Reserve Ratio, affecting the profit margins of banks.

In the last couple of months, after I wrote the article series - "Is RBI handling inflation correctly", I had been in touch with a few financial columnists in India, working for Bloomberg, Hindu Business line and Business Standard and a few of them were very apprehensive of the rupee's effect on exports and cite their good old model - China on how to manage the inflows. However, good China had been in energizing the economy, I dont think that it is an good example for everthing. It has its price.

To put it short, if you have to manage heavy inflows - you have to screw one or more among the four crucial variables
a) Inflation
b) Export competitiveness
c) Financial health of banks
d) Interest rates and capital availability

So, if you have allow all those dollars to flow into India, unhindered, you will immediately cause rupee to appreciate (by simple demand-supply) and India's export competitiveness will be eroded as exports will be costs compared to imports. So, if the central bank buys up the dollars and prints rupee to prevent appreciation, it will cause inflation by making more money available in the system and weakening the currency. Now, to keep money supply constant and prevent inflation, the central bank has to increase interest rates and cash reserve rates (the amount banks have to keep idle and not use for loans from their deposits) affecting the availability of domestic capital and affective investment in crucial sectors. Now the Chinese model - sanitise all those dollars and not cause inflation by arm twisting the market by fixing constant prices and wages. And use banking sector to fun unproductive enterprises and load them with debt. This way the banks will take all those blow associated with maintaining the dollar low.

Each of these paths have a price. Inflation is the worst and no elaboration is needed here. If managed wrong and allowed to go on a vicious cycle, can cause the worst nightmares as seen in the hyper-inflation in Greece, Germany in the early 20th century and in Latin America in 1980's and 90's. Interest rates are among the next worst as it affects needy companies from raising adequate capital and affects crucial investment opportunities. Corporations would be unable to raise debt at favourble prices and affect economic expansion. And financial institutions are very crucial for a good market economy and making them a scape goat for increasing exports will debiliate the economy in the long run. Its like smashing the leg to give more blood to the hair. The last comes exports - whose importance varies from economy to economy.

For economies like Japan, Korea, Singapore and even Germany, the domestic population is so small and spend allergic that there is no way that they can ensure good jobs by relying on producing for local markets. They are forced to export and to export they have to have good currency support and so artificially affect exchange rate even at significant costs to economy. But, this doesn't hold good for China or India. They have 1 billion+ customers each and a good economic history that they dont theoratically need any external markets for their goods. If they can stand on their own legs by developing good local markets, the enterprises have so much of room to grow that they can forget about currency manipulation. And given their rate of expected growth and scale of operation, they cannot afford to depress currencies forever. Elephants cannot afford to jump trees and hide in burroughs and the managers of these trillion+ dollar economies better know this.

(Next part: The reasons why should the RBI allow freer flows and there is a solution, where we could avoid screwing up any of these 4 variables, to a great extent)

Back to Blogging after a long hiatus

I'm back to blogging atlast, after a 3 month sojourn. There were two many things that were happening that I hardly got time to sit down and write something. I got to write a couple of drafts, but later discarded them. I wish I could write a few elaborate articles, but the time required to put long good article in place (including the background reading) was demanding and I couldn't do enough allocation.

Last 3 months in Brief:
>> My parents and grandfather came to visit me and it was great time May - July. They were with me for my graduation ceremony, my dad's birthday, my birthday, my parent's wedding day and its great to be with the family. It was the longest vacation ever for my father and its the longest time, I spent with them since my school days.

>> I had the longest and best drives in the month of May. I drove for 2300 miles during my trip to Calgary, Canada visiting Banff and Jasper parks on the way. The one week trip through some of the world's most beautiful glaciers that are source for the biggest chunk of world's freshwater (most of water flowing through Missouri, Missippi, Niagara and other great rivers & lakes of North America draw its source near here). On the second leg, I flew to New York and had another 2500 miles drive around Toronto, Niagara, Pittsburgh, NYC, Baltimore, Washington DC...showing some of the iconic American tourism destinations to my folks. The 5000 mile+ drives on solo in 3 weeks had taken most of my energy for that period. I'll write on these trips, after a while.

>> My Ski accident in March had screwed the ligaments on both of my knees and on May 1, I realized that I had to get surgeries on both legs to repair back. I had one of the surgeries on June 11 that fixed 2 of my ligaments and I might have one more later this month to get everything completely fixed. But, the recovery for the ligament repair is long and so it will be a year, before I could take much of strenous physical activity (like Skiing or Skating :)). This was my first major surgery and the experience with General Anesthesia was overall very disturbing. I couldn't remember anything of that 2 hours and to think back of that overall blank state, I could think of death as the only closest thing. And the first week after the surgery was horrible. It was paining, itching and totally disturbing :( to have a knee locked out. And walking with braces and crutches was pretty discomforting to say the least.

>>I got a traffic ticket in May that put my overall driving under great stress. I just spiked to 90+ on a 70mph zone, as I was overall very tired after a week of driving and there stood a cop. Normally, I learnt to watch for a cop so that I could drop from 120mph to 70+ in no time, but this time tiredness and darkness took over. I was given a speeding ticket, but since I was perfectly alert and stopped immediately after the lights were put on, I was given no other citation (normally 23+ the limit can cause multiple tickets). After the ticket, I got so careful that I dont drive above the speed limits and life is a hell now. I couldn;t chase any powerful cars and I had to constantly move to right lanes to gave more faster cars a room in left lanes. Even stupid, sluggish and humongous trucks, tail-gate me. The moral: If you are a Lion you have the luxury to sit over your prey, but if you are as innocent as the lamb you are a sitting duck for others to prey on you.

Luckily, my ticket is dismissed by having an expert lawyer on my side, but its doubtful I would ever go to the 120-130mph range, that i occassionaly try on deserted highways with my V-8 machine. And with high gas prices and low fuel efficiency at high speeds due to wind resistance, I'm now happy at 70-75 mph range.

Overall, life has never been so tough and 3 of the passions that I had so far - Movies, Skiing and Driving all took a backseat. I also stopped communicating with people - no phone calls, emails, orkut scraps, blogging... Now, I'm very close to come back with my normal life. Let's see how the next few months unfold.

In the meantime, I'm getting back to touch with the economics literature and I'll be back to serious blogging there.

Is RBI handling inflation correctly? Part 3

In Part 1, we saw why RBI had to resort to hard measures like interest rate hikes and free exchange rate controls. 6% inflation is just a small indicator of the overall overheating that could be witnessed in the asset prices that show more than a triple digit appreciation, leading to a monetary policy change. In Part 2, we saw about the main tools for a Central bank - interest rates and exchange rates and how they could be used. No how all these changes impacts on us? The "us" involves exporters, importers, India economy, Indian consumers, Indian banks, Indian enterprises and Indian/overseas investors. In this part we will mainly see the impact on major export industries and in the next part we will see the impact on others.

In general, an interest rate hike dampens growth rate by squeezing liquidity (more money is absorbed by bank deposits, bonds and other fixed instruments) and make credit unaffordable (businesses have to pay more money on the loan). An exchange rate hike rate will discomfort exporters and help importers leading to a more bigger trade imbalance, and might again dampen economic growth. But, when we have to choose the lesser of two evils, the choices are not so clear. A point to be taken is between 1970s to 1990s when Rupee tumbled so much, did our exporters become very strong?

Exporters: In general exports go down as Rupee rises against the dollar. Why? For example, you make a car for Rs.2 million in India, at an exchange rate of Rs.50 to a dollar you can export and sell it to US or other countries at $5,000 (Rs.2.5 million) and still make a Rs.500,000 in profit. But, what if the exchange rate changes to Rs.40 to a dollar? Now, you cannot sell it at $5000 and might have to increase the price to $6250 to make the same margin but face a tougher competition against other country exporters who might sell for $6000 or something, or sell it under $6000 to gain the markets but lose the profit margin. In both the cases, the exporters are to lose, if you assume that the car will be made at the same Rs.2 million independent of the exchange rates.

But, this is where nominal and real exchange rates come into place. To put it simply, if the exchange rate changes there will be some impact on the price of production of the car. The movement from Rs.50/$ to Rs.40/$ will reduce inflation and can reduce the wage rises and domestic production costs. More importantly, you could import the components like engines, tires and steel bodies far more cheaply and the production of the car might fall much below Rs. 2million if other things are equal. The converse is also true, a runaway inflation and high import costs can offset whatever gains exporters get from a depreciating rupee as seen in the previous 20 years. Thus, if the central bank manages appropriately, the rupee appreciation can help a lot of sectors to get stronger, though in the short term they will be squeezed. In effect it is sector specific - the dependency of a particular sector on imports and domestic wages.

India's main exports include - Petroleum, Gems and Jewellery, IT services & Software, Textiles and emerging sectors like Auto, Pharma and Electronics.

Petroleum and Chemicals: India is oil poor, but still Petroleum is one of its top exports. Weird is it not? Iran imports good amount of its gasoline from India. Its primarily because of the Administered Pricing Mechanism for oil, where oil distribution companies have to sell things at a loss while private refiners are under no such compulsion. Result: private refining companies like Reliance and Cairn sell or plan to sell most of production abroad earning their actual value, while public sector companies like IOC and BPCL stand like losers. Politics apart, this indirectly helps India to have a very good refining capacity and become a good power in petro chemicals. But, this industry is not going to be much affected by exchange rate hikes as most of the export component is imported thus, profit dents will be marginal at best.

Gems and Jewllery: India is a market leader in Diamond cutting and polishing and one of the top makers of Gold jewellery that is mostly consumed at home. Since, gold and diamond are mostly imported like petroleum, this sector is not much affected. Even more, the industry being labor centric is also sensitive to wages (of skilled artisans) that could be affected by inflation. Thus, if inflation is dampened by exchange rates, thereby reducing wage rises the net effect on this will be very close to ZERO. And the domestic consumption is very high for these gold and diamond sectors to cushion any significant drop in overseas markets.


IT Services and Software: This is my favorite industry :) and if this industry is impacted who cares. There is much more cushion and slack in this industry than any other India's export industry and whatever perceived competition of China, Vietnam etc, they are not gonna be too soon to take advantage of this currency appreciation. This industry has its own problems like runaway wage appreciation and talent shortage, and compared to them exchange rate is still a minor thing. $1 still equals Rs.41+ and in India even now Rs.10000/month ($250) can earn a reasonable middle class living for a family of 4. So, most people demand more wages just because the companies could afford to give it. Surely, the current condition of an IIT professor or the Prime Minister receiving lesser wages than some startup junkie moving one file from this computer to another is not a perpetually sustainable one. And the sector is fat enough from a lot of tax holidays. Time for milking this holy cow.

Since, this exchange rate uniformly applies to all Indian IT companies they can uniformly cap wage hikes and with a very good margin they can still thrive in the competition. Thus, this sector does not deserve much merit in including for exchange policy settings and surely if Indian IT companies die out in competition, exchange rate will be the last thing in the post-mortem list.

Textiles and Leather: By far this is the export sector that is gonna be receiving the biggest blow. Not much of the components are imported, though some part of the sector is labor centric thereby benefiting if a lower inflation comes out of stronger rupee. But, for now the 500 pound gorilla (Chinese exports) is held back till next year due to export caps and China itself is facing currency appreciation, wage rises, reduction of tax benefits for exporters etc. So, the competition will also be slightly scaled back (relatively). But, being labor centric and producing $25billion+ this industry merits serious attention from the Indian government and sector specific sops and tax holidays apart from investments in new design could be promoted by the government.

Emerging Industries: These include Auto, Electronics and Pharma where India is not a major power yet but have a good future. We export a good amount of design and we still dont have much competition as we operate in a niche. For example, Indian pharma companies have established themselves as leaders in Generic drugs, in Electronics we operate on chip design etc and Auto we are into designing reliable components. In my opinion, we still have more margins to be worried about immediate exchange rate crisis. If the government sets up a proper environment and enables progressive policies, this sector can go far beyond the current level and the government must step up huge investment in these sectors that in the future could become cash cow for us. Personally, I would like the government to shift tax holidays and sops to these industries from the IT services and software, as the latter has matured enough.

Tourism and Services: Finally tourism. Again, the asset prices affects hotel rates so much that it is far more cheaper to stay at Manhattan than a rundown Bangalore, even in dollar terms. So, the asset prices have to be cooled to make India a good player in tourism and exchange rate appreciation will reduce the cost of buying planes and fuel for airlines, making India travel cheaper and competitive. And we have far more potential to be achieved in sectors like Medical tourism and cultural tourism, apart from NRI tourism, so this sector has only one way to go (up).

Is RBI handling inflation correctly? Part 2

In part 1, we saw the overheating phenomenon in India and why RBI is pushed into action. In short, consumer inflation is just part of the story, most important danger lies in the asset price appreciation that pushed RBI to take hard steps. So, what is inflation? In this part we will see how the central bank controls the two main entities - interest rates and exchange rates that affect inflation. This part will be more about inflation theory about the two main tools of a central bank.

Inflation is the classic condition of more money chasing few goods, and it means that the value for the currency you hold is having less value than what it used to be. There are four main components - domestic production, exchange rates, interest rates and consumption rate. Here interest rates (atleast short term) are more of an independent variable controlled by the central banks, domestic production depends on this and entrepreneurial skills + healthy conditions, exchange rate is semi independent in some countries controlled by government while it has to be really proportional to domestic production and consumption rate is dependent on people's psychology and all other variables. Together the effects end up at the consumer when he sees the high price and calls that inflation. Actually, it is just an end product of a whole deal of complex dependent and independent variables. Let us briefly look at each of them.

Interest Rate:

Interest rate is fairly direct. I giveup today's thing to you in anticipation that you will give me something better tomorrow. So, I pay you $10 today and expect you give me $11 back after a year. Here I have $10 available readily, and the other guy has expectation of making atleast $1 in the year's time. The $10 ready availability is called liquidity and the $1+ that he could make with this is called productivity. Now, if the system is perfectly elastic, and I now have $20 still I can loan it to him fully and get $2 back and so on, indefinitely. But, real systems are seldom elastic. At somepoint, the other guy cannot take all my money and still make enough money to give me the interest. At the that point the interest rate starts climbing down. Thus, in global bond markets (that is essentially a market for trading loans) as liquidity increases interest decreases. Conversely, if there is a credit crunch where I dont have $10 even and none of the people have it then the interest rates increase. But, there is a limit here, at some point the producer cannot give enough interest to you without raising prices so much or go out of business.

In the first case, when there is excess liquidy, the money fetches lesser interest rates in the long term, and this makes somepeople to not giveup today's comforts or they go for other sources of making money. Henc, they buy up junk instead of loaning the money and this causes inflation and asset boom. In the second case, the increase in interest rates causes the end products to be costlier and drives up the interest. Thus, inflation can be a resultant of both over liquidity and under liquidity - Damned if you do. Damned if you dont! This is where the central banks enter the system. They first establish some mechanism in which the markets are dependent on them and keep this as an handle. For example, they always give banks the short-term loans (they can print money at will and destroy it when they get back) and mandate the banks to keep some of their long term loans with them and this is the great way in which hold control. And even more, since they are the most trustable business system (they print currencies) they can setup some rate for taking medium term loans from other people (these are called treasury notes or bonds or T-bills) and many people keep atleast some portion of assets in these instruments as they are the safest.

So, now they have a full handle on the system. On one end they can get money from people at pretty low interest rate and on the other end they can loan short term money to banks at any rate they choose, as they print money. So, if the liquidity goes beyond a certain limit, they start issueing more higher rate treasury notes and increase short term interest rates so that people will put more money into governments and take less money from them. Thus, contrary to what we expect, liquidity forces T-bill interest rates to go up, while the rest of the interest in other long-term instruments that offer at more interest rates might fall if they dont find enough takers. This is what currently happening in the US. Long term bond rates have fallen and short-term T-bills have increased for a while now. At some point, the yield curve will be inverted, short-term loans fetching more interest rates than long-term loans.

Now, what if there are enough takers for the loans. Then, both T-bills and long-term rates go up, and this is essentially not an over liquidity situation but actually a liquidity cruch (more demand than supply of money). This is what happening in India. Whether RBI had increased rates or not, the banks would have increased the rates, as there were more demand for loans than more supply of deposits. This is actually a healthy condition IF the loans were absorbed by the producers implying we are having rising productivity. But, most of the loans were absorbed by stupid consumers who bought houses and depreciating assets out of them, thereby not causing any increase in productivity. With the natural increase in rates these people will be priced out, but in a dramatic change of fate we will have higher inflation as the interest rates will cause producers to mark their prices up or else lose margins. The first will cause inflation, second will cause market crash. In some sectors (steel, oil and cement) Indian government deliberately muscled in to cause the second.

In short, interest rate is a function of liquidity and productivity, and we are actually having a liquidity crunch in many sectors causing interest rates to spike which will also puke up the sectors that have been gorging money, like housing and auto loans. While, this could increase prices in the long term, it will reduce demand in the short and medium terms and cause asset depreciation thereby cooling the system.

Exchange rates:

Exchange rate control how much one good should be exchanged for to get another good, in a open market. For example, in a closed system if a farmer produces 10 kgs of rice and a gatherer produce 5 kgs of firewood, they both can exchange stuff on some fixed mechanism, say 1kg rice = 0.5 kg of firewood, so that both benefit from other's stuff. Now, if the farmer could produce 20kgs of rice, can he get 10 kgs of firewood from the market in this closed system? The answer is no. So, now the exchange rate would be adjusted such a way that 1kg rice = 0.25 kg of firewood. Thus, the price of firewood is said to be inflated, whereas it is actually the production of rice that is inflated 10 to 20kg and as a result its dependent exchange mechanism got changed. This is ECON 101.When you produce something more than the exchangeable limit, its value keeps going down and this is the natural process by which economies readjust and make things that are more valuable and productive. In the closed system case, the farmer could focus more energy on gathering some firewood too instead of overproducing rice.

This is all in open market (in 2 person system it ought to be), but are they true in complex real world markets? Not necessarily. The farmer can keep producing his 20 kgs of rice and then give it to the gatherer at the same exchange rate and each time he will get 5 kgs of firewood and 5kgs of firewood in I Owe You notice, which means he writes a paper in which he says he has to give the farmer 5kgs of firewood later (and in this closed case, it is impossible unless he finds a way to dramatically improve the yielf of firewood). This is the farce that is currently going on in the pegged exchage rate system done by Japan, China, Europe and others including India. Instead of allowing the exchange rate of Yen/Renmimbi/Rupee to Dollar (rice to firewood) to flow by natural process they just keep getting the stupid IOUs that the gatherer (USA) has no intention of paying back. But, it doesnt matter: by the time the crisis occurs the old men in the central banks would have died leaving us all in the jeopardy.

Now, what we like many other central banks have been doing is to keep getting IOUs from US (called dollars and T-bills) and right now we have more than $200b worth of them. This whole money has not dont much good to the country and it has just made the exporters like IT sector filthy rich. The appreciation of rupee could have reduced the cost of imports and increase rupee's value threby reducing inflation. But, instead of allowing rupee to appreciate when we got billions of dollars from investments and exports, what RBI did was to print trillions of rupees of money and got the dollars from the exporters and FIIs. Thus, our money supply went up by many trillions (2 to 3) in the last few months just because of this. In effect, indirectly we were subsidizing FIIs and exporters by putting domestic people to strain. And this has currently been stopped for a while, thereby appreciating the currency.

In essense, RBI is currently doing the right thing of allowing the rupee to float freely and the markets determine the exchange mechanism instead of just gorging on the dollars, that might not have any use if US falls.

So, how this twin effect of interest rate hike and exchange rate appreciation going to impact us? That's in part 3.

Is RBI handling inflation correctly?: Part 1

Nowhere in the recent economic history of India, has an issue that is so well debated and polarized as the inflation/ overheating debate going on India circles. Now, the question has changed slightly from "is India overheating" to whether Indian central bank (RBI) is correctly handling the overheating. Inflation has spiked from around 4% to over 6% now and RBI has recently gone through a round of interest rate hikes that pushed the interest rates from around 7% last year to over 13% now. Simultaneously, it has hiked the reserve rates (that will prevent banks from giving more loans) and allowed the rupee to appreciate against the dollar. As the stakes in Indian economy are growing bigger and bigger, different parties are taking sides on what are the implications of the policy. The market has voted with its foot by crashing the Sensex (it has recovered partly though as i write this) and analysts have smashed the policies. I myself have written a couple of articles arguing against the RBI's policy. Here, I'm giving the other side of the picture. So, what is happening and what will be the implications on various parties concerned - Indian poor, middle class, corporates, exporters, government, foreign investors?

Great Indian Growth:
First, what is happening? India is on a big boom cycle since 2003 and a lot of people have come to begun that the time has come for India to get to the center stage and rightly so. The growth rates have gone up over 9% from a dormant 6% rates 3 years ago, and the efforts of reforms during the previous regime is finally paying off. The fundamentals look good - a nation with atleast 250 million people with reasonable spending power, a vast network of well bred universities (atleast 25 of the institutions are now in the elite category, including the IITs, IIMs, AIIMS & IISc), a great history, center of major trading routes in Asia, and a vast network of expatriates providing free diplomacy and act as conduits for knowledge and economic exchange. India is simply in the best possible position for development, so far, and here is the link for India's scorching growth prediction.

Oh no... not so soon. However, too many things happened and the growth was simply too fast for the system to handle and the overheating signs have been showing its ugly teeth now. 6% core inflation shows nothing and honestly, I believe the RBI doesnt care as much about that. What is dangerous is a precarious position in asset markets. Indian infrastructure and housing development, along with even good corporate stocks, couldnt withstand a sudden barrage of this huge money flood. House prices in Indian major cities have gone up by over 300% in 3 years, stock index appreciated over 300% in the mean time, real-estate and commercial property have gone up by over 5 times in a few places, and all these dwarf the 6% core inflation rate that is mainly showing global inflation in commodity prices. And all these were fed with cheap credit, and loan growth is at a dangerously high 30%/year. The condition is really risky now.

Indications of overheating:
Housing: Rocketing house prices where people are willing to pay $200,000 for some second-grade apartments in not-so-good localities when the country's per-capita income is just around $1000/year is definitely a scary sign. To put things in perspective, in Seattle (the home of Boeing, Starbucks, Amazon and Microsoft) good apartments in nice localities can be got for $400,000 when the median household income is over $100,000, and people fear overheating here! So, the hard-earning middle class is priced out, while a lot of people have dangerously accumulated huge amount of loans to buy white elephants. In the last 1-2 years RBI has issued a lot warning regarding this situation, and asked banks to cool down housing loans, but banks have not turned their ear to it.

Real Estate: Its not just the houses that are too expensive. Commercial property is an unexpected peak where shady locations in Bombay and Delhi seek prices that would shame even Manhattan. This has affected expansion plans for many hotels (nation of India has less hotel rooms than the city of New York), many companies are holding their plans to open offices in Mumbai and Bangalore, and even retailers are affected by this skyrocketing prices. At some point the cost of doing business will cross a tipping point, and India will no longer be a favourite service/production outsourcing even with low wages, if we dont address this real-estate quandary.

Stocks: And the stock markets have been affected by this irrational exuberance. While the fundamentals are definitely good, the prices (in terms of P/E ratios) are really high for an emerging country, enough to price out many serious investors. And a lot of investment is in the hot-money section (foreign institutional investors and domestic buyers trading on margin) that could vaporize at a degree above room temperature. While, a good stock appreciation encourages the corporations to expand more, over-appreciation and over-hype could cloud us on crucial things like efficiency and cost-management, and over-paying on unworthy assets like what the Japanese did in 1980s. It is time for some correction to more moderate levels (probably around the 10-11K region in the Sensex).

Savings: For an Asian country, India's saving rate is not impressive. While, the Europeans and Americans have social security and good nets (comparatively) and the Asians have good domestic savings, Indians have neither. India is on a complete blow-out cycle, learning to spend from the Americans, before even they have learnt to earn from them. Personal credit growth is rocketing, and unlike their previous generation, people are not afraid to go on big loans for flat-screen TVs and unaffordable houses. Automobiles are overcrowding before the roads are even built and Indian researchers are worrying more about obesity and cholestrol than hunger and poverty! Indian domestic consumption as visible from rocketing non-oil imports have also caused the current account deficits to zoom (imports much greater than exports) inspite of a healthy growth in export industries like IT, Auto, Pharma and Chemicals. Indians are currently just over-consuming and a developing country cannot afford to have deficits for long.

Thus, the current overheating, if left unchecked, could rock the Indian boat and the Japan's painful experience from over-exuberance in 80's and America's experience in 90's should not be forgotten. Brimming prices of Housing, stocks, commercial properties and runaway loan growth has already given enough indications that the supply-side pressures from agricultural commodities, oil and metals are just an excuse for the inflationary pressure. RBI has got nothing to do with these latter things, and the solutions are pretty simple and are with the government: Liberalize sectors like power, mining and agriculture and you would see the same benefits. But, we are not arguing about these core principles for now, and RBI with its monetary stick is tackling the runaway overheating than core-inflation with interest rate hikes. Commodity inflation is just a pretext for RBI to pull the government to take action (governments are the biggest beneficiaries of inflation and low interest rates, as they are usually the biggest borrowers). If RBI is even half as intelligent as I would assume them to be, they would know that monetary policies cannot control commodity inflation (no one is going to stop eating food because you increase interest rate by 0.5%) and so it should not be a secret that the recent measures are more against over-heating fears than CPI per se, what many analysts assume it to be.

In the next part let us see, how the current measure are enacted and in the third part how it will individually affect the various players in the game (including us).

(This article has been included as an Op-Ed in Asian Development Bank's E-Newsline)